European Debt And The Spanish Middle Finger


Highlights This Month

Read this month’s commentary in PDF format.

 
The NWM Portfolio

Overall, June was a “risk on” month, with most asset classes ending the month in the black.

Bonds maintained their remarkable run with the NWM Bond Fund ending up 0.1% – a small gain, but still positive. Bonds were all over the map in June, but ended the month near where they started.

Mortgages continued to be rock solid in June, with the NWM Primary Mortgage and NWM Balanced Mortgage funds increasing 0.6%. We expect the Balanced Mortgage Fund to start out-pacing the Primary Mortgage Fund in the coming months, as it becomes more fully invested.

Canadian equities were higher in June with the S&P/TSX gaining 0.7% (price return not including dividends) and the Strategic Income Fund 1.5%. Year-to-date, the S&P/TSX is down 3.0% (-1.5% including dividends) while the Strategic Income Fund is up 2.6%.

Our running yield in the SIF is just under 6.00%. We hope to move this a little higher by re-writing some more covered calls in July. We sold our position in Whistler Blackcomb as we are concerned that snow conditions can only get worse next year. We also sold our position in Canadian Oil Sands as we are concerned that their high distribution is at risk.

Other sales include Primaris, sold out of the REIT Fund, and Progress Energy, which is being taken out at a handsome profit. We have established a new position in Black Diamond, a supplier of modular housing units to the energy patch.
  

JUNE IN REVIEW

Equity markets were mainly higher in June with the S&P/TSX gaining 0.7% while the S&P 500 and Dow rose 4.0% and 3.9% respectively.

While overall returns were positive, trading in June was choppy, mainly due to headlines coming from our old friend, Europe. Perhaps the volatility is best exemplified by the trading pattern of Spanish 10-year government bonds over the past couple of months.

It is one of the first things we look at in the morning and is usually a good indicator of the direction the markets likely will follow the rest of the day. If Spanish yields are headed lower, equity markets are likely headed higher as traders switch into “risk on” mode.

When yields are rising and peak above 7%, traders around the world become very nervous as Spain looks to be headed for a bailout. As can be seen in the chart below, traders really didn’t know what to think in June, which is understandable because most European policy makers didn’t either.

Of course, we can’t start any discussion about Europe with checking in with Greece. It is ground zero when analyzing the problems facing the Euro-zone.

As hoped, the New Democracy party won the most seats in the June 17 election, though just barely, and was able to form a new government with the support from two other parties. The coalition generally supports the existing bailout and doesn’t want to risk getting kicked out of the Euro, but they do hope to gain some concessions from the bailout’s harsh austerity terms.

Basically, they don’t want to undertake massive public sector layoffs and would like a two-year extension to meet fiscal targets set out in the bailout package. They are pleading their case, but many worry the new government won’t last long enough convince their Euro-zone paymasters that they’re serious about reform.

Global equity index MSCI has seen enough already and recently reclassified Greece as an emerging market, making it the first developed country to be cut to developing market status – a huge embarrassment. In the theory of economic evolution, it’s not supposed to work this way. Greece, the cradle of democracy, continues to head in the wrong direction.

There is no easy solution for Greece. Less austerity won’t solve their problems. Greece needs to become more efficient. They can blame Germany all they want for demanding reforms and austerity measures in return for bailout funds, but if Greece wants to truly increase their standard of living, they are going the have to work more like Germans, and this is not going to be easy.

In a recent survey conducted by Pew Research Center, Europeans were asked which EU nation is the most hardworking. Every country in the poll identified Germany as the hardest working nation, with the exception of Greece, who felt they were. Greece, in fact, was the most popular choice for least hard working nation.

Interestingly, Greece did identify themselves as the most corrupt nation. Hardworking, but corrupt.

Euro-Zone, Euro Cup

Ironically, real life drama between Greece and Germany was played out on the soccer pitch recently when Germany and Greece met in the quarterfinals of the Euro 2012 tournament. While most Germans viewed the game as, well, just another game, German newspapers couldn’t resist taunting the Greeks with headlines such as the one below.

For their part, Greeks viewed the match as a personal vendetta, believing that it was German Chancellor Angela Merkel herself their team would be shooting against. In the end, for all the Greek strikers knew Merkel could have been in net, as they rarely got close enough to the German end to see that national team keeper Manuel Neuer was, in fact, in goal.

To be fair, it wasn’t just the Greeks who were taking a few shots at Germany and Angela Merkel. Unfortunately for the Irish, they ended up going home to work much sooner than they would have liked.

Germany’s path to the Euro 2012 championship was remarkably similar to its current financial struggles in the Euro-zone. After dealing with Greece, they needed to defeat Italy in order to face Spain in the final. Unfortunately for Germany, they were done in by two Marios.

While two first-half goals by Italy’s Mario Balotelli resulted in Germany’s defeat on the soccer pitch, it was another Mario, Italian Prime Minister Mario Monti, who was able to defeat Germany, and more specifically Angela Merkel, at the 27-nation EU summit in late June.

While Italian newspapers were jubilant over the Mr. Balotelli’s two goals and the Azzuri’s victory over Germany, traders were busy cheering Mr. Monti’s efforts.

Spanish Bonds Sell Off Dramatically

On June 18, despite the positive election results in Greece, Spanish bonds began to sell off dramatically, with trading patterns exhibiting what technical analysts referred to as the “middle finger formation.” Traders began dumping Spanish bonds, fearing the necessary €100-billion injection into Spanish banks would ultimately result in Spain itself needing a bailout.

When Germany’s Merkel appeared to cave in to pressure from Mr. Monti and friends and agreed to allow bailout funds to be injected directly into Spanish banks, Spanish bonds began to rally. Lending to Spain (who would then lend to their banks) rather than directly to Spanish banks would just add to Spain’s national debt and reduce their credit worthiness.

Merkel also agreed that any aid given to Spanish banks wouldn’t be senior to normal Spanish government debt in the case of a Greek-like restructuring. Investors had been dumping Spanish debt, fearing they would get subordinated in a future restructuring, like had happened to Greek bond investors.

Finally, Merkel appeared to give the green light for the new Euro-zone bailout fund, the European Stability Mechanism (ESM), to buy sovereign bonds. In return, Merkel secured support for a single supervisor for banks in the 17-nation Euro-zone (equivalent, in our opinion, to the last minute penalty kick Germany was awarded against Italy).

Capital markets reacted positively as the moves were seen as a sign that maybe Germany wasn’t as resolute in their positions as feared and could eventually become resigned to its fate as co-signer on the loans of other European nations.

The positive impact was short lived, however. As with most Euro-zone agreements of late, it was vague and lacking details. The new ESM bailout fund was deemed too small to be effective and unable to inject capital directly in to banks until the central Euro-zone bank supervisor is set up, likely in the second half of 2013.

Even worse, there is some speculation that countries whose banks receive loans would still be required to guarantee the loans. Germany wouldn’t be co-signing any loans. In fact, Merkel was quoted as saying that Germany would never agree to issuing Eurobonds as long as she lived.

Even though the concessions may prove to be minor at best, it did send the message to countries that had already received a bailout, namely Germany and the ECB (the European Central Bank) may be open to re-negotiate after all. To Greece, Portugal, and Ireland, it appears Spain is getting a better deal than they did.

It seems to be one step forward and one step backwards for Europe. Just when you think progress has been made, details later emerge that we are really back to square one.

Namely, Germany is pushing for reform and fiscal unity while the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) battle for concessions and more time. I mean there have been 20 summits since the Euro crisis began and we are no closer to a resolution!

In the meantime, the European economy is heading for recession. The Euro-zone purchasing manager’s index was 44.8 in June, well below 50 and indicating a contracting manufacturing industry. Even Germany saw its PMI decline to 44.7, a three-year low.

Spain’s PMI declined for a fifth straight month, coming in at 41.1. On July 5, the ECB cut overnight rates 25 basis points to 0.75%. This will help, given many struggling Southern European banks that are heavy borrowers from the ECB. It won’t solve the problem, however.

The solution the market is waiting for is Germany stepping up to the plate and supporting Spain and possibly Italy’s debt. Just the prospect of this is happening is causing German bonds to lose some of their safe haven premium.

Germany is going to have to take one for the team, or the team could fall apart.

Problems in Europe mean problems in China. Historically, nearly 22% of Chinese exports have found their way to Europe, an amount comprising 5.6% of China’s GDP. Chinese industrial production increased 9.6% in May, but many feel this number may be inflated by over-zealous local officials.

Electricity production (generally seen to be a more accurate indicator of economic activity) was up 2.7% versus last year, while China’s June purchasing managers index came in at 48.5 – below 50 and thus indicating the manufacturing sector is contracting.

It was hoped China would take over from the U.S. consumer as the engine of world economic growth. Unfortunately, it’s looking more like the rest of the world is dragging China down with it.

China’s not going down without a fight, however. Slated to undergo its once-in-a-decade leadership transition this fall, the last thing China wants to deal with is a hard economic landing.

Since the beginning of June, China’s central bank has cut interest rates twice and has recently shown signs of relaxing controls on the property market. Construction alone accounts for about 11% of China’s GDP and closer to 20% if related industries like appliances and furniture are included.

Already real estate prices are starting to pick up, with the average home price in 100 major Chinese cities increasing in June after nine straight monthly declines. China is also ramping up investment spending by state-owned companies, a tried and tested way to maintain economic growth in times of global turmoil.

During the depths of financial crisis in 2008-2009, China invested more $1-trillion USD in infrastructure spending. Many claim the fallout from this massive monetary expansion was a property bubble and bad loans.

It is unlikely they will need to go to the same lengths this time around, but dubious projects, like the recently awarded $11-billion USD steel mill by state-owned Baosteel Group, are getting fast tracked.

First proposed 15 years ago, the plant is now slated to go ahead despite the fact the steel industry is presently losing money. Perhaps not the shrewdest investment in the long term, but it will help keep the economy growing in the short term.

China knows it must evolve away from relying on export growth and cheap labor, and move towards a more consumer-led economy. Given the state of the global economy, however, this might not be the time to do it.

Like China, the U.S. is also faced with a potential regime change this fall. And, like China, the U.S. is fighting as hard as it can against the evil forces of deflation emanating from European shores.

Economic growth in the U.S. has slowed. The Federal Reserve recently acknowledged this by lowering their GDP growth forecast this year by 0.5% to a mere 1.9%. They also conceded unemployment would remain above 7% until at least 2014.

In response, the Federal Reserve announced on June 20 that they would extend their “Operation Twist” program until the end of the year. More importantly, they also signaled they were prepared to take further action if progress on the job front isn’t made.

But what exactly can they do? Cutting short-term rates like Europe and China is not an option. Been there done that. Rates are already zero.

Even extending Operation Twist is getting tough. The first stage of Operation Twist resulted in using the proceeds from maturing securities held by the Fed to buy $400-billion in treasury bonds with maturities ranging from 6 to 30 years in hopes of driving longer term-rates lower (and juicing up the stock market).

The recently announced second stage will result in the purchase of an additional $267-billion in long-term treasury bonds. When the buying is finished in December, the Fed won’t hold any securities maturing before January 2016. Cross another item off the Fed’s playbook.

Remaining options in the playbook included another round of quantitative easing, where by the Federal Reserve would buy more bonds or mortgages and add them to their $2.5-trillion portfolio, or pledging to keep short-term rates at zero beyond the current promise of 2014.

If the economy continues to fall, the Fed will be under a lot of pressure to act, but it is uncertain whether it will do any good. Really, the Fed has done enough. We would argue they have actually done too much.

It’s time for Congress to step up and show some leadership by dealing with the short and long term fiscal imbalances in the U.S. economy.

Bond markets are focused on Europe right now, but the U.S. has a debt problem too. Because the U.S. is the world’s reserve currency and can print and borrow as much money as it needs, the bond market is giving them a free pass, for now.

The same, however, cannot be said for individual states and municipalities. A state can’t seek bankruptcy protection in Federal court, but a municipality can, and are. Three municipalities in California have filed for Chapter 9 bankruptcy protection in the past month, including Stockton – at 300,000 residents, the largest U.S. city ever to go bust.

Extravagant public pensions are a major catalyst, as depressed city revenues can’t meet obligations negotiated during better days. California itself would love to follow suit.

Economically gifted, California ranks tops in the U.S. in technology, agriculture, and entertainment, and has a pretty good climate to boot. Unfortunately, it’s also a welfare state run amok with almost half of all residents paying no tax.

It is the Greece of the United States and a sign of things to come if Congress doesn’t get its fiscal act together. They can’t go bankrupt, but they can continue to raise taxes and force corporations to re-locate to more tax-friendly states.

Overall, Europe is bringing the rest of the world down by reducing investor confidence and the result is slower global economic growth.

But don’t kid yourself: Europe is not the only one with a debt problem. The whole developed world will eventually suffer the same fate unless action is taken.

The U.S. Economy

A slowing global economy took its toll on U.S. manufacturing in June with the ISM Manufacturing Index falling below 50 (the threshold between a contracting and an expanding manufacturing sector) for the first time since July 2009.

With the exception of the Chicago PMI, most other regions confirmed the decline in manufacturing activity in the U.S.

With just 80,000 new jobs created in June, the U.S. job market continues to disappoint.

After a strong start to the year, only 225,000 new positions were added over the past three months, less than January alone. The unemployment rate remained at 8.2%, but the “marginally attached and involuntarily part time” number increased slightly to 14.9%.

The average length of time America’s 13 million unemployed workers have been looking for work is nine months. 28.5% have been looking for over a year. And these are just the workers that claim to be still looking.

The percentage of the working-age population either working or actively looking for work has declined to a 30-year low of 63.8%, as discouraged workers have given up looking for work.

And no age demographic is more discouraged than workers in the 45 to 64 years of age category. At a point in their careers when they are supposed to be in their prime income earning years, more than 3.5 million “middle-aged” workers in the U.S. find themselves out of work.

While the unemployment rate for the 45-64 year group is only 6%, much lower than the hard hit youth category, it takes an average of almost a year for many senior workers to find a new job. When they do find jobs, it is usually for less money, which is a problem, given older workers tend to have higher financial commitments.

There are also more workers in this age category, such that unemployed middle-aged workers out-number those aged 16 to 24 years of age in absolute terms. Hurting middle-aged workers, is their reluctance to change industries and take an entry level job in a new field – understandable given the investment they have made in learning their trade.

Unfortunately, given they started their careers years ago, they are more likely to be in “old tech” industries that are in decline and where there are fewer opportunities or alternatives. Many of these positions have be automated or moved offshore.

It’s a tough spot to be in. Some of these workers will never work again. At least not for the kind of money their lifestyles had grown accustomed.

Faring better are workers in the personal services industry who perform functions that can’t be automated or performed remotely. Also doing well, are what are referred to as “top of the pyramid jobs, such as managers and professionals.

Between 2007 and 2010, the number of jobs in the U.S. has declined by 6%, with the middle skilled positions (those most at risk of automating or offshoring) declining by 12%. Higher end jobs declined only 1% and personal service jobs actually increased 2%.

Of course, off-shoring and automating has been happening for years. The recession just compounded the hardship.

All this is bad news for President Obama, as no incumbent president has been able to keep their job when the unemployment rate has exceeded 7.2%, and it is a virtual certainty the unemployment rate will be higher than this come November.

Private companies are just not creating enough new jobs. While layoffs are back down to pre-recession levels, hiring remains sub-par. Global staffing firm ManpowerGroup reports only 21% of U.S. companies plan to hire new workers in the third quarter, a similar level as last year.

While core CPI and PPI remains stable, headline inflation continues to decline, mainly due to lower commodity prices. If the global economy continues to slow, commodity prices could continue to decline and eventually core CPI will move lower.

So far, however, this has not happened, and while there is certainly enough slack in the economy to make the case for deflation in the short term, we remain cautious over the prospects of higher future inflation given the significant monetary easing conducted by the world’s central banks.

Conference Board consumer confidence declined for the fourth consecutive month while the University of Michigan consumer confidence index declined to its lowest level of 2012.

Weak consumer confidence usually translates into weak consumer spending and this is what we saw in May and June.

Excluding auto sales, May retail sales were at their weakest level since May of 2010 and flat same store sales in June mean retailers shouldn’t expect an improvement any time soon. High-end and luxury retailers did better, but mainstream retailers like Costco, Target, and Macy’s came in below expectation.

While it’s too early to be worrying about the important back to school shopping season, retailers may start panicking if sales don’t pick up soon.

Unlike the rest of the economy, the recovery in the housing market remained on track in June. Existing home sales were marginally lower, but prices were firm. Pending home sales were also strong, indicating that sales over the next few months should move higher.

What is encouraging for the economy in general, is new home construction continues to show signs of life. Housing starts are up over 28% compared to last year and a strong increase in building permits indicates future construction and jobs are on the way. Multi-family construction is particularly strong – understandable, given the robust rental market.

Perhaps one of the best indicators that the housing market has bottomed is the decline in the inventory of homes for sale. Inventory of un-sold homes consisting of six months of sales is normally consistent with a balanced market.

A 6.6 month supply of pre-owned homes and a mere 4.7 months of new homes, looks pretty good. But what about the dreaded “shadow inventory,” foreclosed homes now owned by the banks and slated to hit the market and eventually drive prices lower?

It’s still a concern, but less so. The shadow inventory peaked in 2010 at 2.1 million homes, but has since declined 28% to 1.5 million. At about four month’s supply, the shadow inventory is at its lowest level since October 2008.

It’s not just Americans that are helping drive the inventory of homes for sale lower. Foreigners are finding a weak U.S. dollar and bargain prices an opportunity to own a piece of the American dream.

In the previous 12 months ending in March, 8.9% of residential real estate buyers in the U.S. were international buyers with 55% coming from Canada, China, Mexico, India, and Britain.

Of course they weren’t just buying anywhere. Over half the purchases were confined to the states of Florida, California, Texas, Arizona, and New York. And who can blame them.

The trade deficit declined in April, but for all the wrong reasons. With both imports and exports declining, it is clear the economic slowdown in China and Europe is hurting international trade.

The only good news is slower economic growth has translated into lower commodity prices. This should help put extra cash into U.S. consumer pockets as energy prices decline.

A bigger concern, however, is that a decline in global economic growth could lead to an increase in trade protectionism as nations under take a “beggar thy neighbor” policy.

This is already evident with currency manipulation, but an independent monitoring group has recently warned of a spike in protectionist measure with at least 110 new incidences reported since last November. Since November 2008, the EU is the leading culprit followed by Russia and Argentina with China surprisingly topping the list of victims.

At the beginning of the year, we optimistically highlighted three segments of the U.S. economy that were turning the corner: manufacturing, employment, and housing. At the moment, only the housing sector is living up to expectations.

Hopefully it’s just a soft patch, but manufacturing and employment have stalled.

 
The Canadian Economy

 

GDP growth was solid in April and leading indicators were strong.

Manufacturing was mixed, with the RBC PMI indicating a positive trend while the Ivey PMI decelerated. Both were still in positive territory, indicating that manufacturing is still growing in Canada, unlike many other countries in the world.

We suspect this is only temporary and manufacturing in Canada will follow global trends lower.

At just over 7,000 new jobs, job growth in June could hardly be described as robust. It was higher than expected, however, and follows a strong April and solid May.

The unemployment rate ticked down a notch, though mainly due to a decline in the number of people in the labour force.

Headline inflation moved substantially lower in May, mainly due to lower gasoline prices. Core inflation also declined, but most analysts believe the move below 2% to be an outlier. It does give the Bank of Canada a bit of breathing room with interest rates, however.

Given the recent change in mortgage rules and soft global economy, it is unlikely the Bank of Canada will increase rates any time soon. In fact, the market is currently pricing in a 21% probability the Bank of Canada cuts rates 25 basis points by the end of the year.

The decline in April retail sales offsets the increase in March, pointing to relatively sluggish consumer spending.

Given the high consumer debt levels for Canadians, we wouldn’t expect retail sales to accelerate meaningfully higher in the near future. The unemployment rate appears stable but a volatile global economy should keep consumers wary.

With household debt in Canada hitting a record 152% in Canada and housing prices continuing to percolate higher, Federal Finance Minister Jim Flaherty tightened Canada’s mortgage lending rules.

The maximum amortization period was cut from 30 years to 25 years and the amount of home equity Canadians are able to borrow against without obtaining mortgage insurance was reduced to 80% from 85%.

Unfortunately, mortgage insurance will no longer be available on homes valued in excess of $1-million, meaning anyone wanting to buy a home in Vancouver (which are mostly prices above $1-million) will need to come up with a down payment of at least 20%.

TD Bank Chief Economist Craig Alexander believes the recent changes will have the equivalent impact on the housing market as a 1% increase in interest rates. It’s the fourth change in the mortgage rules in the last four years and shows the government’s conviction in avoiding a housing related crisis like experienced in the U.S. and several European countries.

Prices have started to decline in Canada, but markets such as the over-heating Toronto condo market is still a concern.

Canada’s trade surplus turned into a trade deficit in April as exports declined for the third time in four months. Energy, material and machinery and equipment exports were all lower.

So far, Canada’s economy has shown minimal signs of slowing. Employment is decent and the housing market in most regions remains strong.

Slowing exports, however, highlight our concerns going forward. Slower economic growth south of the border and in China will result in slower growth in Canada. The poor recent performance of the resource heavy S&P/TSX index is indicating as much.