Friday, August 08, 2014 - Rocky Relations

DOW + 185 = 16,553
SPX + 22 = 1931
NAS+ 35 = 4370
10 YR YLD - .01 = 2.41%
OIL + .01 = 97.35
GOLD – 3.90 = 1310.10
SILV - .03 = 20.02

The S&P and Dow both posted their best day since March. For the week, the Dow rose 0.4%, the S&P 500 gained 0.3%, and the Nasdaq rose 0.4%.

The Pentagon says US warplanes have dropped bombs on an ISIS artillery positon in northern Iraq, near Erbil, the Kurdish regional capital. US military planes have also carried out air drops of food and water to displaced refugees. Last night, President Obama announced the plan for assisting Iraqi religious refugees stranded on a hilltop in northern Iraq, and also authorizing limited airstrikes to protect US personnel in Erbil. The air strike is the first time the US has been directly involved in a military operation in Iraq since American troops withdrew in late 2011. No time limit has been set for air strikes.

In very short order, the Islamic State of Iraq and Syria, ISIS, captured one-third of Syria and about one-quarter of Iraq, and they continue to expand their frontiers. Just to put it in perspective, they now control a land mass larger than Great Britain, with a population bigger than Denmark. In northern Syria some 5,000 ISIS fighters are using tanks and artillery captured from the Iraqi army in Mosul to besiege half a million Kurds on the Turkish border. ISIS has also built a huge war chest by looting Iraqi banks of perhaps half a billion dollars, making ISIS the world's richest terrorist organization, by some estimates. And they have been gathering weapons, US weapons left behind by the Iraq army.

ISIS now controls most of Syria’s oil and gas production. In northern Iraq, ISIS now controls a 750 megawatt dam near the city of Mosul. The Mosul Dam is considered one of the most dangerous dams in the world; it was poorly constructed, leaks constantly, and requires near constant maintenance to avoid collapse. In addition to controlling the electric output of the dam, the militant group now has a real weapon of mass destruction, capable of extreme destruction along the Tigris River, including possibly flooding Baghdad under 15 feet of water.

The Iraq army shows no signs of recovering from its earlier defeats and has failed to launch a single successful counter-attack. The only large-scale counter-attack launched by the regular army and the newly raised Shia militia was a disastrous foray into Tikrit on 15 July that was ambushed and defeated with heavy losses. There is no sign that the dysfunctional nature of the Iraqi army has changed. Iraqi politicians have gone on playing political games as they move, ever-so-slowly, towards replacing the discredited prime minister, Nouri al-Maliki.

Iraq’s Shia majority seems to believe the present situation is not as dangerous as it looks. They argue that Iraq’s Sunnis have risen in revolt and ISIS fighters are only the shock troops of an uprising provoked by the anti-Sunni policies and actions of Maliki. Once he is replaced, as is almost certain, Baghdad will offer the Sunnis a new power-sharing agreement with regional autonomy similar to that enjoyed by the Kurds. Despite all signs to the contrary, Shia at all levels are putting faith in this myth.

The foster parents of ISIS and the other Sunni jihadi movements in Iraq and Syria are Saudi Arabia, the Gulf monarchies and Turkey. The rise of ISIS was crucially supported by outside Sunni powers. It’s unlikely the Sunni community as a whole in Iraq would have lined up behind Isis without the support Saudi Arabia gave directly or indirectly to many Sunni movements. The same is true of Syria. The Saudis now seem fearful of the monster they helped create, and they have pulled support from the jihadi opposition, but it may be too late. For the US, Britain and the Western powers, it makes for rocky relations with major oil suppliers. And then, to complicate matters further, Israel and Gaza resumed throwing bombs at each other after a nearly 3-day ceasefire.

You may remember that oil prices had spiked to $108 a barrel in June, but then ISIS failed to attack Baghdad, and ISIS did little that threatened oil infrastructure affecting deliveries outside Iraq, and oil prices slipped. The price at the pump is down 15 cents a gallon since July 4^th; down 35 cents per gallon since mid-June. And now that the US has re-entered the battle, it is widely anticipated that the craziness in Iraq will be defeated and oil prices will stabilize, but it would be foolish not to expect ISIS to retaliate against US aerial attacks.

In economic news today:
Wholesale inventories grew by 0.3% in June, while sales increased 0.2%.

Productivity in the second quarter increased 2.5%, compared with a revised 4.5% drop in the first quarter. Cold weather in the first quarter hurt output, but workers produced more in the spring, proving that 90% of the difference is just showing up. Unit-labor costs increased 0.6% in the second quarter, and inflation adjusted hourly wages were up just 0.1%.

White House economic officials say the labor market is about 80% back to the level before the financial crisis, an indication the economy is steadily healing. It just doesn’t feel that way for many Americans. As the US economy recovers, hirings increase and people are encouraged to look for jobs again; at least that’s how things are supposed to work.  Instead, the ratio of the adult population with jobs, or looking for one; what’s called the labor force participation rate, has been falling, standing at 62.9% in July 2014. This represents a 3 percentage point decline since the financial crisis and the lowest rate since 1978. Gains in participation rates between 1960 and 2000 were largely driven by sweeping social changes such as the post-war baby boom and the entry of women into the work force, but in the past 7 years half of those gains have been reversed; the equivalent of 7.5 million workers have been lost from the US labor force.

The shrinking pool of workers in the job market is due in part to demographic shifts as the boomer generation moves into retirement, but today the International Monetary Fund, the IMF said more needs to be done to strengthen the labor market, raise wages, and bring people back into the labor force. The IMF says up to one third of the post-2007 decline in participation rates is reversible and we need to look at economic policies to turn things around. Suggestions include better job training, employment search assistance programs, affordable child care, and immigration reform.

The Federal Reserve has released a nationwide survey, the first of its kind, designed to get a better understanding of how households view their own financial situation and economic well-being. The short answer is “not so good”. Just 30% of survey respondents described themselves as better off than they were in 2008, with 34% saying they were doing about the same and 34% saying they were worse off. Some 77% of respondents said they either didn't expect a raise in the next 12 months or expected their income to decline. About 30% of Americans said their household income for 2012 was lower than what they'd expect in a normal year.

About 40 million Americans have student loan debt totaling more than $1.3 trillion, and only 40% of them think the education was worth the cost. Some 35% of survey respondents who are paying back student loans said they had to cut spending by "a little" over the past year to keep up with their student debt payments, and another 11% said they had to cut back their spending by "a lot." One finding of the survey is that debt can affect your health. Some 44% of Americans with student debt said they avoided medical treatment because they couldn't afford it, while only 30% of Americans without student loans said the same thing.

Almost half the participants said they were not saving any portion of their income, and roughly one-fifth said they're spending more money than they are currently taking in. Only 39% of people reported having a rainy-day savings fund that would cover at least three months of expenses. A combined 25% of households who told the Fed they'd had savings prior to 2008 reported having used up "all" or "nearly all" of their savings as a result of the recession. And just 48% of people said they would be able to completely cover a $400 hypothetical emergency expense without selling something or borrowing money. Just under a third of non-retired households reported having no retirement savings or pension, including just under 20% of households aged 55 to 64. A quarter of the respondents said they had done no retirement planning at all.  Of those who have given some thought to retirement planning and plan to retire at some point, 25% didn’t know how they will pay their expenses in retirement.

Next week’s economic calendar includes a look at July retail sales on Wednesday. The recent drop in gas prices may actually dampen the real outlook for retail sales. On Tuesday we’ll get a look at the strength of the labor market in the JOLT report, the Job Openings and Labor Turnover survey measures workers who are quitting their jobs; the thinking is that when workers are confident about their job prospects they’re more willing to jump ship. The quit rate has edged up in the past couple of years but is still well below the rates posted in the last expansion. Another measure of strength in the labor market is hiring activity among small businesses. On Tuesday, we’ll get the Small Business Optimism survey. In June, 26% of small businesses surveyed said they had at least one job opening they could not fill.  On Thursday, the New York Fed will release its second-quarter Household Debt and Credit Report. The New York Fed reported that in the first quarter, households increased their total borrowings (including mortgages, credit cards, student loans and auto loans) for the third quarter in a row, led by gains in mortgages and student loan debt.

Monday, July 14, 2014 - Clearing Up Outstanding Issues

Clearing Up Outstanding Issues

by Sinclair Noe

DOW + 111 = 17,055
SPX + 9 = 1977
NAS + 24 = 4440
10 YR YLD + .03 = 2.55%
OIL + .22 = 101.05
GOLD – 32 = 1307.80
SILV - .54 = 21.00

The Dow Industrial Average hit an intraday high of 17,088, but couldn’t close above the old closing high of 17,074 from July 2.

I woke up this morning and checked the Euro markets; the headline read: Global Stocks mostly higher as Portuguese debt concerns ease. Banco Espirito Santo’s parent company sold part of its stake in the bank to pay off short-term debt, so everything is cool. Portuguese bond prices popped. Nothing to see here. Move along, move along.

Just to refresh your memory, Banco Espirito Santo is 25% owned by Espirito Financial Group, which is in turn 49% owned by Espirito Santos Irmaoes, which in turn is wholly owned by Rioforte investments, which in turn is wholly owned by Espirito Santo international. What’s the point of owning a bank if you can’t make loans to yourself; and that’s what happened, until last week, when Espirito Santo International, the parent company failed to make a payment on short-term debt. The collective companies under the Espirito Santo umbrella have borrowed several billion from the bank, and then the bank made about 8 billion euros in loans to Angola, and that has a non-performance rate approaching 90%. And I know you’re wondering why you should be concerned about loans to Angola, and it’s because everything in finance is leveraged. No loan lives in isolation.

Panic ensued. The fear was that creditors and/or depositors might be on the hook in the event of a shortfall; no one could be certain because of a lack of transparency. But the bank says they have a cushion; the parent company sold a few assets to come current on the loan. Hopefully, I’ve cleared up the transparency issue. Regulators say there’s nothing to worry about and they should know because they didn’t see this coming in the first place, and so there’s nothing to worry about; the situation in Portugal is contained, and global stocks moved higher.

Here in the US, we know a thing or two about banks behaving badly. Today, as expected, Citgroup agreed to pay $7 billion to settle civil claims the bank misled investors about toxic mortgage backed securities leading up to the 2008 crash. Citigroup admitted it was aware that "significant percentages" of sample loans did not comply with underwriting guidelines but the bank pooled them into securities anyway. In one 2007 deal, a Citigroup trader told colleagues in an email he had reviewed a due diligence report on the poorest quality loans, and that they "should start praying." Many of the loans listed unreasonable borrower incomes or home values below the original appraisals, the trader wrote, saying he "would not be surprised if half of these loans went down." Citigroup still securitized loans from the pool. Quite simply, they knew the mortgage backed securities were full of bad loans, they lied about it to make the sale.

Under the agreement, Citi will pay $4.5 billion in cash and provide $2.5 billion in aid to low-income tenants and struggling homeowners; details of terms of the help and how many will benefit are not yet known, but there’s no indication people they will go back to help make people whole. Some homeowners with Citi mortgages could see the amount of their loans reduced, or could have their interest rates reduced. There will also be down payment and closing cost assistance to future homebuyers. But none of that starts until 2018. I don’t know why.

Last year Citi settled with the FHFA for $250 million. The regulator of Fannie Mae and Freddie Mac had sued the bank over soured mortgage securities sold to the taxpayer-owned entities. The cash portion consists of a record $4 billion civil payment to the Justice Department, double JPMorgan’s penalty in November, and $500 million to resolve claims from five state attorneys general and the Federal Deposit Insurance Corp.

And there is a little gift for Citi; the state AG and FDIC payments would be deductible, along with any costs Citigroup actually incurs in relation to consumer relief, which could be less than the $2.5 billion amount of relief in the settlement.

As part of the settlement, Citigroup “will take a charge of approximately $3.8 billion pre-tax in the second quarter of 2014." Second-quarter earnings results were also posted this morning, and if you exclude the multi-billion dollar settlement, Citi beat expectations. The settlement wipes out the quarter’s earnings, but if you look the other way, it was a kick ass quarter for earnings. Citigroup exceeded Wall Street expectations in the second quarter with adjusted earnings of $1.24 a share. On that basis, analysts had been expecting Citigroup would earn $1.05 a share. Citi posted a 15% drop in trading revenue. Investment banking revenue rose 16% from a year ago. Mortgage originations were down.

This is a civil settlement, not a criminal settlement. Attorney General Eric Holder at a press conference said: “Citi settlement doesn’t absolve bank, employees from criminal charges.” Of course nobody expects the Department of Justice to pursue criminal charges. Citi is also under investigation for possible fraud and money laundering in its Mexican unit. And if you look at all the wrongdoing, you might come to the conclusion that this is just a corrupt organization.

If you’re wondering where the next subprime meltdown will occur, well you can pick from a wide selection of possibilities. Markets seem to be considering only a very narrow spectrum of potential outcomes. They have become convinced that monetary conditions will remain easy for a very long time, and may be taking more assurance than central banks wish to give. Debt ratios in the developed economies have risen by 20 percentage points to 275% of GDP, since the Lehman crisis. Credit spreads have fallen to wafer-thin levels. Companies are borrowing heavily to buy back their own shares, and 40% of syndicated loans are to sub-investment grade borrowers, a higher ratio than in 2007, with fewer protections from loss.

The Bank of International Settlements, the central bank for the central bankers of the world, warned it is annual report two weeks ago that equity markets had become "euphoric". Volatility has dropped to an historic low. European equities have risen 15% in a year despite near zero growth and a 3% fall in expected earnings. The cyclically-adjusted price earnings ratio of the S&P 500 index in the US reached 25 in May, six points above its half-century average. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.

Some of you might pick the student loan market, with over $1 trillion in outstanding loans and growing. The deeply indebted college graduate has become a stock character in the national conversation: the art history major with $50,000 in debt, the underemployed barista with $75,000, the struggling poet with $100,000. That’s not really typical of student loan debt. Only 7 percent of young-adult households with education debt have $50,000 or more of it. By contrast, 58 percent of such households have less than $10,000 in debt, and an additional 18 percent have between $10,000 and $20,000.

That’s not to say student loan debt is not a concern, it is, and it is growing. In 2010, 36 percent of households with people between the ages of 20 and 40 had education debt, up from 14 percent in 1989. The median amount of debt, among those with debt, more than doubled, to $8,500 from $3,517, after adjusting for inflation. Student loan debt is a problem, but it isn’t a new problem, it’s just a trillion dollar problem now, but it hasn’t imploded in the past 2 decades and there doesn’t seem to be an immediate catalyst.

How about a bubble in energy? Ambrose Evans- Pritchard writes: Data from Bank of America show that oil and gas investment in the US has soared to $200 billion a year. It has reached 20% of total US private fixed investment, the same share as home building. This has never happened before in US history, even during the Second World War when oil production was a strategic imperative.

The International Energy Agency (IEA) says global investment in fossil fuel supply doubled in real terms to $900 billion from 2000 to 2008 as the boom gathered pace. It has since stabilized at a very high plateau, near $950 billion last year. Output from conventional fields peaked in 2005. Not a single large project has come on stream at a break-even cost below $80 a barrel for almost three years….

There are, of course, other candidates for the bubble prize of the current economic cycle, now into its 22nd quarter and facing the headwinds of US monetary tightening. China’s housing boom has echoes of the Tokyo blow-off in 1989, and is four times more stretched than US subprime in 2006, based on price-to-income…Emerging markets have racked up $2 trillion in foreign currency debt since 2008. They are a much larger animal than they were during the East Asia crisis of the late 1990s, so any crisis would do more damage.

Yet the sheer scale of “stranded assets” and potential write-offs in the fossil industry raises eyebrows. IHS Global Insight said the average return on oil and gas exploration in North America has fallen to 8.6%, lower than in 2001 when oil was trading at $27 a barrel. What happens if oil falls back towards $80 as Libya ends force majeure at its oil hubs and Iran rejoins the world economy?

And that’s before we get to another threat to fossil fuel investments that Evans-Pritchard mentions: that governments might get serious about climate change and impose meaningful restrictions, like hefty carbon taxes. Right now, that seems like a tail risk, but the crisis just past was a tail event as well. And much higher energy prices resulting from restriction on fossil fuel production would slow down economic activity markedly, which again could blow back to leveraged investors in unexpected ways.