Saturday, September 24, 2011

Thursday Thoughts

History rhymes: The European sovereigns and banks are today where our country and banks were in 2008.

Importantly, the risk premium (the difference between the earnings yield and bond yields) is such that U.S. equities -- relative to investment grade and high yield debt instruments -- are now more undervalued than at the Generational Bottom in 2009.

Low interest rates don’t hold the key to the market. But I am increasingly encouraged that lower commodity prices (especially of an oil-kind) might hold the key to a recovery in the economy and in the U.S. stock market.

"Following a story earlier in the day that 'there is a growing consensus among EU diplomats and officials that Greece will default while remaining inside the eurozone,' the EU Economic Commissioner Rehn is just on the BN tape saying that they are working toward a recap of European banks. Germany said they are doing this internally a few weeks ago and the Spanish Budget Minister said the same last week. While Greece will likely get its next round of bailout 1 money in a few weeks so they can pay upcoming bills, the time is now possibly finally approaching that Greece will have a more pronounced default that will allow them to write down a more significant level of debt and EU officials are in the process of preparing for the fallout." -- Peter Boockvar, Miller Tabak

Read Peter's comments in conjunction with the Bloomberg report that quotes Treasury Secretary Geithner at a National Journal event in Washington today:

“You are going to see them act with more force in the coming weeks and months."

“It’s a difficult challenge to do because it’s not just about financial support ... Financial support is a necessary condition but it is not sufficient ..."

Lower mortgage/interest rates a la Operation Twist are no longer the answer. The ball is in the politicians' court.

"Economic growth so far this year has been considerably slower than the committee expected. Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out... " -- FOMC

Let’s review my thoughts regarding Operation Twist, the U.S. stock market’s reaction yesterday and the German and Chinese economic news released last night.

I still don't know why there will be any real benefit to the economy from this strategy, as the shape of the curve and the level of interest rates are not currently growth constraints.

The Bernank does not control fiscal policy and the economic ball is no longer in his court. It is in the hands of our political "leaders."

Upon reflection, I see the FOMC release as a negative to risk assets because it emphasized (for those who live in another bullish economic galaxy, and there remain some) that the current domestic economic challenges (significant downside risk in FedSpeak) will likely continue to be in place absent a pro-growth strategy.

There were other factors that led to a post-FOMC decision selloff yesterday and overnight:

* Reports that French bank BNP might be seeking capital.
* The European banks continue to be reluctant to recapitalize (which they must).
* A divided Europe continues to be unwilling to address its fiscal issues.
* We still have no sense regarding counter party risk when Greek defaults.
* The tape was already exhibiting deflationary signals going into FOMC announcement -- industrials, transports, etc. breaking down -- so maybe the “downside risk” Fed statement was a tipping point where investors simply gave up.
* By making the “downside risk” statement, investors might have come to the conclusion that the Fed has a better sense of how bad upcoming economic numbers will be and that poor August sentiment will translate into weak hard economic data in early winter. (One can even argue that the “significant downside risk” pronouncement might have frightened the markets more than Operation Twist helped in reducing interest rates.)
* Growing recognition that the Fed will not likely entertain QE3 in the face of much opposition within the Fed and in the Republican Party.
* Growing recognition that the domestic economy (combined with the eurozone uncertainty and structural challenges) is now on its own.

Let’s now briefly return to a discussion of home refinancing and mortgage activity, which helps to explain an important reason why I believe that lower interest rates may no longer hold the economic answer.

Based on Wednesday, the Federal Reserve and its chairman appear to still be in favor of more cowbell. They see lower interest and mortgage rates as fuel for the consumer, as lower–rate refinancings, in theory, aid consumer's cash flows and expenditures. But refinancings have not improved in response to easing rates. In fact, the opposite has occurred.

The logic behind more Fed easing has grown less compelling. That’s a blow to the easy money crowd and explains the broken connection between lower interest rates and an improving housing market. Perhaps it also helps to explain the market’s recent pasting, as well as help to explain the recent dissents among voting Fed members.

The residential real estate industry is suffering from a structural imbalance between supply and demand. An unprecedented 35% drop in home prices, due in large measure to the egregious use of debt, has resulted in 22% of all U.S. homes with mortgages under water and another 5% at "near negative" equity.

As to refinancing trends, the relationship to lower rates and a rise in refinancings has been broken for some time for numerous reasons. The Fed has been remiss in understanding structural issues (vs. cyclical) like this, though they are slowly warming up to the reality.

1. The mortgage-origination business has changed in the last six months. Most mortgage brokers now get paid a salary plus small commission.
2. The transformation from low- or no-documented mortgages (like a pendulum) has moved back to the old days, when credit scores, incomes and net worth are actually documented. Many are no longer qualifying for mortgages (as their loans to values are too high and incomes/credit scores too low).
3. As credit gets tighter, the appraisal process is getting much longer. It’s more conservative and much more stringent since lenders do not want to make any errors, be sued or face additional rep and warranty issues.
4. The pool of available refinancing applicants are diminished importantly by the number of homes that are still underwater and the weight of a heavy supply of shadow inventory of unsold homes (which keeps home prices down).
5. The weak jobs market is still keeping homeowners on the sidelines (especially after a 30%-plus drop in prices over last five years).
6. The tenuous real-estate market is forcing many homeowners that are considering refinancing to raise their equity investments before banks agree to lower mortgage rate terms.

Given that shaky situation, the banking industry is not keen to expand its mortgage lending activity, even if Treasury rates move ever lower and real-estate lending provides a better net interest margin. The housing situation remains weak and it will take years to clear despite affordability at multi-decade highs. Lower mortgage (interest) rates a la Operation Twist are no longer the answer.

The ball is now in Washington’s court. While I remain extremely suspicious of a meaningful break in gridlock, the current crisis could potentially serve to reduce the divisiveness and polarization even before the November 2012 elections.

But should a divided government not change, we are in for an extended period of uneven and lumpy domestic growth and that's hard for investment managers (with limited upside and corporate managers with limited pricing power to navigate.

Nevertheless, all is not lost and getting more bearish with lower share prices could be wrong footed.

With sentiment and expectations low and finally adjusting to reality, inflation, at least in how the government counts it, contained, a friendly Federal Reserve and balance-sheet-healthy corporations (operating at a high level of profits), I still expect that we have seen the lows on the S&P for the year.