Diogenes in the Barrel.

via sentinel investments.


It's a good time to sit tight and stay with cash. It's not uncertainty. We can live with that. It's the certainty of temporary impasse. Here's why.

When Europe gets it wrong, it gets it really wrong. The cycle of tighter budgets, lower growth, higher deficits and higher bond yields is so manifest that you would think some coordinated policy response would be front and center. Not a bit of it. Greece is fast approaching the point where a declining economy cannot support debt repayments. It does not matter if the country embraces frugality or not. There is simply not enough juice to pay off debt. There are plenty of solutions: Consol-type perpetuities, ECB purchases, Eurobonds. All rejected. So now, we have near runs on the banks. European bank stocks are down 37% this year. This week we saw furious denials from leading banks that they did not have funding problems. Euribor OIS spread tells a very different story. It's up 20% in two weeks.

Clash of Wills: We may not see any respite until one or more of the following happen: 

i) the ECB cutting rates

ii) a deliberate QE program, if only as a back door recapitalization of the banks as happened in QE1 in the US,

iii) restructured fiscal policy or 

iv) currency depreciation. 

Even these will probably not avoid a Greek default and Euro exit, which we now put at a 20% probability. It's tough to sit through. But we're in the midst of a major policy divide: fiscal consolidation to allow some magical multiplier to work or demand management to step up spending. Heterodox views are not easily reconciled. Hence the market funk.

Come Together: Asset class correlations have reached very high levels. In SPX[1], industry correlations are 97%, compared to 82% a few months ago. Similarly, international and emerging markets, the AUS$ and high yield bonds all show readings of above 90%. Twenty years ago, it was around 40%. It's not new to see higher correlations when markets stress. What is new is the high level of market velocity and asset class trading, which bypasses stock research and valuation measures. We see that as a good time to pick up names where dividends and growth comfortably exceed GT10 yields and inflation.

Prices: It was mostly a week of price information. Producer prices fell rapidly in the last few months. Lower energy prices, down 5% YOY, were somewhat offset by higher food, up 1.7%. We saw the story of subdued inflation over in import prices, which fell for the fourth straight month. Consumer prices came in at +3.8% with core CPI at +2.0%. Some of this is food inflation but some is in the elusive OER, which was negative a few months ago and is now rising at 1.4%. This may be no more than a reflection of a tight rental market but, at 25% of the index, it's something we're looking at closely.

The Regional Surveys: Philadelphia improved from a miserable August with a very firm rebound in future growth expectations. The Empire index again had a large number of respondents saying there was no change in expectations. We put it down to the painful August headlines. Production was encouraging especially given a weather related drop in utilities output. Put all the data together and it's soft but heading better. Not a ringing endorsement but not recessionary.

And did you see: new census data, which showed 46m in poverty (defined as living on $30 a day) and a whopping 7% decline in HH income since 2000. Tough to see any discretionary income kicker with that.

Bottom Line: If inflation continues then GT10s at 2.07% and core inflation at 2.0% make no sense. We'll position for higher rates but trade both ways in the meantime. We continue to buy. But no hurry.

Sources: US Census Bureau, US Dept of Commerce, Bureau of Labor Statistics, ConvergEx, Federal Reserve Banks of New York, Philadelphia