If You Kick a Can Down the Road Long Enough...

If you kick a can down the road long enough you will eventually reach an intersection or a dead end. We can't help but picture a child kicking a can down a quaint dirt road. Its a peaceful and bucolic. Now, that same kid but caught in an intersection, and not just any intersection, but of two 4-lane roads during rush hour with no traffic lights! Melodramatic imagery aside, the attempt to bailout Ireland has thrown these two concepts into the spotlight.

First and foremost is the contagion risk. This is not new. We saw it with U.S. banks and have been fighting it on the sovereign side for the past 9 months. PIIGS is at risk of becoming BIG PIGS.  Not only have the spotlights refocused on Spain and Portugal, but Italy and even Belgium are gaining some notoriety. "G" is in twice since Greece is already back renegotiating their prior bailout. But at this rate, the "G" could eventually become Germany as it continues to take on the obligations of other countries.

Second is that for the first time we have a recipient that does not seem to want the bailout. Ireland seems extremely reluctant to take the money. There is a real movement growing to just take the pain. Perhaps their anger at bankers may be clouding their judgement and making this option appear better than it is, but it is the right option. The austerity plan is more of a fiction than our New Year's resolutions.  Sure, they sound great, but what is the realistic chance of any of this occurring?  ZERO!  So the recipients are becoming more reluctant to live with the consequences of bailouts and are starting to seriously contemplate just dealing with it now.  Since politicians have finite terms in office maybe some of them are more willing to deal with it than corporate CEOs who have huge upside from kicking the can down the road.

This is an interesting development to watch.  We would imagine that at least some politicians in Greece are contemplating ditching the whole plan and scoring major populist points. And the countries providing the bailouts are also getting tired, and possibly scared. Germany, in particular, seems to be realizing that one possible end game is that all the bailouts will eventually drag them down. They are caught in a dangerous situation. They have played the "loaded bazooka" game to make the capital markets blink and lend to the weaker countries. Well, the capital markets have done their work and realized it is not safe to lend to some of these countries. Now Germany is trying to figure out how to make people lend money without having to take risk themselves. Very tricky and unlikely to work out.

As the street realizes that the big countries do not really want to bailout the little ones, we will see continued pressure on sovereign debt. We are still amazed that the U.S. contribution to the bailout has not hit the mainstream news.  The media has dubbed this a European Debt Crisis. Really, this is just the continuation of the debt crisis that started in the U.S. Too many people borrowed too much money. Everyone relied on either income or assets appreciating to repay the debt, or at worst that someone would just roll the debt over at maturity. It started with U.S. subprime borrowers. It has worked its way up to prime borrowers, smaller banks (the number of FDIC takeovers continues to grow) and weaker countries. It had hit big banks but that seemed to have been resolved. Its starting to hit bigger countries - Spain and Ireland. There is some concern it is starting to hit municipalities.

What scares us more than anything, is that the problem of borrowing too much spreads beyond those currently mentioned. Can France, or Germany, or even the U.S., run into trouble? Not likely right now, but it would be foolish and arrogant for those countries to proceed as though they are immune from the consequences of too much debt and not enough income. The mantra of decoupling is coming through loud and clear. Every stock bull is mentioning the good economic data. This week has a lot of economic releases. IF the economic data does not come in strong, the market seems very susceptible to a sell-off. It seems to me that most people are back to being long, have bought the recent dip, and are buying into the argument that European debt issues will be contained. We think its unlikely that they remain contained and that if we are right and the market is long, we are due for a continued pull back. GM stock continues to hold the issue price. It has come close to breaking it a few times, and that would probably put some additional pressure on the market. MUB was weak again. LQD was okay, but not strong and shares outstanding continue to trend lower. Recent new issues are well offered. Always a telling sign is when it gets hard to move recent new issues. Too many flippers and not enough real long term holders. Whenever it gets difficult to trade recent new issues, the market has sold off as people eventually start the cycle of buying CDS, buying index, and hitting "throwaway" bids on bonds. There is enough data out there that we could rally, but away from that, its getting hard to see what takes the market higher/better in the near term as the government bailout game seems almost over.

Mixed Bag of Economic Releases and News

Certainly initial jobless claims number looks good.  Last week's good number was only revised a little higher (will one ever be revised lower?).  We also continue to question the view that numbers below 450k are indicative of growth.  We remain convinced that the combination of a smaller work force, and a massive structural shift in employment to part-time and consultants means that companies will have fewer people to lay off.  Also, as this crisis has continued, we question whether people are getting let go but don't qualify to apply for unemployment benefits.  Anyway, for now, it is clearly a good sign, although not as good as people would have you believe, and somewhat understandable coming into the holiday shopping season.

Is it just us, or does opening at midnight for $5 barbies, and 3 a.m. openings across the board seem insane? Playing the fiddle while Rome burns down somehow comes to mind. The rest of the data seemed disappointing.  The situation in Europe remains fluid.  It looks like Ireland will get its money.  Even though the credit markets will quickly shift its attention to Portugal and Spain, the equities and corporate bond markets seem stable.  Maybe it is the end of contagion, but if Spain really does come into play, the slippery slope may not end there.  Concern could spread to Italy. Not just because of Italy's existing problems but also because that they will have bought or guaranteed so much other debt.  It feels like the market is pricing in Portugal, but not Spain. If Spain does step up to borrow money from ECB/IMF/you and me, the markets will react very negatively. It is just too big relative to the "bailout" facilities. 

Korea and China seem calm.  Maybe this is a chance for Obama to play peacemaker and win another Nobel Peace Prize.  On other continued themes, GM looks like it could break $33 today which would not be good, and LQD continues to see shares outstanding decrease. As does TLT and JNK. So seeing evidence of retail investors pulling out of longer dated treasuries, investment grade corporates (~20% financials), and the weaker end of the high yield market (JNK). The fact that HYG shares continue to be stable may mean that JNK is being affected by GM or something and not a sign of investors pulling out. Somewhat surprisingly to me, MUB shares have not been reduced.  Either investors aren't pulling out, or dealers are more scared to own the actual bonds than the shares so they haven't redeemed inventory.

Should be a quiet day. It wouldn't surprise us to see a modestly higher day in the U.S. as people want to be long for the bailout. I would trade that position in futures as it may not last until Friday. A very wise trader once mentioned a few years ago that weakness into long weekends or the thanksgiving holiday is a very bad sign. Good luck and Happy Thanksgiving.

What to Expect from Expectations Management

The Fed Chairman has become a fan of his abilities to manage wall streets' expectations. We do not believe its that easy and he has to be looking further down the road than he may be.  One mantra, which Wall Street has grasped on to, largely because its self satisfying, is that QE2 will result in consumers getting nervous about future inflation and therefore spend more now.  That strikes us as way too simple.  It's like exposing a bishop in chess so that the other player, in their greed, will take take the bishop and expose their queen to you. Maybe, but if you are only thinking one move ahead, and focus mostly on the outcome you want to see, rather than all that could occur, you will be surprised, and not in a good way.

What if QE2, rather than spurring consumer activity, actually has the opposite affect?  For every person out there in a rush to spend their money, especially if prices are going up, there has to be someone who is watching TV, reading the paper, or listening to the radio who is getting concerned about the future. Are taxes going to be much higher in a few years? In 10 years? Will benefits that you take for granted now, be extremely reduced or taken away all together? More people have to be getting worried about the long term consequences of reduced spending or increased taxes and that may encourage greater savings now, rather than less, even though for most of us, long term future is next Saturday.  Likely we will see great shopping numbers this weekend, but I think the theory that inflation expectations will increase consumption will be put to the test over the next few quarters, and will fail.

Another area where expectations seemed to have shifted, is the attitude of sovereigns in Europe. It seems that early on in the Greek crisis, the consensus view was that evil Wall Street was cutting off financing, and that the problems were one of short term liquidity and nasty hedge funds.  It seems that Europe, and Germany and Austria in particular are starting to realize that the problems are structural and likely won't go away. Its not just a matter of shifting out the maturity time-line, its the realization that they should expect losses on their bail-outs! Doesn't it make a lot more sense for them to force the pain onto existing holders and deal with the problems, which will be large, from a position of strength, rather than taking on the problems and taking on the real risk of loss in the future, and that their own economies won't be as strong then as they are now? We would be careful playing the sovereign bail-out game as expectations of real potential losses grow. We would also read the analysis we put out on EFSF and the domino effect that drawdowns create. We have no clue what to make of the Korea situation. Our gut tells us it goes away without amounting to much, or even if it grows, the market will deal with that. It would be very interesting to find out that food shortages in the North have anything to do with the activity - if you can't have bread and circuses for the masses, might as well at least have the circuses.