Brothers In Arms

Through the fields of destruction
Baptisms of fire
I've watched all your suffering
As the battles raged higher
And though they did not hurt me so bad
In the fear and alarm
You did not desert me
my brothers in arms - Mark Knoplfer / Dire Straits

www.mksense.blogspot.com


The second have last week was certainly a blood bath. Friday bordered on an apocalypse until word spread throughout the markets that the EU may announce a rescue plan for Greece over the weekend. Some pundits questioned why the potential economic collapse of a small (approximately 11 million people) would rattle markets around the globe. The reason is that there are other economies is similarly dire straits and a run on Greece could easily spill over to the remaining PIGS and beyond. Let's be clear. Europe is not an economic expansion powerhouse. Job creation is almost non-existent. Corporations experience significant interference from government and unions. They are not for profit engines of growth as to what we in the U.S are accustomed.

It has baffled me for many years why investors have looked to Europe as a replacement for the U.S. to invest for growth. It is true that the former Eastern Bloc nations experienced robust growth, but that was do to their playing catch up to Western Europe. Portugal, Italy, Greece, Spain (PIGS) along with the former Eastern Bloc nations took advantage of cheap financing and an almost insatiable investor appetite for all things European to lever up as a way to fuel growth. Now they are saddled with an enormous deficits relative to their size and, since these countries are not market places for goods like the U.S., no one has to invest in their sovereign debt.

Many people view the EU as a United States of Europe. This is not the case. The EU as loose confederation of nations, a trading bloc if you will. Yes there is the ECB, but it does not have authority over sovereign banks and banking systems. That falls to sovereign central banks and governments. To be sure there are many people in larger European economies, such as France and Germany, who do not want their tax dollars bailing out countries which overextended themselves. I believe that EU governments will rescue the PIGS as not doing so would comprise the integrity of the union.

Things are not all that rosy on this side of the Atlantic either. Jobs data has been lack luster. Yes, the unemployment rate fell to 9.7%, but the economy continues to bleed jobs. Construction jobs led the way in losses. Market bulls made arguments such as: 1) If not for construction jobs losses we would have added jobs. 2) Companies continue to add temporary workers, a sign that a recovery is in progress. 3) Employment always lags. It will catch up, eventually.

Although these arguments are not necessarily incorrect, they do not depict a situation in which we see companies open up the doors for new permanent jobs. Due to productivity gains, more economic activity is required than ever before to create jobs. Much of the economic recover has been via inventory management and business to business activity. This can only do so much. Some economists say to be patient. Eventually consumers will stop deleveraging and take on more debt. Have these economists taken a good look at household debt levels. Even if banks began a repeat performance of irresponsible lending (which is not happening until a new brood of business grads are hatched from their Ivy League coops a time sufficiently in the future for the recent mistakes to be forgotten), consumers cannot afford to service such debt. It was consumers inability to service their current debt when many more of them were working that got us into this mess.

What does this mean for the markets? Long-term treasury rates will creep higher (as will mortgage rates) as the Fed removes its quantitative easing of purchasing treasuries, agencies and agency mortgage backed securities. This will cause the yield curve to steepen as the Fed will keep shirt-term rates at 0% to .25% for most or all of 2010. In 2011 we are likely to see a bear flattener in which short term rates rise towards long-term rates. I would recommend LIBOR-based floating rate preferreds heading into such an environment, but their current trading levels, spreads over LIBOR and their floor coupons of 3% to 4% (which are perfectly positioned to not benefit much from what promises to be mild Fed tightening) make them unattractive propositions.

Corporate credit spreads have tightened nicely during the past year. Many experts believe that will continue. I agree, but further tightening will be much more modest and sector (and even name) specific. Industrials, utilities and telecoms have little room to tighten. Financials have some room, but the better names such as GS and JPM have little more tightening left. If jobs continue to lag, productivity gains slow and the benefits of inventory management wanes we could even experience renewed spread widening. In such a scenario, the dollar would be the currency which benefits the most.

"No the sun's gone to hell
And the moon's riding high
Let me bid you farewell"
















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