Housing Starts rose more than expected on the strength of multi-family construction, such as apartments and condominiums as an increasing number of Americans choose renting over home purchases. This was the strongest read for multi-family construction since October 2008. Building Permits fell to a five-month low as a glut of existing homes, a backlog of foreclosures and real estate values, which continue to decline, weigh heavily on the home building industry. Moody’s analyst Aaron Smith told Bloomberg News prior to the report:
“Through the volatility, the trend in starts appears to have picked up, though the level is still historically low. Multifamily activity is trending higher as the shift from homeownership to renting boosts demand for rental units and brings down vacancy rates.”
This does little to help single family home owners who have seen their home values tumble from their bubble peaks. At the risk of sounding like a broken record (for those of you who remember records), housing cannot recover until the excess supply of homes is absorbed. Accomplishing this is becoming increasingly difficult as the U.S. economy seems to have hit cruising speed at a modest pace, lending standards remain tight (but closer to traditional standards) and changes to demographics have young adults choosing to rent in urban settings while eschewing the suburban McMansions of older generations.
As has been the case for the past several years, CPI has, to a large extent, decoupled from PPI as producers remain unable or unwilling to pass, or fully pass, price increase on to consumers. Inflation, as measured by CPI, increased at its slowest pace in three months. This lends credence to the Fed’s view that inflation pressures could moderate in the coming months. It is also a signal the businesses may be losing pricing power or are concerned that consumer demand may slacken and are working to maintain or increase their market share.
Core CPI MoM rose by the smallest amount (0.1%) since last March. Moody’s Senior Economist Ryan Sweet stated:
“Inflation is playing out according to the Fed’s script. The economy is sluggish and businesses are very hesitant to pass on higher input costs to consumers. Consumers are very price sensitive right now.”
Leading the way toward slower inflation were the biggest drop in clothing prices since 1998, lower prices for both new and used vehicles and the smallest increase in rents in four months.
Late yesterday, the markets were startled by a report by The Guardian newspaper that France and Germany had ostensibly agreed to a deal to infuse three-trillion euros into the EFSF as part of a solution to the European sovereign debt crisis. Shortly thereafter European officials, including German Chancellor Angela Merkel, refused to confirm that The Guardian’s story was accurate. However, information leaking out to the financial press indicates that The Guardian’s report may have an air of truth about it.
CNBC reported (yeah, we know it’s CNBC) that EU officials are close to a deal in which France and Germany would contribute three-trillion euros to the EFSF which would act as an insurance plan for banks. The plan would have banks take more aggressive haircuts on Greek debt (specifics were not given, but the prior haircut amount most recently discussed was 50%) and banks would recapitalize with private money instead of government funds, Investors would theoretically be comforted by the three-trillion euro insurance fund waiting in the wings should a bank need more capital or is unable to raise sufficient capital on its own from private sources.
This sounds encouraging. Indeed, the markets were encouraged when the possibility of the three-trillion insurance fund was announced late yesterday, but whether or not it works in practice remains to be seen. The question becomes: Will investors infuse capital in banks in which European governments do not have a stake with only an insurance fund sitting on the sidelines?
Such an approach was discussed in the U.S. in the fall of 2008. However, financial institutions needing to recapitalize only did so after the U.S. government bought a state in those troubled banks. In other words, investors wanted governments to have skin in the game before they committed their own capital.
How the banks are recapitalized carries implications for investors in preferreds issued by European banks. If banks can recapitalized without government (taxpayer) assistance, preferred dividends for those banks may continue unabated. However, banks needing direct government investments could be forced to suspend dividends as per last week’s suggestion by the European Commission. We favor large domestic banks over their European counterparts.
Will the proposed three-trillion euro insurance fund calm the markets and solve the European sovereign debt crisis? That question can only be answered by market participants. Not necessarily those who are currently moving the equity and fixed income markets, but by those who will decide whether or not to commit their capital in the form of common equity investments in European banks. One thing is for sure, European officials had better agree on a solution very soon as reports coming out of Greece today are pointing to a disorderly outcome in more ways than one.
Moody’s downgraded Spain by two notches to A1, and keeps it on negative outlook, citing vulnerabilities from high levels of debt in the Spanish banking and corporate sectors. Earlier on Tuesday, S&P downgraded 24 Italian banks and financial firms. Spanish media reports a new European bank stress test could apply haircuts of up to 20% on Spanish sovereign debt.
Speaking of banks, have readers looked past what appear to be encouraging headlines and really analyzed earnings? If you have, you would have noticed a recurring trend. The biggest profit gains have been from banks marking down their outstanding debt. This accepted accounting practice assumes banks could retire their outstanding public debt below par value or at a lower price than in the same quarter a year ago because it can be purchased at a discount or at lower prices in the open market. Of course the reason it is trading at a discount or lower prices from the same period a year ago is because current bank financing costs are higher, making such debt repurchases unlikely. Accounting gains are usually brushed aside by market participants. Another trend has been sharp declines in investment banking revenues as banks adjust to new financial regulations which nearly eliminate proprietary trading.
Although it is very unlikely that any of the large U.S. financial institutions have difficulty servicing their debts, the best values on a risk-to-reward basis may exist in the bonds issued by banks with large traditional banking businesses, as well as regional banks located outside the most troubled real estate markets. Subordinated notes issued by banks offer yields which rival many high yield bonds, but more moderate investors can pick up attractive yields in senior bank debt. The sweetest spot on the bank and finance credit curve is in the 5-year to 10-year range, but good values can be found in 15-year step ups and short-term buyers can find good value in bank debt in the two-year to three-year area of the curve. Also, $1,000 par senior notes offer better values than their long-term $25-par brethren, especially those with coupons below 7.00% which are unlikely to be called at their first scheduled call date, if ever.
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