Predicting America:

As we head to the finish of 2010, the economic situation in the US seems to be on the upswing. There are a number of reasons for investors to be confident about the coming year barring any black swan events that may derail economic recovery (and the imminent collapse of a few more Euro zone economies might tip the scale to the negative side). I prefer to be cautiously optimistic about the US economy in 2011. As an optimistic year end target, I would say the S&P 500 should finish at 1450 in December 2011. As always, there are many factors to consider before establishing a medium to longer term view of the US:

The Good: 

A big reason for the upswing in the US over the last year has been the increase in business investment, which has risen by nearly 20% over the last four quarters. A point that is repeated over and over in discussions about the recovery in the US economy is that it has to be lead by the private sector. Clearly the government is not going to be creating too many jobs any time soon. Unemployment remains to be the Achilles Heel in the recovery process, and this was echoed by the November non farms report, which showed a rise of only 39,000 jobs. This was a sharp decrease from the numbers in October coming in at 172,000. An average over the two months shows a modest increase of 105,000 which is indicative of a sluggish pace of job creation. However, at the same time, the ISM manufacturing and non manufacturing employment estimates have seen their four week moving average fall to the lowest levels since 2008, which bodes well for a continued upswing in 2011.

Consumer confidence has also been on the upswing, as people look to be spending money again. The good part is that the majority are no longer spending debt, and sticking to spending based on their incomes. The ratio of consumer credit to household expenditures are on decade long lows. Boosted by the Christmas cheer, retail sales have also picked up over the last few months, especially ex auto sales numbers which pointed to a 1.2% gain in November.   

The Bad: 

Off late, there has been a lot of talk about the increasing yields on US government bonds. For investors in the US, the bond markets have been a pretty dull place to be for some time now, as the yields are not anything to write home about. However, there has been a slight surge in yields over the past couple of months, lead by the poor fiscal situation which is likely to be further exacerbated by the budget agreement between Obama and the Republicans. 

The $858 billion dollar bill to extend the Bush era tax cuts which was recently passed by Congress is going to take a toll on the fiscal deficit which already stands at nearly a whopping $14 trillion. With debt levels inching their way to 100% of GDP, it is certainly not a gamble to be predicting a loss in investor confidence in the US fiscal situation in the long term if growth does not pick up as projected by the bill and if there are no sustainability measures put in place over the next few years to get the debt trajectory back on track. The fiscal responsibility could come in the form of cuts in defense spending, caps on discretionary spending, raising the retirement age, and reducing tax breaks on certain sections of society. However in the nearer term the cause for concern is not at very high levels as the increase in yields could be an indication of return to a normal economic environment more than anything else (after all a lot of intervention was required to keep yields low so far). 

Rise in yields across the board

The Ugly:

There are a number of local governments in the US which are knee deep in debt. The rise in yields of municipal bonds or "munis" as they are fondly referred to by investors, is a major cause for concern. A significant amount of attention was paid to municipal bond expert Meridith Whitney, who on CBS 60 Minutes voiced her concern stating that she sees about 50 to 100 major defaults amounting to hundreds of billions of dollars of defaults. While the way the real situation may pan out can be very different from her predictions, as municipal bonds have been historically safer than corporate bonds and there is a recoverability rate of about 66% on defaulted munis; even a fraction of her predicitons coming true would add to the US fiscal voes in a significant way.

An added cause for concern is the overbought and overvalued situation in the equity markets. John Hussman has listed out the following factors which make me weary:

1) S&P 500 more than 8% above its 52 week (exponential) average 
2) S&P 500 more than 50% above its 4-year low 
3) Shiller P/E greater than 18 
4) 10-year Treasury yield higher than 6 months earlier 
5) Advisory bullishness > 47%, with bearishness < 27%

These above conditions are indicative of the US economy before many major market meltdowns and corrections over the last dew decades. Market timing is also a major issue, with some traders getting bullish after a rally and bearish after a market fall. A smart investor would hedge his/her bets with some care with regard to predictions about the US economy and equities in particular in the coming year. 

From the Economist: Punch in the numbers and see when China overtakes USA

AND SOME MORE FUN:
http://www.usdebtclock.org/

The Spanish Inquisition

What are the reasons for Spain's imminent collapse? Here are my thoughts:

The Numbers:
The European Commission has projected that domestic demand in Spain is expected to contribute-1.2% to the GDP in 2010, and have revised their forecast for 2011 down to -0.4%. Its private sector surplus projected to decline from -11.9% in 2007 to 4.5% in 2010. These numbers are indicative of the fact that there is very little the government can do at this stage in efforts to shore up demand domestically. With German exporters coming to the party and taking advantage of being in a single currency union, Spanish companies face stiff competition. Spain's Automobile sector which accounts for about 3.4% of GDP (the largest contributing sector in the economy) will certainly need to see better domestic demand in order to propel economic growth. The European Commission has also predicted a debt to GDP ratio of 69.7%  and deficit of 6.4% in 2011 which are both above the Stability and Growth Pact requirements of 60% and 3% respectively but well below catastrophic projections (In comparison the Congressional Budget Office predicts USA's debt to be at 90% of GDP in 2011).

The Psychology:
I have had many a discussion about the psychological factors coming into play with my Spanish friends and colleagues, and they all seem to agree on one point more often than not. They all agree that the Spanish have an inherent mentality of wanting to own a property to call home. This need to buy a house  is something that is instilled in the minds of the Spanish people from an early age, though none of my friends could put a finger on the exact reasons for the same. This "need" to own a house as oppose to rent a house until savings permit one to buy a house without being in eternal debt (its not uncommon for banks to offer 50 year mortgages), is one of the central reasons for the real estate crisis that has fueled this downturn in Spain (The residential real estate bubble has seen the real estate prices move 201% between 1995 to 2007). It is not unusual for psychological factors to come into play in economics and the way economies function, and it reminds me of the HSBC advertisement projecting a deeper understanding of different cultures in order to be able to locally do business better.

The Cajas:
Clearly there cannot be smoke without a fire, and the reason the cultural and psychological aspects have been allowed to shape a real estate crisis are because of the callous "thrift" lending agencies in Spain. The Cajas (pronounced Cahas) are small savings banks which are experiencing a big crisis since the global downturn. There have been numerous mergers in this past year between different Cajas which has scared investors. These mergers have been made in order to preserve liquidity base for writing off the huge amounts of bad assets held by these banks. These assets are mostly in the form of property and resembles the problem in Ireland. The Cajas are also highly politically controlled bank. They have been used to finance many an unsuccessful infrastructure and housing projects (backed by toxic assets) and the behest of politicians looking to garner votes.

The Structure of Labour:
Spain's unemployment numbers are truly "quotable" statistics in the scheme of unemployment numbers in the developed world. Standing tall at just over 20% and projected to remain that way until 2012 by the European Commission, Spain's unemployment figures are truly baffling for a country which is listed as the 9th biggest economy in the world on Wikipedia. However, there is a very simple reason behind the high unemployment in Spain. The reason is that about a third of all Spanish labour is contractual workers. These are workers who can be fired without any severance packages, and are easily hired as well because there are big numbers of such workers flowing in and out of employment. In the aftermath of the global economic crisis, there are no prizes for guessing which workers were fired first. Spain also has a very high rate of immigration, with estimates placing it at 2% of total population per annum. Indeed it is not uncommon to be walking the streets of Barcelona and hearing someone calling out to you in the distance in Hindi asking if you want to buy some pirated Estella or San Miguel! Catalonia has famously lax approach to dealing with illegal immigrants, and as a result there has been a huge influx from India, and Bangladesh in the past decade, most of whom are finding it increasingly hard to sustain a living in the current situation.

Zapat -Euro:
Jose Zapatero, the current Prime Minister has been a confused leader over the past year. Recently declaring that the crisis afflicting Spain is over, he seems to be over eager to assuage the bond vigilantes at the cost of ignoring the structural problems that are increasingly exacerbated by his asymmetrical  reforms. Being a part of a currency union, and at the same time fighting a country like Germany for competitiveness of exports, is certainly not fun for him. Zapatero comes from a minority Socialist party (so he cant take on unions), and he has been able to consolidate his leadership with the support of the Basque Nationalist party by allowing for devolved employment and training powers for the Basque regional government. He is involved in a give and take relationship with too many factions pulling in different directions for him to govern effectively. He has put in place tax increases on the rich (who earn above 120,000 Euro), but this will only effect about 200,000 people, most of whom will be able to evade the tax collector as is so often the case in Spain.

In conclusion, it will be interesting to see if the austerity measure put in place by the Socialist party will be able to achieve the target of reducing deficits to 6% in 2011. It will certainly be hard, and things can get really tricky for Spain if the numbers are not sorted out before markets set their sights upon attacking it head on. This will be very likely to happen if Portugal is bailed out in the near future and then the sustainability of the European Monetary Union will be in question.

The week of November 29th: 'Fed up'

Ho Ho Ho:

It never ceases to amaze me how much holiday sentiment moves the stock markets. This week, Christmas cheer has brought about a veritable 'Santa-Rally' in the American markets, with the S&P 500 hitting year highs, ploughing through previous highs set after the QE2 announcements. It comes as no surprise, because Santa Claus has helped the DOW and S&P have the best month each year in December every year since 1950! So buy in November and sell in January would be the advice that I would give for a very very safe investment strategy in American indices!

The rally has managed to overlook appalling unemployment data on non farms Friday. The unemployment percentage crept up to 9.8% for November. This number came as a big shock to me given that this weeks ADP report and Challenger Job Cuts were better than expected. One possible explanation could be some number rigging for the Mid Term elections in the release of October's payrolls data. I would not think it to be an impossibility given the desperate situation for the Democrats prior to the polling.

Fed up with the Euro zone:


It seems that American investors want to forget about European woes for now and concentrate on the rally. Yesterday with the worse than expected data, markets saw a huge amount of dollar sell off immediately after the data release. The Fed probably had a big part to play in that to limit the downside for equities.The ECB had already put the Euro into an uptrend following aggressive bond purchases. This move has been a complete U turn on part of the ECB on their proposed alternatives for easing the fiscal troubles in the Euro Zone. Trichet had been denying the need for bond purchasing up until this last week, and the claims of the ECB can hardly be taken on face value now.

The total state of disarray in the Euro Zone is bordering on the comical now. Portugal and Spain are to be taken to the guillotines next year and it remains to be seen if bond purchases have a longer term calming effect on the markets. I have my doubts.

Standard and Poor's also managed to show their famously incredible foresight and declared that there might be a problem with Portugal and they are looking into a possible downgrade. Amazing! The fact that the Portuguese economy has been in trouble since the past decade because it hadn't been able to get its fiscal house in order before joining the Euro zone was of course not a cause for concern for rating agencies (Portugal was the first country to be threatened with sanctions by the European Commission for breaking the Stability and Growth Pact). I sometimes really fail to understand what exactly analysts at rating agencies sit and do all day, but that is probably a rant for another time.

In my opinion, the only way to save the Euro Zone from complete collapse would be to prop up Portugal's economy as much as possible, because if the risk of contagion spreads to Spain (after a possible Portuguese bailout which is highly likely), it will get too much to handle given that the Spanish economy is double the size of the Greek, Irish and Portuguese economies combined. Yields on Portuguese 10 yr debt has fallen slightly this week as a result of ECB's intervention in the bond markets but remains unsustainably high:

So what is the problem with the Iberian peninsula? What are the structural and cultural factors at play? Ill have a go at explaining the same in next weeks post. Until then, the ECB asset purchases should be interesting to watch over the coming week, and American markets will probably remain in a range near their highs unless there is some massive loss in confidence. The Yanks are trying desperately to hold on to the gains made over the past few months, and it would be foolhardy to think that there will be a correction because the fundamentals dictate it. Do not fight Santa!

PS...watch out for Crude, which has rallied all the way back to $89.44 a barrel. Optimistic analysts hope to see this rally continue into the next year and reach $100 a barrel. I suspect this might be heavily correlated with the demand from China in the coming year.