Please read about the "State Pension Funds Shortfall”.My respect for our state goverment just hit a all time low. - Dave's Top Ten
Merrill Lynch
3 June 2005
This research product summarizes the 10 major macro themes of the past week as a
prelude to our weekly publication the Market Economist.
1. Fodder for the bond bulls and Fed policy doves: About the only risk we see in the
Treasury market is more short-term and technical in nature – overbought, and the
speculators have done much more than close their short positions (non-commercial
accounts now net long in the 10-year note to the tune of over 95,000 contracts, which in
the past marked an interim yield trough). Note that at the last three forays to or below
4% (February/05, October/04, and June/03) on the 10-year note, the net spec position
got as long as 94,494, 95,619, and 109,494 respectively. However, the macro landscape
is still very much bond-friendly. Note that Ford announced that it is going to cut Q3
output by 19% from Q2, in what will be the lowest production level since the end of
2001. GM intends to cut its assemblies by 12% quarter-over-quarter. Ford’s sales were
down 12% year-over-year, and GM down 11%. Even red-hot Toyota was off 2.4%. As
for all the inflation-phobes out there who believe that speculative runups in home prices
deserve to be in the CPI, look what’s happening in the auto sector – GM has embarked
on a “discounts for everyone” program, where rebates on 2005 models generally
reserved for employees will now be made universal. Paul Ballew, the company’s chief
sales analyst, stated that “our pricing is going to be more aggressive in June than it was
in May.”
2. No one can understand why bonds are rallying: Guide them away from the year-onyear
CPI data (yesterday’s story) to the pending pension crisis (tomorrow’s story). See
“Warning Over U.S. Friday announced huge losses and said it may end up needing a taxpayer bailout as more
companies are expected to pull a UAL and walk away from their pension obligations.
The really grim stuff is that by many accounts, the underfunded liability in state pension
funds is even more acute. The article uses New Jersey as an example where the shortfall
under a conservative set assumptions is north of $30 billion. All this smacks of an S&Ltype
crisis, which, if we remember correctly, represented a period of ever-declining bond
yields even as commodities were filtering through to the PPI and CPI. Let the
economists get consumed over those lagging indicators as investors focus on what’s
happening in the real world that is driving bond prices higher.
3. ISM Edges Closer To 50-Mark: Following in the footsteps of the European
PMIs, the ISM manufacturing index came in weaker than expected and
displayed weakness virtually across the board, confirming that the
manufacturing sector is struggling to keep its head above water. The headline
index dropped to 51.4 in May, the lowest reading since June 2003. Both
manufacturing and customer inventories remained below the 50 mark. For the
first time since October 2003, the employment index moved below 50, dropping
3.5 points to 48.8 in May, which is consistent with our view that the pace of job
cuts in manufacturing intensified in May. It is also consistent with our below
consensus 150k forecast for total nonfarm payrolls due out this Friday. Other
details of the report suggest that the pace of manufacturing activity has shrunk
to 2003 levels. Notably, the production index slipped to 54.9 from 56.7 – the
lowest since June 2003. The forward looking subcomponents such as new
orders and new export orders also posted notable declines, an indication that
production activity will remain slow in the near term.
4. Back on February 3rd of this year, we published a report titled “Why The Bond
Market Has Optim-ISM”, which showed how ISM cycles are inextricably
linked to bond market cycles. It is not complicated-market rates are highly
cyclical and so is ISM. Look at the “nominal ISM” (prices paid multiplied by
the headline index) against the 12-month change in the 10-year note yield.
This has nothing to do with whether the yield is “too high or too low” and
whether it’s “over or undervalued.” And it certainly has nothing to do with
foreign central bank activity. It’s about the business cycle. If you’re
fundamentally bearish on the direction of the 10-year Treasury note yield,
have a view that we are either going to see the ISM index, prices-paid, or both
to embark on an upward path (as it did from mid-’03 to early ‘04 when we
had that vicious bond sell-off). Meanwhile, the ratio of orders to inventories
suggests that the ISM has yet to make a bottom ... so it would stand to reason
that 10-year yields haven’t either.
5. Chinese Revaluation – Not a “Fair Trade” from an Employment Standpoint:
The grim reality is that a yuan revaluation would likely not add one solitary job
over here in the USA (Pakistan, Thailand and Bangladesh, perhaps) but it
could end up costing jobs, in our view. Consider for a moment that the U.S.
employs just over 1.5 million people in the sectors where we import the most
from China – toys/appliances/electronics/apparel. And let’s not forget,
U.S./China wage differentials being what they are, the trend towards
outsourcing to China is not going to go away. At the same time, there are
nearly nine million employed in construction and real estate – “only” six times
larger than the sectors that have lost market share to China (and if it was not
China, it would be some other low-cost foreign locale). When it comes to
what a revaluation would mean for the overall U.S. job market, the math is
pretty daunting. For every one-percent loss of employment in the construction
and real estate sector due to the prospect of higher interest rates (though a
sustained run-up in rates is not our base-case view, the risks cannot be totally
dismissed), we would have to basically create 12% more jobs in the
apparel/textile industry just as an offset (the income trade-off is even larger).
Now from our lens, that hardly looks like a fair trade – for the economy.
6. Cracks in the Housing Boom’s Foundation Beginning to Surface: We have
said for some time that where we would start to see signs of the bubble
bursting would be via the press (like we saw with Orange County in Barron’s
circa Dec/94 and LTCM in the WSJ in Aug/98). Now a sobering article in
Wednesday’s Washington Post titled “U.S. Foreclosure Surge Taints Housing
Boom”. The article centers on Philadelphia ... the city and its suburbs, and
indeed much of Pennsylvania have experienced a foreclosure epidemic as
low-income homeowners take on mortgage debt they can’t afford. According
to the article, foreclosed properties are now running in excess of 1,000 per
month – tripling from five years ago. In fact, according to Foreclosure.com
(an online foreclosure-listing service), foreclosure rates rose in 47 states in
March. With nearly one in ten Americans spending more than half their
income on monthly mortgage payments, and over 60% of new mortgage
originations in ARMS and interest-only loans, the acting U.S. Comptroller of
the Currency (Julie Williams) said “we are clearly seeing a spike in
foreclosures in a number of our major urban areas .... we’ve produced a new
class of lenders willing to take on riskier and riskier borrowers at a very high
price. Many of the products are nothing more than time bombs”. This is why
it is a mistake to lay this at the Fed’s door and why a bear market in
Treasuries would be disastrous...in our view, it’s a problem of widespread lax
lending standards (it’s no coincidence that 70% of the foreclosures are among
households who were lured into the market by “subprime” mortgage brokers).
7. A look at inflation from 30,000 feet in the air (where I have been spending a
considerable amount of time in the past two weeks): What will make this
inflation cycle less of a long-lasting threat than what we saw in decades past
is the lack of labor bargaining power. In 1980, 22% of the workforce was
unionized versus 12% today. The telecom sector is a great case in point – in
the mid-1980s, the union membership was 625,000 strong compared with
275,000 today. Mergers, deregulation and technological change has sharply
compressed wage and price pressures. A Cornell University study found that
a technician in the unionized Bell company earns $46,500 a year while a nonunion
worker at a cable company earns $35,700.
8. Jump in unit labor costs not at all worrisome, in our view: For several
reasons we do not believe that the jump in unit labor costs poses a significant
inflationary threat. We highlight three reasons: 1) The bulk of the increase in
unit labor costs was in the fourth quarter, so it is a backward look at what
costs and prices have been doing, which provides no information about what
is going to happen going forward. Given the downside risks to economic
growth as the Fed keeps pressing on the monetary policy brakes, we think the
trend will be towards softer, not stronger, compensation growth. 2) Since
profits surged by more than 65% in the fourth quarter and by 20% in the first
quarter, margins remain high by historical norms. 3) We believe that the
surge in compensation likely stemmed from one-time payouts to employees,
such as year-end bonuses, which only increase the level of labor costs but are
not inherently inflationary. In all, we continue to believe that inflation will
start to trend lower later in 2005.
9. Both France and the Netherlands rejected the EU constitution. Although
market reaction to the results was relatively subdued – it was widely expected
and was priced-in – the political repercussions and its effects on the euro are
huge. In France, with such a decisive vote on the issue it will be very hard to
call for a second vote. In addition, the “non” vote also meant a “non”
confidence vote on the current government and the leadership of President
Chirac. Indeed, PM Raffarin handed his resignation papers to Chirac (as
expected), and in turn he quickly appointed Interior Minister De Villepin to
the post of PM – his socialist leanings are not expected to benefit reform or
market focus developments.
10. Australian house price index rose 0.2% q/q in Q1, which brought the yearover-
year trend to 0.4% – a huge slowdown from the 19% y/y growth rate in
the fourth quarter of 2003. Among the 8 major cities, house prices in Sydney
were flat, while prices in Melbourne fell 1.6% q/q, and Darwin saw the
biggest increase of +3.8% q/q. This situation looks very similar to the U.K.’s
housing market and we believe that the U.S. will follow in their footsteps
sooner or later. Imagine, all the RBA and the BoE had to do was to raise rates
125 bps to effectively cool down the housing market; the Fed has raised rates
by 225 bps and the housing market still continues to be red-hot. The day of
reckoning may be coming. The year-on-year pace of real estate loans is
slowing, going from a cycle peak of 17.8% in May of 2003 to just over 11%
currently, refis are down 78% from its peak and purchases of new mortgages
have now cooled off, down 12% from their peak. In addition, our proprietary
housing index is now down for the 11th straight week, which suggests that the
housing market is poised to slow. |
