Deteriorating Financial Conditions Threaten To Escalate The European Debt Crisis

Mosaic Global Perspectives
Fundamental and Technical Analysis, but Mostly Judgment
Date: 11/22/2011
Global markets remain captive to the ebb and flow of headlines associated with the European debt crisis. Market forces are creating an environment that may compel European policymakers to make hastened decisions regarding the future structure of the Eurozone. Meanwhile, the escalating crisis within the European short-term funding markets is fueling additional concerns regarding counterparty risk and solvency within the banking sector. Given the increasing level of government intervention in the global financial markets, theres a heightened risk of additional policy mistakes and unintended consequences that outweigh the recent improvement in U.S. economic growth. Our process of evaluating global financial conditions and leading indicators has kept us tactically underweight in equities and high yield since May. The widespread deterioration among our primary metrics for global financial conditions and leading indicators suggest that portfolios should remain tactically underweight in equities, particularly small cap along with most other risk-oriented asset classes. In Europe, spreads such as the Euribor-OIS, FRA-OIS and swap spreads have widened sharply due to the growing fear of counterparty risk based on potential exposure to sovereign debt risk. However, the conspicuous widening of the 3-month EUR-USD cross-currency basis swap provides a cleaner view than Libor spreads of the U.S. dollar funding crisis within Europe. In the U.S., our Mosaic Financial Conditions Index has been signaling lower equity prices since late April; however, the recent dislocations within the interbank lending markets have heightened the probability for more pronounced downside shocks. Although the short-term funding markets are more stable in the U.S., speculation has caused a spike in the FRA-OIS spread over the past two weeks. In our view, elevated levels of stress within the interbank lending markets carry negative repercussions for both the accessibility and cost of credit. This has historically led to slower economic growth rates or recession. One of our core investment principles involves analyzing the various credit markets for valuable insight regarding the future direction of equities. Despite a brief recovery in October, most sectors within the credit markets have been forecasting lower equity prices since May. Overall, the current spreads within the various credit sectors (not spreads versus USTs), are consistent with prior recessionary levels. As Italy has overtaken Greece as the primary source of anxiety amid Europes deepening debt crisis, its important to note that French banks have the largest exposure to Italian debt. Increasing speculation that France could lose its triple-A rating has contributed to the doubling of the OAT-Bund spread over the past six weeks. As expected, both Italian and Spanish government yields have also widened sharply versus the German Bund during this same period. The continued talk of austerity without addressing growth initiatives will certainly deepen the widely anticipated recession in the Eurozone. Even the Bundesbank announced yesterday that growth in Germany may slow to a standstill next year. Benefiting from the status of a safe-haven asset, the 10-year U.S. Treasury yield is back below 2.0 percent, and the 2s10s curve has bull flattened considerably in so far this month. Lower bond yields in conjunction with a flatter curve have often preceded periods of future economic weakness and lower equity prices. The U.S. and global financial sector have been broadly weaker than the broad equity indices throughout most of this year. We contend that a healthy and durable rise in equities must be accompanied by reasonable relative strength in the financial sector. In addition to bank profits being constrained by a flatter yield curve, the most recent Senior Loan Officer Opinion Survey (SLOOS) reported a modest tightening of loan standards for large C&I firms coupled with a sharp decline in loan demand. Please see Financial Conditions, Page 2
M o s a i c M a r k e t R e s e a r c h , L L C K e v i n A . L e n o x , C F A W e b s i t e : M o s a i c m a r k e t r e s e a r c h . c o m [email protected] i c m a r k e t r Fundamental and technical analysis, but mostly judgment m a i l : K l e n o x @ M o s e s e a r c h . c o m
Financial Conditions, Continued

Meanwhile, anxiety is being reflected by the sharp rise in CDS spreads throughout the industry due in part to the largely opaque disclosures regarding counterparty risks (gross could potentially move much closer to net). It been especially encouraging to see the 4-week initial unemployment claims figure drop below 400,000 for the first time since April. The most recent NY Empire and Philadelphia Fed Surveys also point to further strengthening in the upcoming Institute for Supply Management (ISM) Manufacturing Survey for November. In addition, retail sales that excludes both autos and gasoline jumped by a surprising 0.7 percent in October. Overall, the higher frequency economic reports point to a more sanguine economic environment, but we suspect that the current weakness in asset prices will prove to be the better leading indicator. At this point, the weight of the evidence suggests that risk oriented asset prices will remain vulnerable to heightened levels of volatility coupled with an unfavorable risk/return environment. In our view, equity prices could move meaningfully lower if financial conditions continue to deteriorate. Specifically, further stress within the interbank lending markets would constrain the availability of credit while simultaneously raising the cost of debt in many of the already debt-laden OECD countries. Fortunately, equity valuations, particularly relative to bonds, should provide support for equity prices. Overall, companies within the S&P 500 are supported by healthy balance sheets and lean cost structures. That said, our proprietary analysis of financial conditions and leading indicators have kept us tactically underweight in equities and high yield bonds since the May 9 issue of Mosaic Global Perspectives. Weve missed a few trading opportunities since then, but were content to remain defensive until our indicators show broad-based improvement.
Disclaimer
All opinions expressed are solely the opinion of the author. You should not treat any opinion expressed as a specific inducement to make a particular investment or follow a particular strategy, but only the expression of an opinion. Such opinions are based upon information the author considers reliable, but it should not be relied upon as such. The author is not under any obligation to update or correct any information available in this report. The author may be actively involved in securities discussed herein. Also, the opinions expressed may be short-term in nature and are subject to change without notice. Past performance is not indicative of future results. You should be aware of the real risk of loss in following any strategy or investment discussed in this report. Strategies or investments discussed may fluctuate in price or value. Investors may get back less than invested. Investments or strategies mentioned in this report may not be suitable for you. This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. You must make an independent decision regarding investments or strategies mentioned in this report. Before acting on any information, you should consider whether it is suitable for your particular circumstances and strongly consider seeking advice from your own financial or investment advisor.
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Fundamental and technical analysis, but mostly judgment

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Mosaic Global Perspectives

Fundamental and Technical Analysis, but Mostly Judgment

M o s a i c M a r k e t R e s e a r c h , L L C K e v i n A . L e n o x , C F A W e b s i t e : M o s a i c m a r k e t r e s e a r c h . c o m [email protected] i c m a r k e t r Fundamental and technical analysis, but mostly judgment m a i l : K l e n o x @ M o s e s e a r c h . c o m

Financial Conditions, Continued

Fundamental and technical analysis, but mostly judgment

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