Weekly Pulse: Apple pie

Political posturing continued this week as U.S. President Barack Obama embraced a $3.7 trillion debt cutting plan from a bipartisan group of senators known as the ‘Gang of Six’. The administration signaled it may accept a short-term increase in the debt ceiling if it is combined with a major agreement to cut the deficit.

Obama’s remarks spurred optimism that an agreement ahead of the August 2nd deadline can be reached. Republican House Speaker John Boehner then threw cold water on that plan claiming a deal was ‘not close’ despite strife within the ranks and little time to avert a U.S. default. Gold seems to like the uncertainty, as it rallied to yet another all time high. Silver also rose for the third consecutive week.

European stocks climbed, snapping two weeks of losses as Euro leaders agreed on a second bailout package for Greece. Leaders announced €159 billion in new aid for Greece and cajoled bondholders into footing part of the bill. Europe’s biggest banks stand to take about a €21 billion haircut as they ‘voluntarily’ agree to a bond exchange and debt buyback program. Greece may be a write-off, but the goal is to prevent this crisis from engulfing either Spain or Italy. This latest deal was viewed as at least a step in the right direction.

In tabloid news, embattled News Corp boss Rupert Murdoch was attacked by a protestor and hit with a foam pie. (The protester was subsequently ‘volleyed’ by Murdoch’s wife). Mr. Murdoch likely wishes the pie was ‘apple’ rather than ‘foam’ had he known what kind of blow-out quarter Apple Inc. would have. The tech giant crushed expectations once again as part of a strong week of earnings. 147 companies have reported and the results have been favorable. 110 have exceeded expectations (74.8%) in Q2/11. In Q2/10 the positive surprise rate was 75.3% so we are tracking nicely despite expectations of a slower economy and squeezed margins.

Offsetting to the favorable earnings results was a round of downbeat economic reports including China’s Manufacturing PMI which dipped below 50 in the month of July. The drop was further evidence the world’s second-largest economy is slowing. Also, U.S. weekly jobless claims remain stuck above the 400,000 level largely seen as a threshold to be breached before there is any progress on the employment front. The Bank of Canada suggested higher interest rates will be here sooner than later, but June CPI data was slower than expected so it’s anyone’s guess when rates will begin rising. The market is suggesting September.

The Trading Week Ahead

Earnings Season will assert itself as the main focus for stock markets next week although it is the final full work week for politicians trying to strike a debt ceiling deal ahead of the August 2nd deadline. We believe a deal will be reached and it could be announced in the week ahead. A deal will almost certainly give stock and bond markets a short-term boost ending at least one overhang of uncertainty.

On the data front, U.S. housing saw a ray of light last week with stronger than expected starts in June and a larger than expected FHFA price index increase in May. The question is was this one-off or has the housing market finally bottomed? Tuesday’s CaseShiller Composite index should give further evidence. The index, which looks at property values across 20 cites, fell 4% in the month of April.

Next week’s Beige Book summarizes the central bank’s discussions with business leaders that took place from June through early July. The report is being prepared for use at the August 9 FOMC meeting. The tone of the last Beige Book, released June 8, was decidedly weaker than those of the previous three reports. The silver lining last month was that specific factors were cited for the slowdown in some districts – factors that have since dissipated. These included bad weather, disruptions related to the Japan disaster, and higher food and energy prices.

U.S. and Canadian Q2 GDP growth should basically be flat compared to Q1. What explains the disappointment? Temporary factors undoubtedly account for some of the shortfall. Surging oil prices flattened consumer wallets and the Japan disaster disrupted production, particularly in the auto sector. Assuming the consensus is correct, U.S. growth would have to average between 3.4% and 3.9% in the second half of the year to match the Fed’s 2011 forecast.

Canadian earnings season gets underway this week with big Energy and Mining companies due to report, including Cenovus, Suncor, Teck, and Barrick Gold. We anticipate healthy cash flow and positive earnings surprises, specifically in energy and mining, as analysts may have been too aggressive cutting estimates in light of the commodities price pull back.

Question of the week?

What if the United States loses its AAA credit rating?

After having failed to warn investors of the dangers associated with the toxic debt of entities like Enron, Fannie & Freddie, as well as the perils of investing in mortgage-backed securities and sovereign debt of various bankrupt countries, the credit ratings agencies have now apparently decided to be more vigilant. The agencies have offered warnings that they may lower U.S. debt ratings if Washington fails to make progress on its fiscal problems. Some argue a downgrade would not be such a disaster.

We contend that global stock, currency, and bond markets would all shudder violently and heave uncomfortably if the U.S. cannot see fit to increase its debt ceiling and also agree to a deficit reduction plan by the August 2nd deadline. The spending cuts and tax increases would have to be serious ($3-4 trillion over 10 years) to avoid a rating downgrade. Other nations have been downgraded (Canada in the 90s) and in turn survived, but none have had the same degree of dependence on overseas capital that the United States’ economy has.

At the very least, if politicians cannot put aside their partisan theatrics and get back to the business of running the country, a credit downgrade will almost certainly extend the already seemingly endless period of uncertainty and volatility in the markets. One thing is clear. The fallout from the global financial crisis continues has now transferred from the banks and on to the governments of the world.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP