Fueling recovery: business and consumer lending on the rise

Credit is the fuel for economic recovery and expansion. We may be seeing the beginning of the next credit expansion, with the nation's largest commercial banks finally increasing their lendings to both businesses and consumers, see this WSJ report.

Signs of a lending rebound in business loans already were evident at some big U.S. banks, and Mr. Dimon cited "fairly broad-based strength across corporate, middle market, even small business." But consumer lending has lagged behind because of unemployment, foreclosures and the reluctance of many Americans to go deeper into debt.

Now, the economy is gaining momentum, as shown by the Commerce Department's report Friday that consumers spent more for the sixth straight month. That means profit-hungry bankers are growing more eager to make new loans, especially to borrowers with strong credit histories.

JP Morgan has just reported a great quarter. More are yet to come from Wells Fargo, Bank of America, and Citi this week.

According to Dick Bove, an influencial bank anaylst, banks are entering a "golden age."

What the bond markets are saying

It's often very important for equity investors to look at what the bond markets are saying.

The long-term yields of US Treasuries have stabilized after the December FOMC meeting. They were creeping up since the Fed indicated its intention to do QE2, and especially after the bi-partisan decision to extend Bush-era tax cuts. US government has no trouble borrowing. The upward sloping yield curve is re-assuring for bank stocks and general equities.

European countries are a different story. The Euro crisis is pretty much still with us. Credit spreads for Greece and Ireland continued to climb in recent weeks. The Greek bond spread is now wider than it was in May, 2010 before it was bailed out by EU and IMF (see Atlanta Fed Financial Highlights). All eyes are now on Portugal as its government are trying to convince investors that they can narrow their budget gaps. The yield on Portuguese 10-year bonds stood at over 7 percent as of last week, according Bloomberg. Can ECB and IMF manage the situation before the crisis spreads to Spain? Investors are not convinced.

In the US, a worrisome development continues to be the muni market and state budget crisis. Illinois is the poster-child of the fiscal mess. The state's bonds have the highest spreads of any state. Illinois's 10-year bond spread has widened in recent weeks to 2.1 percent above the benchmark. A year ago, that spread was less than 1 percent... meanwhile, Bernanke's testimony last week made it clear that the Fed has very limited power to bail out the states.

The bright spot is US corporate bonds. Companies are taking advantage of investors' hunger for yield and the general belief that the corporate sector is healthy and may be poised to deliver the much-needed hiring. Corporations have sold more than $35 billion of investment grade bonds in the first week of 2011, according to the Wall Street Journal, on track to reaching the highest amount sold in the year-opening week since 1995.

Taken together, we agree that it may be wise to invest in US equities, and focus on companies that conduct businesses in states that are relatively healthy and can take advantage of the needs from the emerging markets. Avoid European exposures for now. And be vigilant about systemic risks posed by the Euro crisis and the US state budget crisis.

We do not think China's and India's inflation problem pose such a systemic risk to global financial markets, but it's something to watch out for.

Explosive optimism

This weekend's Barron's has the usually bearish Alan Adelson put up a big warning in "Signs of a Top?"

Market sentiment following the surging December is characterized as "explosive optimism." Indeed, forecasts from Goldman Sach's Jim O'neill's 20% stock market gain and "Year of USA" proclamation, to various market gurus that Barron's has assembled, to the recent low in VIX all seem to agree on a very good year ahead.

Could this be the sign of a temporary market top before the real economies produce sufficient results to support it?

This is probably the most important question to ask heading into the first week of 2011. Perhaps the December surge was really just an amplified "window dressing" and short-covering effect when all the under-performing portfolio managers tried to buy the year's big winners and short sellers ran for the cover. If so, these stocks are over-bought and can see sell offs in January.

As noted by Adelson, one important area to watch is indeed the commodities-related stocks which seem to have not reflected the new policy stand by China trying to reign in inflation and the potential bubble in property markets. China has raised interest rates multiple times and bank reserve requirement multiple times. And RMB has not appreciated much. It seems pretty clear that the easy bank-lending policy of the crisis era is now on reverse.

Yet, from copper, iron ore, to other industrial metals and the companies engaged in their productions, the market continues to assume an ever-expanding appetite out of China. FCX has hit 120/share! Can this continue in the new year? If that reverses, it could be a leading signal for things to follow. For a good anlysis of the copper market, and a fair warning, see this Seeking Alpha article.

Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.

State Budgets: Day of Reckoning

While the VIX has been trending down to below 16%, the lowest level since April of 2010, the Muni bond market may be telling us something quite different. The yield spread (against an index of the highest-rated muni bonds) on debt issued by the State of Illinois, for example, has been increasing rapidly from pre-crisis level of about 0.2% (2008) to about 2% in late 2010.

The video below from CBS 60 Minutes is a must see.


Will weak local governments create a similar systematic financial problem posed by the weak Euro members?

Rising mortgage rates goes with rising housing starts?

Housing starts have been in the dump for most of 2010, especially after the experiation of the tax credits. This morning's report shows some life in this important sector. Perhaps the sector is now ready to stand on its own feet.

Mortgage rates however have been rising rapidly since the Congress and the Administration started to work on extending the Bush-era tax cuts. Investors have been shunning Treasuries, in favor of cash, commodities, or equities. This is not necessarily a reflection of rising inflation expectations, although that could be part of the reason (judging from the implicit inflation rate priced into TIPs). On balance, investors are probably betting that the expansionary monetary policy as expressed in QE2 should work well in the thort term with the accommodative fiscal policy should it passes the House. Rising long-term T rates, which causes the T yield curve to steepen, is a sign that the economic recovery may quicken 2011-2012.

The Fed's goal was to stimulate the economy via asset inflation. It has so far succeeded in chasing investors away from the "safe haven" of the Treasuries, into more risky assets that are more tied to the US and global economies.

That's only the beginning. For this twin stimulus to work, the private sector needs to move up in a big way to employ more works. Millions more. More jobs would help housing starts. And more housing starts would jump start more construction jobs.

For people looking to buy a house, mortgage rates in 5-6% are still relatively low. The dominating variable is job security. Besides, when the rates rise to a certain level, bond funds and foreign government would purchase more long-term US government bonds to help hold down the rates.

In this mix, banks that have repaired their balance sheets and have successfully re-positioned themselves to take advantage of the steep yield curve and the economic recovery should be ready to print profits in the boat loads. One of the prime beneficiaries will be Wells Fargo, whose market cap has again overtaken that of JP Morgan today with its share rising over $30. A recent Barron's article has put WFC's shares at $35-40 range based on its normalized earnings power, which it should start to show itself in 2011 when Wachovia branches are all converted.

Investors should hold on to these bank shares, and some of the home builder shares for an interesting "rabbit ride" in 2011. 

Job news so bad that the market doesn't care

It was a lousy headline: the economy added only 39,000 jobs in November against the expectation of 150,000. Unemployement rate creeped up to 9.8% from 9.6%. You would think that the Dow should take a nose dive and gave up all gain from the two previous sessions. Instead all major indices held their grounds pretty well.

The BLS report stands in stark contrast to recent data from ADP (+93,000 jobs), and modest Challenger layoff announcements (+48,711).

The employment index from the ISM Non-manufacturing release today also showed a pick up in hiring.

So, perhaps the market is looking forward to upward revision in the BLS data.

Or, perhaps that the market takes the bad news as a piece of good news in the sense that the Fed now can use it to strengthen its bond-buying program announced in November. The next FOMC meeting is only 10 days away. The Fed's support was essential for the market's run from late August to early November.

If the headline had been a positive surprise, the market may actually get worried.

Gold runs up either way...