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This note was originally published September 30, 2010 at 08:10am ET.

“A government big enough to give you everything you want is a government big enough to take from you everything you have.”
-Gerald Ford [Address to a Joint Session of Congress - August 12, 1974]

EARLY LOOK: The Incorrigible Hand - Gerald Ford

In yesterday’s Early Look, Keith said “I haven’t considered a heightening probability of a US stock market crash in an Early Look note since 2008.”  After reading that all I could think about was 1987 and a very difficult Friday in October.  We have five Fridays in October this year and I, for one, am concerned about all of them!

The current backdrop:

First catalyst - The Incorrigible Hand:

  • A financial bubble fueled by easy money and loose credit bursts  
  • Unemployment rises and GDP growth slows 
  • The misguided in Washington blame foreigners for unfair trade practices and pass a trade bill   
  • Thus sending the country into further economic weakness

EARLY LOOK: The Incorrigible Hand - Schumer

Some elder Americans have seen this movie before.  The rest of us can read about it.  The fragile state of our economy, which the data is speaking to daily, is not lost on Main Street America.  In Washington, politicians are posturing accordingly.  Schumer and friends are spitting fire about China’s “economically injurious behavior” and the need for action against the “currency manipulators” in the form of a trade tariff on Chinese imports.  Look no further than the Smoot-Hawley tariff act of 1930 for an example of what such action may result in for this country.  Despite a petition signed by over one thousand economists requesting a presidential veto, this law was signed into effect and many believe exacerbated the Great Depression.

Yesterday, the House of Representatives passed H.R. 2378 or the Currency Reform for Fair Trade Act.  If it becomes law this year (which is unlikely given the mid-terms and that the Senate is only in session for a few more days), the bill would give the Obama administration the power to raise tariffs on imports if the Commerce Department determines that an exporting country is manipulating its currency.

The refusal to yield to common sense on the part of those pushing this bill is beyond belief; you can’t make this stuff up.  The CBO released a report showing that the new tariffs would raise only $20 million versus the billions in trade we do with the Chinese.  Thinking we can legislate the YUAN higher is just lunacy.

Second catalyst - the Financials are at risk:

According to our Financials analyst Josh Steiner, certain Financials are setting up to be a great short.  In his note yesterday he said “this is the third time this year that we've written a note on high yield and its relationship/implications for the XLF. High Yield is knocking on the door of its YTD highs once again; the index peaked at 8.19% on April 29th, 8.28% on August 3rd and closed two days ago (September 27) at 8.24%. Following those first two peaks in high yield, XLF dropped 18% and 10%, respectively over durations of 64 and 23 days.“

Third catalyst - the cost of bailing out the European mess is on the rise:

Europe’s woes continue, whether the eyes of the manic media are focused on them or not.  Ireland’s government has injected 30 billion euro into Anglo Irish Bank since January 2009 and estimates that 11.4 billion euro in additional liquidity may be required.  Another lender, Allied Irish Bank, is also set to receive government funding bringing the total cost of Ireland’s bank bailout to as much as 50 billion euro ($68 billion).  In addition, the country's budget deficit will balloon to 32% of GDP this year.

Fourth catalyst - Fridays ISM print:

Once again, we are looking at a Friday in October as bonds signal trouble and stocks levitate.  I understand that the economic backdrop of the crash in October 1987 was very different, but it’s still all about interest rates, the dollar and budget deficits.  This time, the “emergency” level of rates is not helping to stimulate the economy as intended. 

Tomorrow the ISM manufacturing index for September will be reported.  The August reading of 56.3 posted a big upside surprise versus expectations of 52.8, setting off a 9.09% rally in the S&P 500.  Since then, Factory orders, ISM non-manufacturing, Empire Manufacturing, Philadelphia Fed, Chicago Fed and the Dallas Fed have all reported disappointing numbers relative to expectations.  All of the regional FED readings, except the Empire State manufacturing reading, are showing September numbers that imply economic contraction, not expansion. A reading below 50 on the ISM is in play for the first Friday in October.

EARLY LOOK: The Incorrigible Hand - obama schumer

We believe that the fundamentals are pointing to the downside and the catalysts outlined above highlight some key risks to be aware of.  With many close races in the November elections, pointing fingers at others is the favored position in D.C. Rest assured, government’s Incorrigible Hand will be in action.  There are historical precedents for this kind of policy.  Looking at a more contemporary cautionary tale, Japan, is also instructive.  We will be exploring the lessons to be learned from Japan’s experience next Tuesday, October 5th when the Hedgeye Macro team hosts the 4Q10 Macro Themes conference call (email sales@hedgeye.com if you are interested in the call).  The three themes are:

(1)    Japan’s Jugular  - Japan got rocked last night, down 1.99%, now down 11.6% YTD.

(2)    Krugman’s Kryptonite - comparing our Japan conclusions to academic dogma about debt financed deficit “stimulus”, and deconstructing  Paul Krugman’s math.

(3)    Consumption  Cannonball  - The Incorrigible Hand strikes again!

Function in disaster; finish in style.

Howard Penney