Big Picture:

The balance sheet recession continues here in the US, and in Japan and Europe. As Reinhart & Rogoff suggested in their book – This Time Is Different – we can expect recessions to come more frequently and economic growth to be more shallow than we’ve come to expect over the past several decades.

The greedometer and mini greedometer are showing some very interesting readings. In some respect, current risk levels are similar to those seen when the US stock market reached the all time high in 2007, and again at the April 2011 peak. (much more in the private client letter next Tuesday.)

In the US:

• 4Q 2011 earnings season kicked off this week. A solid read on 4Q 2011 earnings will be in place by the end of the month.
• You may recall that last quarter’s earnings season saw large banks book profits as a result of their own bonds losing value over the third quarter (yes, you read that right). That process will have been thrown into reverse as large US bank bonds saw price gains in 4Q — forcing banks to account for the increase as losses. This is because those bonds are a liability to banks. Thus, if a given bank’s own bonds rise in price, its balance sheet will have weakened since its debt became larger. Rest assured, the bank will play down the loss as accounting gimmickry. Funny though, you didn’t hear banks downplay the paper gains they made when the reverse was true last quarter — when they booked gains from accounting tricks.
  • case in point: JP Morgan. Last quarter (3Q 2011), JP Morgan added a $1.9B accounting gain to their bottom line — because of their bonds losing value. That was 44% of the profit! Remove that $1.9B, and throw another $1.9B to account for a reversal of the previous quarter’s bond accounting gain and you’ve got a $3.8B headwind to overcome. Given that 3Q saw $4.3B in earnings, a reasonable earnings guess would have been $0.5B for 4Q. So how’d we get to $3.7B this time (and on $2.2B less in revenue!)? You guessed it. More accounting gimmickry. JPM only accounted for a $.57B loss from the gain on their bonds (nowhere near a $1.9B loss). And loan loss reserves were lowered again by $.73B. By the way, I wrote this paragraph before 4Q earnings came out and left blanks to be filled in for the numbers. I was expecting these games to be played. It’s nice to have a few $B to slosh around when you need it to “make your numbers for the quarter”. Much the same thing was done at the beginning of the Great Recession. I would not expect these numbers to make investors happy.
  • Here’s a wider & simpler view. 2011 saw $5B less revenue and $1.7B higher expenses than 2010. Yet net income miraculously grew by $1.8B. If it weren’t for loan loss reserves being slashed, JPM would have seen net income drop by $9B — a 50% drop from the previous year.
• Speaking of sandbaggers…… As is the case immediately before earnings season begins, CFOs are busy lowering guidance on the quarter with an earnings report immediately infront of us in order to help drive the stock higher when announced (& masterfully manipulated) earnings are reported that beat the recently lowered estimate. Shameless sandbagging. With this said, the ratio of negative to positive pre announcements is very high right now at 3.5. (the average being around 2.3X)
• The wildly overpaid column: Investment Analysts. Not once in the past quarter century has the consensus forecast by analysts at the start of the year called for a decline in earnings in the aggregate. Yet almost a third of the time earnings fell! You’d have to be a sucker to rely on consensus analyst forecasts.
• The Fed was the most profitable bank in world history last year by earning almost $77B in profit. This comes as a result of QE2 and operation twist. 2010 saw the Fed earn $81B in profit on its bond portfolio because of QE1 and QE2. While this is good news, keep in mind the size of the Fed’s balance sheet. It owns a staggering $2.8T in Tbonds and mortgage backed bonds. At some point, US Tbonds will be shunned by investors (because the US Congress continues to fail to produce a credible debt reduction plan). When this happens, the losses could easily exceed $100B.
• Small business sentiment improved in December — for the 4th month in a row. Nice. But readings remained at recessionary levels.
• If you have not already, you’re going to hear plenty of squawking from the Wall St hype machine over the currently low P/E on the S&P500. According to the hype machine, the forward P/E is 12ish. The more sane Shiller P/E remains around 21. Supposedly anything south of 15-16 means it is time to buy. Let me remind you that the Shiller P/E will drop to the 7-9 range at some point this year or next because this is where a secular bottom has always gone. Other things being equal that means the S&P500 will be more than sliced in half from where it is now.
• 4Q 2011 US GDP is likely to be in the 2.8 to 3.2% range, giving 2011 an end to end 1.6% GDP growth rate. Not enough to generate job growth. We’re told 1.6M new jobs were created in 2011. That’s not enough to keep up with population growth. And what do you know, roughly the same number of people left the workforce in 2011. In short, 2011 was a zero sum game for job growth in the US. Mind you it was the fourth year of wage deflation. I don’t believe that has happened in the US since the 1930s.
• 4Q 2011 also saw disappointing US retail data in December, and a marked increase in the trade deficit. This is not going to help support GDP at all.
• 1Q 2012 is likely to see 0 US GDP growth and contractionary numbers in the eurozone, the UK, and Japan. It is going to be very difficult to stop there. It remains my view that 2012 will see recessions in the developed world, and depending on how Europe’s financial crisis shapes up, the developing world will either stagnate or contract since it remains heavily reliant on exports to Europe and North America — and since it is also heavily reliant on funding from Europe’s banks. (how would you like to be reliant on them right now?)
• There’s a crunch coming. The latest estimates on November US home prices is as I expected: bad. We are going to see prices accelerate downwards in November 2011 through March 2012. This erosion of net worth is going to force a reversal of last year’s savings rate reduction. Combine this with a reversal in gasoline prices and we have an economic crunch in the making that is going to squash any economic growth in the second half of 2012 (regardless of what happens in Europe).

In Europe:

• S&P ratings agency poured water on the rally on Friday. It lowered the sovereign debt ratings by 2 notches for: Italy, Spain, and Portugal. France & Austria were lowered 1 notch from AAA. This move was telegraphed a month ago so markets took the news in stride. The ramifications for the EFSF bailout fund are not good though. There’s no chance it can remain a 440B euro AAA-rated fund now that France and Austria have been dropped out of the AAA club.  If the EFSF is no longer AAA-rated, pension funds will stop buying it.   Fear not!  The EFSF might now be marketed as a AA+ fund instead, and see an expansion.  This is after-all the same rating as the US.
• Greece: After two years of wrangling, arguing, and dodging, Greece continues to fester and pose a risk to the European banking system. Perhaps the saga is coming to a close. Private bond holders are apparently on the edge of agreeing to a 60% haircut. The IMF wants it. Greece wants it. But Europe’s creditor nations remain luke warm to voluntarily taking large losses (go figure). March 20th is the date for Greece to redeem a 14.4B euro payment. It does not have the money to get this done and needs the next bailout tranche. More good money after bad. Sooner or later this will reach a breaking point. Without doubt, that will be this year. But when? 
• A new record (high) for bank deposits with the ECB was set last week. Yup. There’s confidence. No credit crunch here. It’s all good.
• The euro currency is plumbing 16 month lows against the US Dollar. This is going to help reduce the pain of a recession in Europe. But! (you know what comes next…) This same process is going to bring pain to the US economy — not least because 20% of S&P500 company profits come from Europe. A more expensive US dollar hurts that profitability. This will begin showing up in 4Q 2011 earnings reports (now).
• Spain. Thursday saw a successful auction of 3 and 4 year sovereign bonds. I could hear the sigh of relief across the Atlantic ocean.
• Italy. Same story as Spain. Thursday & Friday saw successful debt auctions. But Friday’s was a squeaker. And the yield on the 10-yr remains around 6.7%. Not sustainable.
  • UniCredit — the largest bank in Italy – has been pummeled recently and has seen its stock lose roughly 80% of its value just in the past couple weeks (though it bounced back after the Italian sovereign debt auction). UniCredit announced a hefty discount on a share rights issue that spooked investors.
  • The share of Italian debt held by the ECB has sky-rocketed in the past 6 months. A quarter of the ECB’s holdings are now Italian bonds. It is well known that Italy’s bond refinancing calendar is brutal in 2012 and that it can overwhelm the ECB.
  • Thank you ECB. Per the bond auctions in Italy and Spain this week (noted above), Europe managed to dodge a bullet this week. The ECB’s recently implemented back-door QE feed trough (called LTRO) seems to be working. Banks are borrowing on the cheap from the ECB (money it created from thin air). Then they’re using that money to buy PIIGS debt, and parking that debt at the ECB as collateral. If this continues, Europe’s banking system crisis may be kicked down the road. After a couple years of this, banks will have mountains of cash from an immensely profitable carry trade, and they’ll then be able to write-off massive losses on PIIGS debt against their mountain of cash. This is what the Fed & Treasury manufactured here in the US 3 years ago. The fly in the ointment is European banks are under immediate pressure to increase their cash positions and improve their balance sheet to meet near term targets. The LTRO program represents a large increase in risk and could (should) be seen as weakening the balance sheet.
  • Germany. Weak German industrial data caused some stress this week — and drove many investors to buy the ultimate safety — short term German Bunds. The yield was driven into negative territory. Translation: Investors loaned their money to Germany and accepted a guaranteed loss.
    • Apparently the German economy contracted at a -1% annualized rate in 4Q, leaving it with 3% GDP growth for 2011. Not bad at all. A weaker euro should help German GDP stabilize in 1Q 2012. But the rest of the year does not look good.
  • France: Since the beginning of the year, the ECB has expanded the list of assets it will accept as collateral (it lowered its standards / increased risk). Roughly 80% of the newly acceptable assets are bonds from French banks. Is this a pre-emptive move prior to a loss of AAA rating in sovereign French bonds? Perhaps. One thing is for sure: it is a desperate move. Absent the latest ECB feed trough and lowering of standards, it is likely that several large French banks would be collapsing right now.

In Asia:

• China:  The most recent trade data (December) shows a much larger trade surplus. Hence China continues to grow at a nice clip. But! Much of this came from a weak showing in imports — a year low. On the whole, 2011 saw a $155B trade surplus –the third consecutive annual decline and the lowest trade surplus in six years.
• Inflation dropped to 4.1% –the lowest in rate since mid 2010. This will provide more room for the PBOC to lower bank reserve ratios and stimulate the economy. Maybe China will pull-off a soft landing. It is far too soon to tell. Trade with its largest partner (Europe) is going to be worsening all year long.