Michigan Consumer Sentiment Since 1978

The preliminary Michigan Consumer Sentiment reading for August came in at 54.9, which is the lowest it has been since 1980.  The number is significant for a couple reasons 1) It’s lower than it was during the 08/09 recession 2) It’s the first economic reading that we get for August, which doesn’t bode well for the rest of the month’s economic data.

Michigan consumer confidence first hit this low level in April of 1980.  It’s noteworthy that between that point and the end of 1980, the S&P 500 rallied 36%, from 100 to 136.  The market did end up giving that rally back between 1981 and 1982 though.

The other times Michigan confidence was this low were in November of 2008 and March of 2009.  Recall that the S&P 500 bottomed in the 700s in November 08 and had a 30% rally from there through the end of December before hitting a longer term bottom in March of 09 at 666.

Confidence Intervals and Seasonal Adjustment in Retail Sales

Retail sales were reported to have risen 0.5% for July over June, up 8.9% year over year.  Many cheered the number ex-autos which beat consensus of a 0.3% increase.  Economic data is noisy though, despite the fact that even mild “beats”can move markets.  Two factors adding to the noise are discussed here: confidence intervals and seasonal adjustments.

Confidence intervals are rarely reported with economic data, even though they are easily understood when reporting a public opinion poll.  Retail sales, like other economic data are only estimates (based on a sample of a larger group) and therefore each report has a confidence interval.  Retail sales’ confidence interval happens to be +/- 0.5%, meaning that there is at least a 30% chance that retail sales actually missed the consensus estimate of 0.3% in July.  

Another factor that significantly changes the interpretation of reported economic data is the seasonal adjustment, which is particularly true for retail sales.  Take a look at a comparison of seasonally and not seasonally adjusted charts since ’00.

Seasonally adjusted, retail sales were up in July 0.5%.  Not seasonally adjusted, they were down 1.04%. Adding to the noise, the seasonal adjustment isn’t constant and varies from year to year.  For example, the seasonal adjustment factor for January is below:
1992 0.898
1993 0.88
1994 0.876
1995 0.873
1996 0.885
1997 0.895
1998 0.897
1999 0.883
2000 0.882
2001 0.893
2002 0.901
2003 0.907
2004 0.909
2005 0.889
2006 0.889
2007 0.904
2008 0.914
2009 0.922
2010 0.906
2011 0.903
2012 0.899
2013 0.918
Seasonal adjustment is an added estimation on top of the estimated retail sales figure.  This creates the opportunity for further misstatement.  
Ignoring confidence intervals and seasonal adjustments can have a significant effect on the lens with which one views economic data.  In addition to these factors, “real” data adjustments (particularly to GDP) and historical revisions effect the interpretation of individual data-points.  Because of these inadequacies, beats and misses for any individual economic datapoint should be taken with a grain of salt.  

Foreign Holdings of Federal Government Debt

There was a particularly weak 30 year Treasury auction today, which helped send interest rates higher.  Notably the indirect bid, which is typically taken as an indication of foreign interest in a treasury auction, was only 12.2%.  This number is normally in the 30%+ range.  While individual treasury auctions are generally pretty noisy, treasury bears seized the opportunity to opine on the possibility of foreign boycott.

For context, below is a chart showing the percentage of publicly traded US Treasury debt held by foreign investors.  There has been a steady, slow downtrend since 4Q08, but compared to the increase over the last 4 decades, the decrease is just a blip.  Treasury issuance has exploded since 4Q08, so foreigners are still purchasing debt in huge amounts–just at a smaller share of the new issuance than they were.

Source: US Department of Treasury

Italian 10 year bond below 5% Yield

One of the reasons cited for the stock rally today is that Italy’s 10 year bond yield dropped below 5%.

Italian 10 Year Yield

This is a level that was considered by many to be unsustainably high and has been at least part of the catalyst for the recent selloff in US equities.  While the spread vs. Bunds is certainly large for a Euro sovereign, the idea that >5% interest rates are unsustainable is a little scary when one thinks about the number in absolute terms.  5% is a pretty low rate in any other environment.  Consider the history of the US 10-year since the 1960s.  A vast majority of time has been spent above 5% interest rates.

It begs the question: given the large debts that global governments have accumulated just within the last 3 years in a low interest rate environment, what would happen in a rising rate environment?

Looking at the Swiss National Bank’s Balance Sheet

The Swiss Franc (CHF) is trading sharply lower today against the dollar on news that the Swiss National Bank is considering a “temporary” peg of the currency against the Euro.  However, the move shouldn’t be too surprising to the market as the SNB has been trying to manage the CHF/EUR exchange rate aggressively for the past several years.

These aggressive actions have had a significant effect on the SNB’s balance sheet and, by extension, the assets which back the CHF.  Today, a large portion of the assets which back the CHF are EUR denominated, indicating that a “soft” peg has been in effect for some time.  (After all, a currency peg is executed by a central bank standing willing to purchase foreign currency in exchange for local at a fixed rate.)

Since 2009, the SNB has been heavily buying EUR in order to manage the exchange rate.  Foreign currency reserves now represent nearly 80% of the SNB’s balance sheet:

The bulk of the buying has been of EUR which now represents 56% of the currency reserves, or 42% of the aggregate balance sheet.
During the Eurozone crisis, the CHF has benefitted from a flight to safety trade.  However, a careful inspection of what the central bank holds against CHF suggests that perhaps investors are simply moving assets from the left hand to the right.  If 42% of the “safe” asset is backed by the “risky” asset, then how safe can that asset really be?

What would be the real impact of a capital raise at Bank of America?

I want to preface this post by saying that I don’t believe that Bank of America will have to raise more capital.  The bank has $12 in tangible book value per share, a TCE ratio of 5.87%, a tier 1 common ratio of  8.23% and a total capital ratio of 15.65%.  Additionally, BAC has assets which it could sell at gains in a worst case scenario which would raise capital levels without dilution.

All that said, with BAC stock down more than 40% for the year, the attention of capital markets has been focused on whether or not the bank may have to raise capital.  While I stress again, this is not my expectation, it doesn’t hurt to try to actually quantify what this worst case scenario would look like.  In order to try to quantify what the effect of that dilution might be, here’s some simple back of the envelope math:
Dilution Assumptions
  • In 2009 at the height of the credit crisis, the stress tests (which stressed the bank for depression equivalent credit deterioration) determined that BAC needed to raise $33.9B.  
  • In order to be more strenuous, lets assume that BAC must raise another $50B today, at a price about 30% below where the stock is trading today: $5 per share.  
  • This means that in order to raise a hypothetical $50B, BAC would have to issue 10B shares at that level.  
  • At the end of 2Q11, BAC had approximately 10 Billion shares outstanding, so 10B more shares would double the share count to 20B shares.
Earnings Assumptions
  • Bank of America had $2.26T in assets as of the end of 2Q11.  Let’s say this shrinks at 5% per year for 2 more years, BAC would have about $2T in assets at that point.
  • The ROA for the entire banking industry in 1Q11 was approximately 0.80%, this likely increased in 2Q11.  WFC for instance in 2Q11 earned an ROA of 1.25%.
  • If we apply the industry ROA of 0.80% to BAC’s hypothetical assets of $2T, this means BAC would earn $16B in a normalized environment.  To be clear, I think BAC can earn a lot more than 0.80% ROA and will likely have more than $2T in assets, but these are stressed assumptions.
  • $16B earnings/20B shares = $0.80 eps after dilution.  
If Bank of America raised $50B in capital at $5 per share, doubling its share count, it would still earn about $0.80 per share even in a low profitability environment.  The stock trades for $7 today or 8.75x a strenuous hypothetical dilution.  Where should it trade?

Into the blogosphere we go

Welcome to Avondale Asset Management’s blog and our first official post.  Avondale Asset Management is an investment company focused on growing the assets of our investors by seeking out investment opportunities in public markets.  Here we will opine on financial markets, economics and other topics of interest.

From this humble soapbox we hope to add at least some original and thought provoking ideas to the blogosphere.  If we can’t accomplish that, then at least we’ll be screaming too.