Financial Review

A Messy Business

Financial Review 09-04-2014

DOW – 8 = 17,069
SPX – 3 = 1997
NAS – 10 = 4562
10 YR YLD + .02 = 2.45%
OIL – .98 = 94.56
GOLD – 8.40 = 1261.90
SILV – .11 = 19.16

Wall Street tried to rally but fizzled instead. The Dow and the S&P 500 hit new intraday records, only to close down on the day. The S&P energy index ended down 1.3% as the day’s worst performing sector in the S&P. Crude oil futures lost 1.1% to $94.56 as the dollar strengthened and weighed on commodities. Tomorrow brings the monthly jobs report.

Payrolls processing firm ADP said private-sector payrolls increased by 204,000 last month after rising by 212,000 in July, with gains spread across a range of industries. While the report was a bit softer than expected, it marked the fifth straight month of gains above 200,000. The ADP report does not always predict the government jobs report but it is a general indicator of the report.

The Institute for Supply Management said its services index rose from 58.7 in July to 59.6 last month, the highest reading since its inception in January 2008.

The Commerce Department said the US trade deficit fell 0.6% to $40.5 billion in July, its smallest size since January. When adjusted for inflation, it reached its narrowest point since December 2013.

A new survey from the Federal Reserve shows the gap between rich and poor Americans continues to widen. From 2010 to 2013, average income for US families rose about 4% after accounting for inflation. All of the income growth was concentrated among the top earners, with the top 3% accounting for 30.5% of all income. The disparity was even greater by wealth, with the top 3-percent holding 54.4% of all net worth in 2013, up from 51.8% in 2007 and 44.8% in 1989. Though incomes of the highest-earners rose, none of the groups analyzed by the Fed had regained their 2007 income levels by 2013. Although wealth did not change much overall, many measures of debt decreased, driven largely by declines in home ownership. On average, debt fell 13%.

The European Central Bank finished its policy making meeting today and announced both an interest rate cut and an asset purchase plan. The ECB governing council lowered the bank’s main lending rate from 0.15% to a new low of 0.05%; they also cut the deposit rate from minus 0.1% to minus 0.2%. The deposit rate is normally a positive number and it is the rate the central bank pays banks for parking excess reserves short-term; that idea is flipped on its head with negative rates; now the ECB charges the banks for placing spare funds with the central bank. Also, the ECB announced that in October it would start to purchase asset-based securities (ABS), whose underlying claims are in the private non-financial sector; and they will re-start a program to buy covered bonds, which are bonds issued by banks that are backed by mortgages or public loans.

The decision to cut interest rates was a bit of a surprise because rates were already incredibly low. Back in June, the ECB cut rates and sent the deposit rate into negative territory; and back then, ECB President Mario Draghi said: “for all practical purposes, we have reached the lower bound.” Apparently, today’s rate cuts were not for practical purposes. By the way, the lower bound refers to the fact that there is a limit in imposing negative interest rates since depositors can switch to cash instead. And that is the point, to get money out of the banks, and into cash, and moving through the economy – which hasn’t happened yet.

The ECB had already greased the skids for the purchase of ABS, but now it has set a firm date. The securities will include mortgages as well as commercial loans among the underlying assets. If that sounds a lot like the Federal Reserve’s Quantitative Easing, well, it is – but it is much smaller than QE. The Fed bought more than $1 trillion in ABS under QE; the ABS market in the euro zone is worth maybe €1 trillion, and the ECB won’t be buying everything. The likely size of possible purchases would be €100 billion to €150 billion, which is not enough to make a big difference. The ECB says it will only buy “high quality assets”, but if they’re just going to skim cream off the top, that’s not likely to free up much capital.

The euro hit fresh 14-month lows against the dollar, dropping under $1.30. And this devaluation may be the major benefit of the ECB’s moves. The euro is now becoming a cheap funding currency for the global carry trade, and this may be the best chance to counter deflation. The bigger problem is that central banks haven’t figured out how to boost demand in the real economy.

The Eurozone economy flat-lined in the second quarter and the Ukraine crisis threatens any recovery. Today, NATO met in Wales and demanded that Russia withdraw troops from Ukraine, and vowed to support Kiev, just not with military force because Ukraine is not part of the military alliance; but they are planning tougher economic sanctions against Russia, if needed.

A NATO military officer said Moscow had “several thousand” combat troops and hundreds of tanks and armored vehicles operating in Ukraine. The Kremlin denies it has any forces fighting alongside the rebels. Russia denies it has troops fighting inside Ukraine but has offered a ceasefire. There is cautious optimism about the peace initiative mixed with a healthy dose of skepticism that the move is nothing more than a smokescreen for further Russian intervention.

Yesterday, I implied that the war in Ukraine was all about oil; there is more to it than that of course, but oil is a major motivation, and it isn’t just that Ukraine serves as a pipeline from Russia to Europe and points beyond. Ukraine sits on its own reserves. According to the US Energy Information Administration, Ukraine has Europe’s third-largest shale gas reserves at 42 trillion cubic feet, an inviting target not just for Russia but also for US oil companies; especially since other European nations, such as Britain, Poland, France and Bulgaria, have resisted fracking technology because of environmental concerns. An economically weakened Ukraine would presumably be less able to say no. The fracking could mean both a financial bonanza to investors and an end to Russia’s dominance of the natural gas supplies feeding central and eastern Europe. So the economic and geopolitical payoff could be substantial.

Oil can be a messy business. Just ask BP. A federal judge in New Orleans has ruled that BP’s “gross negligence” and “willful misconduct” had caused the massive oil spill in the Gulf of Mexico in 2010 and that the company’s “reckless” behavior made it subject to fines of as much as $4,300 a barrel under the Clean Water Act. The ruling means that the government can impose penalties nearly four times as large as it could if BP were not found guilty of gross negligence. The ruling could open up the company to fines as much as $17 billion. BP has set aside $3.5 billion for potential Clean Water Act fines.

The question of negligence is the first part of a three-part court case about the fines the government can impose on BP. This part assigns blame. The second part will determine the size of the spill; BP’s estimates are sharply lower than the government’s. And the third part will determine the final amount of the Clean Water Act and punitive fines.

BP has spent about $27 billion so far to clean up the oil spill and compensate people and businesses harmed by the spill. The company has taken $43 billion of charges against earnings so far. All three parts of the ongoing court case are separate from BP’s settlement with private plaintiffs claiming economic damages, which BP expects will top $9 billion. And while that sounds like a lot of money, there must be much more waiting to be made. BP has increased its drilling activity in the Gulf of Mexico and continues to bring new wells online. At the end of 2013, the company was operating 10 deepwater rigs in the Gulf.

As you know, Apple has been the meat and potatoes and gravy trade in the markets for quite some time. The high tech Wall Street darling could do no wrong for the past 5 years, as they led the bull market to become the largest capitalized stock in history. They came out with all the cool new stuff, and when there was a lull, they split the stock 7 for 1, mollified activist investor Carl Icahn, and just kept climbing; until yesterday, when the share price dropped 4.2% and fell below $100 a share, on heavy volume. And this, just ahead of the release of the new iPhone. Maybe Apple has lost its cool or maybe it’s overvalued. Or maybe it just fell into Icahn’s bull trap. While a 7 for 1 split might make the share price a bit more affordable for the average investor, it also makes it easier for existing shareholders to slough off a few shares and pocket some profits. The knife cuts both ways.

The hacking of naked celebrity pictures stored on Apple’s iCloud storage system is the worst of a bunch of bad news that has hit the company at once; toss in a prolonged iTunes outage and a new phone from Samsung, and suddenly the new iPhone Release Day didn’t quite look like the religious holiday of the past.

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