A Haircut, Boost and Drop

The markets are up strongly this morning on news that Greece has agreed to a 50% haircut on their debt, GDP ticked up from 1.3% in the second quarter to 2.5% in the 3rd (first estimate) and jobless claims dropped by 2000 this week as last weeks number, as usual was revised higher.  

GDP

Let's start with GDP for the 3rd quarter.   This is the first estimate of the 3rd quarter economy (July-September) and generally is geared to the average estimate of the analysts which consequently was also 2.5% since there it little actual data to work off of.   In the next two reports that come out we will see more concrete detail about the actual strength of the economy.

With that note the economy is estimated to have strengthened a bit in the third quarter.  This, however, does not change the fact that we will probably still be in a recession by 2012 as the underlying trends are still negative and weak.  GDP growth improved to a 2.5 percent annualized increase in the third quarter, following an anemic 1.3 percent in the second quarter.

Demand numbers also improved as final sales of domestic product increased an annualized 3.6 percent in the third quarter after a 1.6 percent rise the prior quarter. Final sales to domestic purchasers (excludes net exports) gained 3.2 percent, following a 1.3 percent gain in the second quarter.  There was strength in the business fixed investment with personal consumption expenditures gaining momentum also.  We expected to see this after the restart of manufacturing post the Japan earthquake shutdown.   However, the strength going forward remains in question.

Personal Consumption Expenditures is the most critical as it makes up such a large percent of GDP.  PCE advanced 2.4 percent, following a 0.7 percent rise the prior quarter which, again, was somewhat expected after the analysis of the monthly data we have seen over the summer.   There was strength in durables but softness in the areas that are directly impacted by the underlying consumer and a strong increase in the services related areas which is not what we really want to see.  The improvment in net exports was good but is improving at a slower rate and the growth of inventories is disturbing as we are seeing weakness in the ability to get product shipped out the door.  Government spending increased over the last quarter on the Federal side and in Defense, which we saw in the latest durable goods report, while state and local government spending declined.

GDP Growth Recession

The real concern here is in the body of the report when we get down to personal spending and incomes and the actual consumer as discussed previously this week.  Disposable personal income increased $17.0 billion (0.6 percent) in the third quarter, compared with an increase of $110.5 billion (3.9 percent) in the second.  That sounds good until you see that real disposable personal income decreased 1.7 percent, in contrast to an increase of 0.6 percent.

The consumers disposable incomes are falling.  So, if personal outlays increased $133.1 billion (4.9 percent) in the third quarter, compared with an increase of $100.5 billion (3.7 percent) in the second then where did the money come from?  Personal savings of course.  Disposable personal income less personal outlays -- was $472.7 billion in the third quarter, compared with $588.9 billion in the second.  The personal saving rate -- saving as a percentage of disposable personal income -- was 4.1 percent in the third quarter, compared with 5.1 percent in the second.  That continued decline in personal savings is unsustainable.   Therefore, I would look for a good bit of retrenchment in the coming quarter which leads me to my next point.

While the report was better than last quarter I suspect that we will see this number revised down in the coming months as we head into the end of the year.  More importantly, however, is that GDP still remains mired at 1.6% on a year over year basis.  Historically, when GDP growth drops below 2% on an annualized basis the economy was generally well on track to sliding into a recessionary phase.  Take a look at the table which shows the annualized changes in GDP growth just before we slipped into recession one to two quarters later.

In each event the economy was ticking off positive annual rates of change but in just the matter of a one to two quarters the economy slid into recession.   The point here is the same that we always make...it is not the number but the trend of the numbers that is more important in determining the future direction of the economy.  Currently, that trend is still negative and it will take a couple of quarters of stronger than expected economic growth to turn that around.

Jobless Claims

Jobless claims fell this morning by actually 1000 actual claims after you take into account that upward adjustment from last week as opposed to the 2000 claim drop by the media.  However, in reality this is a statistical non-event when we are continually discussing claims in excess of 400 thousand each week.

The four-week average of 405,500 is 10,000 below the month-ago period which hints at a mild improvement in hiring although these are most likely temporary jobs that are being filled going into the holiday shopping period.

Continuing claims in data for the October 15 fell 96,000 to 3.645 million with the four-week average of 3.701 million nearly 50,000 lower on the month-ago comparison. The real issue with this "improvement" in continuing claims is the uncertain mix between those being actually hired and the massive number of individuals that are now rolling off of benefits due to expiration and falling into the uncounted masses of "discouraged workers".
Greek Haircut And An Inability To Do Math

The big news that shot the market higher this morning was the news that European leaders clinched a deal Thursday they hope will mark a turning point in debt crisis surrounding Greece.  Overnight negotiations ended with an agreement that banks will take bigger losses on Greece's debts.  The plan focused on three key points.

A significant reduction in Greece's debts by 50%
A shoring up of the continent's banks, partially so they could sustain deeper losses on Greek bonds;
And a reinforcement of a European bailout fund so it can serve as a €1 Trillion ($1.39 trillion) firewall to prevent larger economies like Italy and Spain from being dragged into the crisis.

However, at the end of the day the banks still have to agree to the haircut on the bonds they hold.   However, it isn't ALL bond holders that will take the haircut - just a few and here are the numbers according to Zero Hedge:

Greece has €350 billion in total debt including about €70 billion in Troika "post-petition" loans; these are untouched.
Of the €280 billion, roughly €75 billion is held by the ECB: this, like the Troika loans, will be untouched.
This leaves just ~€200 billion in actual debt to undergo a haircut.
Apply a 50% haircut to this debt (ignoring the fact that of this about €35 billion is held by Greek pension funds, and once the realization that Greek pensions have been cut in half dawns upon the population, the result will be the biggest riots ever seen in Athens yet).

Total Debt to be Cut: About €100 Billion.

Hence, of the total €350 billion, just €100 billion is eliminated, most of it used to backstop and service Greek pension and retirement obligations
€250, or the residual, of €350, the original, means 72%, or a 28% haircut.
Greek GDP was €230 billion on December 31, 2010 and declining fast.
And that is how a 50% haircut is "cut" to just 28%.

The reality is that the Greek haircut will still insufficient as it excludes ECB Greek debt holdings.  Furthermore, the IMF recently noted that a 60% NPV haircut on all bonds is needed for Greece to return to viability.   The problem is that the EFSF of €1 trillion will not cover the real needs of the banks as there is a very high probability that this haircut will trigger a CDS event requiring injections of capital into many of the largest banks to shore up capital requirements.   

This is only the first inning in a very long game to come.  The ongoing deterioration in economic growth, ratings downgrades, and potential derivative events will require a much larger bailout fund.   Considering the trouble they had pulling this one together, like in the U.S., a second bailout package would be impossible. Secondly, and just as important, how long will it be now before Ireland, Italy, Spain, Portugal and others all began to line up asking for the same debt relief that Greece is now receiving?  

Since we aren't going to see a final roadmap on EU treaty changes until March 2012 there is plenty of time for this to all go "haywire" as people wake up see that nothing will have actually changed in actually solving the crisis.  Furthermore, it won't surprise me a bit to see the banks balk at being the only suckers to take a haircut on the debt and that still leaves the potential for Greece to default on the majority of the debt outstanding that will now be held in a levered up bailout fund.   No, nothing can wrong here at all. 

Please see the attached chart below.