War Room 11 Oct 2011

The Recession Strikes Back

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The Recession Strikes Back

•Europe Recap

•US exposure to Europe

•USA Macro Snapshot

•Why does it feel so bad?

Europe – where are we right now?

2008 – toxic debts on bank balance sheets.

2011 – toxic debts now on public balance sheets.

Europe’s two big problems:

1. Recapitalization of EU Banks

2. Credible plan to preserve the stability sovereign debt of Spain + Italy

Don’t get caught up in the noise:

•Slovakia Vote

•Politician PR Efforts

•Oversold rallies

•Protests

LET THE DATA GUIDE YOU

PIIGS debt (as % of GDP): Greece more than double Argie + Russia at default

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20110

20

40

60

80

100

120

140

160

Greece

Italy

Ireland

Germany

Source: World Economic Outlook, April 2011, International Monetary Fund

Argentina default:

65%

Russia default:

57%

Preparing for Greek DefaultEuro Crisis Averted Now impossible scenario

Greek Bailout package:

July Soft Restructuring – lower rates + extend maturity21% discount in bond restructuring established

Oct Hard Restructuring – principal reduction50-60% discount now needed

Sources: Jean-Claude Juncker, Euro Group President

Standard + PoorsOttmar Essing, former ECB Chief Economist

Thomas Straubhaar, Director of World Economic Institute

Greek Default guaranteed1. Euro Zone Dismissal? 2. Can fallout be contained?

Currencies + Markets = basics

Dollar + Euro – inverse correlation

Dollar + S/P 500 – inverse correlation

US Economy:exposure to Europe

EU – double dip recession begun

Markit Eurozone Purchasing Managers Index: 50.4

(Contraction is anything below 50)

US Banks:exposure to EU defaults + EU bank counterparties

Tim Geithner, U.S. Treasury Secretary“The direct exposure of the US financial system to the countries under the most pressure in Europe is very modest… very limited”

Congressional Research Service

641 billion usd US Banks exposure to PIIGS

1.2 trillion usd US Banks exposure to German + French Banks

holdings – loans, derivative contracts, guarantees, credit commitments

Geithner is wrong!!

US + EU ContagionEuro Banks

- Three banks nationalized in the last week- Dexia = 5.4 billion euros in exposure to Greek Debt

2008 Contagion as guide- Counterparty risk coming to fruition eliminates hedges- US govt kept AIG artificially alive to pay out other banks- Equity markets took SIX weeks to bottom post-Lehman

Historical- 1931 Austrian bank Credit Anstalt led to contagion in US- 1931-33 period saw bank runs in Europe + US

2011 downside potential worse than 2008

Consequences:

1. Credit Crunch in lending to Italy + Spain

2. Other PIIGS decide to leave the Euro

3. EU deep recession

4. Contagion spreads to US banks

Can Greek Fallout Be Contained?

Consequences:

1. Greece likely exits Euro

2. Drachmas already trading on “when issued” basis

3. No carte blanche for other PIIGS

4. Recapitalization plan works

US ECONOMY – OCTOBER SNAPSHOTThe Recession Strikes Back

The VIX experienced its second highest spike ever in early August, indicating the extent to which fear has taken over the market.

While much of the rise in retail sales since 2009 can be explained by inflation, sales have held up this year and are still growing at 3% net of inflation.

Why does it still feel like a recession? From a jobs perspective, we're still at a level of jobless claims consistent with the previous two US recessions (early 90's and early 2000's).

US Indicators: ISM, Oil, and BDI

ISM Indexes both holding over 50 for now

Dry shipping rates up, oil down: Two positive trends

Total Employment Down, Down, Down

Total US employment peaked at 138 million in 2007, and is still 6 million below that level, even as the US population has grown by 8 million.

Employment Ratio: Down, Down, Down

No comparable drop in employment ratio has occurred since the Great Depression.

US GDP and Productivity in Context

Productivity rises tend to accompany layoffs – in this context, low current productivity growth isn't all bad.

When GDP growth drops below the red line (population growth), it feels like a recession.