“A thankful heart is not only the greatest virtue, but the parent of all the other virtues.” – Cicero
During the week we had a moment of clarity, to borrow a line from Pulp Fiction. Like most such moments, it came about in the process of trying to do something else. In our case, we were trying to sketch out a European debt-reform project that would not only pass the market smell-test, but really work. We’ve been saying for some time now that the only real way out for Europe is to write down its bad debts and recapitalize its banking system.
It may seem more than a little obvious to say that the devil is in the details, but never has that been truer for the health of the Western financial system. As recent developments have shown in the European sovereign debt markets, the debt problem extends well beyond Greece, whose importance lies not in the size of its economy, but in being the most vulnerable part of a foundering system.
In this way Greece might be thought of as Europe’s Bear Stearns, rather than its Lehman Brothers. It isn’t because the Greek economy has the heft or reach that either investment firm once possessed, but in being the first part of the archipelago to disappear under a tsunami of bad debt. We know that many Americans are puzzled and tired about why a relatively small country like Greece seems to dominate the headlines, but it’s the tidal wave and protection system that is at stake. If Greece can’t be protected, which other members of the archipelago will be next to go?
The salient weakness of the Greek situation is that the country borrowed too much money relative to its true GDP, and fudged accounts of both. That problem is easy to see now, and therein lies the conundrum for our would-be solution and the financial markets. The rest of Europe’s debt isn’t so easy to see, and in this respect again recalls the time of the Bear Stearns collapse. At that time, the common lament was the lack of transparency about the many forms of debt the banks were carrying on and off their books. The irony is that had we really known the full extent of the rot in our system, asset prices would have collapsed much faster than they did.
The centers of the European housing bubble – yes, besides the junk we sold them, they had one too – were in Ireland, Portugal, and in particular Spain. The Irish situation is well known because the government effectively nationalized the banks a couple of years ago, but much of the Spanish debt is being held at cost in private banks in Spain – and throughout Europe. The market began to turn its attention back to this problem last week, but the true gravity of the situation has been off the screen. It isn’t clear either how much of the bad U.S. paper has been sold off or written down to fair value.
And therein lies the rub. Our attempt to conjure a reasonable approach to Europe’s predicament involves recognition that a much bigger piece of the debt needs to be written off than a few hundred billion euros of Greek sovereign bonds. Portugal and Ireland owe more money than they can pay back in a lifetime of austerity, and any forgiveness of Greek debt will find both countries moving up immediately in the queue. The Spanish debt can’t hide or escape notice for much longer. Italy isn’t quite as badly placed as the headlines make it out to be; the scary part is how quickly the contagion infected its bond auctions.
Our moment of clarity: it’s the very absence of the concrete plan that the markets have been demanding that has paradoxically supported asset prices. It’s a bit like that funny noise coming from under the hood of your car: so long as you don’t know what it is, you can hope that it’s just a loose something-or-other. The bill shock comes later.
A program that could genuinely stand the market test for more than a day or two of short-squeezing is well beyond where the Europeans, in particular the Germans, have so far talked about going. That’s not to say that the Germans or other country leaders are completely ignorant of the problem – Chancellor Merkel recently called the current situation Europe’s biggest challenge since the second world war. As well, various German officials have eagerly seized upon proposals of late that involve disciplining countries for violating agreed-upon financial norms. No doubt some of that reflects the culture’s Calvinist heritage, but it also indicates a certain recognition of the inevitability of German financial support.
Complicating the situation is the mistaken notion that wrenching austerity for all parties but Germany can work, either economically or politically. We can understand why the Germans are comfortable with it, but it isn’t going to work, and the longer the EU pursues it, the deeper their impending recession is going to bite.
Two maelstroms lie ahead (more than two, really, but we’re focusing on the West and the nearer term). The first is the notion that the transformation of the European Central Bank (ECB) into a lender of last resort, similar to our own Federal Reserve, is the key to European salvation. It isn’t, because it won’t make the bad debt go away anymore than the Federal Reserve did. It isn’t at all clear either that the inflation-paranoid Germans would agree to it, but one thing that is clear is that the markets are pinning their hopes on it. Yet it would help matters, that much we agree.
We feel safe in predicting that even a hint that the EU or ECB was willing to move in that direction would cause asset prices to rally strongly into year-end. The real thing might get stock prices to rally 20% or so before traders stopped to reflect – everybody would be too busy trying to make sure they didn’t get left behind in the performance tables. It would be a sucker rally in the end, but try telling us the last time the equity markets have taken the long view. For that matter, more than a few traders would fully believe it to be a sucker rally every step of the way, but would go all-in on the ride nonetheless. One of the quickest ways to lose money in the markets is to trade on the presumption of rational behavior.
The other maelstrom: we are dealing with a political process. No outcome is certain. We’re not going to take the vulgar route of sneering at leaders that ultimately the people have chosen; the reality is that these are controversial issues, dogged by honest divisions and partisan ideologies. The U.S. experience in 2008 shows the difficulty of making unpopular decisions – while Fed chairman Ben Bernanke and former Treasury Secretary Hank Paulson would instantly seize the chance to have a do-over on Lehman Brothers, there remains a hardy core on Wall Street and beyond (prominently represented on CNBC, for example) that rail against any and all attempts to stabilize the system. It won’t be any easier to sell the German public on ponying up for their neighbors than it would be to get Texas to bail out Massachusetts.
Our view is that it will take the threat of imminent disaster for Germany’s own financial system to force the next big step towards supporting the system, much like the reality of market collapse forced our own Congress to reverse field on the TARP program. Given that the EU involves the approval of seventeen governments rather than one, it may take more than a day or two for them to retrace their steps.
That’s another reason why many expect the first relief to come from the ECB, despite new chief Mario Draghi’s apparent reluctance for that direction. It will be a trying time for investors, and many will end up selling out at the bottom and not coming back. Not great for the long-term health of the system.
As we enter the debt-ceiling deadline week, anxiety over the obvious deadlock has surged. Even so, we don’t think that the result will be the same as last July. For one thing, markets rarely sell off on the same fear twice. There will probably be a knee-jerk wobble over a paste-up job, but we’re willing to bet that the markets will try to find a way to move on into a December rally.
We leave you then with a couple more predictions: Europe’s much talked-about “Lehman moment” won’t come from Greece, which we have already compared to Bear Stearns; the over-leveraged Lehman cousin is Spain. And we will discover that the Western banking system, in its latest lemming-like rush for profits, is horribly in over its head again, this time with sovereign credit default swaps. The entanglement is much like AIG, Lehman, Goldman Sachs (GS) et al., and many banking CEOs will be gone by the end of next year.
But all that won’t come until 2012. And we don’t know if the EU will get it right or not.
We wish our readers a Happy Thanksgiving.
The Economic Beat
The most encouraging news last week was probably retail sales. However, we found that the report, while better than expected, was not as straightforward as reports made it out to be, like the other releases during the week.
October’s pace of plus 0.5% slowed from the September increase of 1.1%, but was ahead of the consensus estimate of 0.2%. Excluding autos and gasoline, the increase was 0.7%. Personal income and spending for the month is released next Wednesday, so we will see then how much of the increase may have come from savings. Since the estimated monthly increase in aggregate weekly payrolls was only 0.3%, this bears watching.
The increase was led by a large jump (3.7%) in electronics sales, while the apparel and gasoline categories were down and general merchandise was flat. That doesn’t quite seem like people rushing out to shop on a wave of confidence. While the rise in the stock market was no doubt helpful, we suspect two phenomena were the main drivers: the release of the new iPhone 4S, which set records for orders, probably drove the electronics category (it isn’t televisions or computers, judging by what the vendors say), and the other large increase in home and garden supplies may have been due in large part to the freak snowstorm the Northeast experienced.
To be fair, some of the home and garden category might also have gotten a boost from the increase in housing starts, which was bigger than expected (628k annualized versus 605k expected) and driven by a big increase in the South. We will add parenthetically that the report also showed a fairly large increase in the Northeast, and we don’t believe it. Half of New England was paralyzed for half the month by the snowstorm. Either the estimate is completely off, or it reflects some very small units, the only kind any sensible Northeastern builder would start in the month of October.
The increase in the South may be genuine, though, and would dovetail with the bump up in homebuilder sentiment to 20 (50 is neutral). It was the first time the sentiment index had risen out of the teens since May of 2010. It didn’t last then, and it isn’t clear that it should last this time either, but there have been some positive noises lately coming from the publicly traded builders. If we can avoid wrecking the financial system, homebuilding should begin to revive in the next year or two. The larger-than-expected increase in building permits led to a surprise leap in leading indicators of 0.9%.
The news in manufacturing was mixed. The Philadelphia Fed survey missed expectations, but we thought it better than it looked in the sense that it mostly reflected no change in pace from the previous month. September’s growth was decent; we’ll take a repetition. In addition, the future conditions components rose sharply. While nearly worthless as indicators of real future activity, they are good measures of current conditions.
The New York survey, by contrast, beat expectations, but given that the result was no change after a decline, it’s not clear why that is so good. Nevertheless, the six-month outlook rose sharply, and like its Philadelphia cousin a better clue to current rather than future conditions. The part that bothered us about both surveys is the weakness in prices. Prices paid hit a two-year low in New York, while prices received rose very little after a month of decline in Philadelphia. That clearly points to a mixed bag, not the rosy picture mutual fund managers were trying to depict.
The Consumer Price Index (CPI) and Producer Price Index (PPI) data for October echoed this lack of demand strength. The PPI total fell by 0.3%, with the core index unchanged, and the CPI also fell, in the latter case by 0.1% with core up 0.1%. It isn’t worrisome, but doesn’t suggest 2.5% fourth-quarter GDP, either. However, if the equity markets manage to put on a December rally, energy prices will surge again and the indices will reaccelerate.
Industrial production did rise more than expected in October, posting an impressive-looking increase of 0.7%. The problem was that it really didn’t rise more than expected, since the difference was entirely due to a sharp downward revision for September. That can’t be promising for the GDP revision due out on Tuesday. The increase was led by mining, which like utilities is a lumpy and volatile category.
Next week brings the Thanksgiving holiday in the U.S., with all markets closed on Thursday and an early close on Friday. Europe will be busy on those days, though, with German and English GDP numbers due on Thursday, as well as the much-watched German business sentiment survey.
Here in the U.S., October existing-home sales come Monday; dare we hope for another sign of life in the sector? The first revision of US third-quarter GDP comes Tuesday, along with the FOMC minutes in the afternoon. Traders will eagerly scan the latter for signs of QE-3.
Wednesday will bring a couple of important reports, October durable goods and personal income and spending. Pay particular attention to the income number. Jobless claims will come a day early too, in recognition of the Thanksgiving holiday. A lower profile report than all of these is the Chicago Fed National Activity Index on Monday morning, but we recommend it to you as a good indicator of real trend growth in the U.S.