Im Westen nichts Neues

“You take it from me, we are losing the war because we can salute too well.” – Erich Maria Remarque, All Quiet on the Western Front (German: Im Westen nichts Neues)

It was worth a try. Last week we wrote an impassioned plea that Germany and Chancellor Merkel take genuine steps towards resolving the EU crisis: they did not. Far more illustrious voices than our own mounted similar efforts of a higher profile, though in the end it was unlikely that the return of Friedrich Barbarossa himself could have changed the Chancellor’s mind.

From the German viewpoint, things may look quite different. Being the EU country with the most money on a continent of straitened circumstances, it is in the pivot position and succeeded in imposing an agreement with its own weltanschauung as a precondition for further action. To wit, the rest of the EU must behave in a more Germanic manner and agree to balance their budgets, preferably by constitutional mandate. Violators will agree to be punished and to cede a certain amount of financial independence to a pan-European authority. Weekly luncheons of sauerkraut are encouraged, but remain optional. For now.

The immediate aftermath of the December 9th summit followed a by-now familiar script: the EU leaders came out issuing triumphant statements that everything is finally on the right road. Markets rallied, partly in relief, partly in hope, and probably most of all because they rallied the time before. Investment luminaries immediately despaired at the insufficiency of the new program, and second thoughts began to creep in. Over the weekend, Italian Prime Minister Monti remarked that eurobonds might be made palatable to the Germans; Bundesbank President Schnauzer avowed the opposite. Asian markets rallied as US futures sold off. Yes, we have seen this part of the movie before.

It wasn’t the extra monies appropriated that encouraged the Street: 200 billion euros promised as loans to the IMF (who would in turn lend it back), and a promise to advance the inception of the new European Stability Mechanism (ESM) into July, already old hat. What interested the markets was the thought that the new steps might be enough to get new European Central Bank (ECB) chief Mario Draghi to start throwing some money around. Only the day before, the ECB had cut interest rates and Draghi flirted with the markets by hinting at expanded lending if the politicos would do a bit more. The ECB also broadened and lengthened collateral terms: in the pithy words of one wag, it is now willing to accept VHS tapes of the 1954 World Cup final as collateral.

Our verdict is that the measure was mostly a way to mark time, get away for the holidays, and most of all keep preparing for the inevitable quid pro quo by getting the quo first before handing out any quid. We and others have speculated that Chancellor Merkel is never going to agree to any substantive underwriting until she has the political cover of a major crisis. Perhaps she realizes what needs to be done, but thinks it can’t be sold to the German parliament without a dire emergency. It could also be that she simply doesn’t want to do it and can’t be talked into it – yet – her dislike of the markets being well known.

We can’t know. We’re not sure Sarkozy knows either. But one thing we do know is that rising or stable markets are the nemesis of decisive action. By the time Friday rolled around, we had already given up on the hope of anything really substantive coming out of the summit. So long as markets aren’t breaking, the EU isn’t going to fix it. Not until after the fact.

We would like to give Madame Chancellor credit for preparing the ground first, but the truth is nobody but her knows what’s in her mind, and it may well be that she isn’t quite sure herself. It’s a rare politician that understands the economy well, let alone the markets. Even for the experienced, the pressure of major crises can trigger unexpected behavior. Were we to have a private chat with Merkel, Sarkozy and Draghi in which they revealed all of their thinking and all their contingency planning, we wouldn’t bet everything on what they would do in the actual event.

We do know that the latest program is not only insufficient, but also highly problematic. It is not at all obvious to us that all of the governments involved will agree to the changes, or even can deliver on their agreements if their people start to balk at handing over sovereignty to a German-dominated authority. The UK walkout wasn’t auspicious.

It’s also difficult to see how the proposed fiscal union could be accomplished quickly enough to arrest further deterioration in the debt markets, which looks likely. Despite the one-day rally in the equity markets, the bond markets weren’t really having it, and it’s well-known that they tend to get these things right over the longer term much more often than equities. They are certainly right in this case: the real issue of all the bad debt was left untouched, and the thought that markets might wait until July for the ESM to right matters is pure fantasy. Hopes even linger that China or someone else will pick up the tab and spare leaders from writing domestically unpopular checks. Good luck with that.

For their part, equity traders would love to get Europe off the headlines and focus on year-end. A lot of institutional money feels the same way – a green number for 2011 would be so much better for the client letters. December is the second-best month of the year historically, after all. Aren’t we owed a Santa Claus rally?

We’re not going to say. We think the markets could move up five to seven percent in the next three weeks, but they are also equally likely to shed it. We do know that not every December goes up, and that the market action between now and the end of the year isn’t going to be based upon any thoughts about earnings or the U.S. economy. It’s going to be split between the fear of what might happen in Europe, and the fear of having a down year.

The only prediction we’ll hazard: if the markets do manage to rise the next couple of weeks, we’ll reckon that the last two or three days of the year will sell off, contrary to what Mr. Claus may think. That’s because traders will be trying to get a jump on the January sell-off they know will follow. As you can see, in the West this week, there is nothing new.

The Economic Beat

A quiet week for data allowed markets to devote attention to news from overseas. One seemingly good piece that got overlooked was a drop in weekly claims to 381,000. Markets ignored it over worries about Europe, but perhaps it wasn’t worth paying much attention. Just as the previous week was somewhat better than advertised due to seasonal adjustment factors, this one was worse and we would say that the real adjusted trend over the last two weeks might be closer to something in the 390-395,000 range.

The employment category of the ISM non-manufacturing report for November contracted somewhat unexpectedly to 48.9. Given the underlying components of the responses though, we’d say it was about a wash compared to October. It doesn’t quite contradict the service hiring trend shown in the jobs report, since diffusion reports indicate breadth rather than depth; what it suggests is that hiring in services is as narrowly based as the jobs report indicated.

The rest of the ISM backs a point we’ve been making of late, which is that the US economy seems to have settled into a kind of equilibrium. The overall index came in at 52, a bit lighter than expected and down from 52.9 in October, a change we don’t consider very significant. More significant was that in the business activity segment, nine reported growth and eight reported contraction. Things are steady but not strong.

Factory orders fell slightly more (-0.4%) than expected (consensus was a tenth better) for October. The report was a mixed bag, with the business investment category down (-1.8%) for the month. Wholesale inventories rose a sizeable 1.6% in October, which adds to GDP, but also far ahead of the sales rate so it’s
too early to celebrate.

Consumer credit came in as expected, which is unusual; most of the growth remains away from credit cards. Consumer sentiment rose more than expected, which is good, but the level is still quite low. The trade deficit shrank as predicted, with both imports and exports declining.

Much of the market was focused instead on news from abroad: the ECB rate-cut to 1%, and China reported improving monthly inflation data. We don’t have the greatest faith in China’s government statistics, but one thing we do believe is that the data point to further monetary easing.

Next week will see retail sales for November on Tuesday; they’re expected to increase a healthy 0.5%. We’ll get a deep look at the manufacturing situation on Thursday with the New York and Philadelphia Fed surveys surrounding the November Industrial Production report. Price data will show up with the Producer Price Index (PPI) on Thursday, as well as the Consumer Price Index (CPI) on Friday.

That leaves the usual marquee event, the Federal Open Market Committee (FOMC) in the unusual position of not having the latest price and production data at hand for their Tuesday meeting. We’re not sure what difference it would make, as we don’t expect anything big from the Fed this time around; better to keep the powder dry for when Europe gets into trouble again. Investors would probably do well to follow the same path.

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