Stand and Deliver


“There is a tide in the affairs of men, which, taken at the flood, leads on to fortune; Omitted, all the voyage of their life is bound in shallows and in miseries” – William
Shakespeare, Julius Caesar

There is one thing that everyone in the investment and business press has in mind this weekend, and that is the EU summit meeting on Friday, December 9th. Certainly a great is being written about it, including this column. You can group comments into categories, with a partition for each into European and non-European.

One group is made up of the top of the financial profession, people like Mohammed El-Erian and Bill Gross at Pimco; Warren Buffet; Treasury Secretary Tim Geithner; Fed Chairman Ben Bessrnanke. They are imploring Europe to act forcefully to save its system. Trouble is, they’re Americans, and one cannot hope to win elections in Europe while appearing to take the Americans seriously (except on military matters).

Another group here is more politicized. They more or less want the EU to fail, seeing it as a repudiation of something – socialism, government spending, the EU, snotty Parisian waiters. Millions may suffer, but that is a risk they are willing to take. What’s important to them is that their views and biases and prejudices get validated – not to mention their short bets.

Over in Europe, it’s a bit more fragmented. What might be called the technocrat group, the equivalent of our Grosses and Buffetts, has three sub-currents – UK, German, and continental not-German. The UK is divided: most of their better thinkers realize the perils of the collateral damage and so exhort the eurozoners to fix the problem. This is muddied, though, by the traditional British disdain for both the continent and the euro, such that a fair amount find it difficult to entirely forgo the pleasurable prospect of watching them first both take a header. It’s complicated.

The German technocrats acknowledge that the present course is untenable, but cannot bear the thought of those lazy Greeks and Portuguese picking the thrift from German pockets. Not only that, but give these people a quarter and who knows when they will stop begging! The rest of the continent, on the whole, wants to pursue the Big Fix, but without appearing to listen either to the Yanks or the Brits, and without offending the Germans, who have the biggest economy and the most money. It’s Germany’s ball at the moment, and if they go home, the game is over. It’s complicated.

Indeed, it looks very much like a Morton’s Fork for Germany and the EU. Morton’s Fork (named after the tax policy of a long-ago Archbishop of Canterbury, and familiar to any good bridge player) symbolizes a dilemma in which there is no winning option. In the original case, one paid taxes either because one lived well, or because one lived frugally: the former condition was evidence of sufficient income, the latter of sufficient savings. There was no escape from payment.

Similarly, Germany needs to frame its choice correctly – if it wants to avoid disaster. The key to the situation is that there is no option between paying and not paying for a resolution of the EU crisis. Germany will pay at the front door, or it will pay at the back door, and the back door tab is far higher, as the US experience in September of 2008 showed. There’s a reason the old saying, “an ounce of prevention is worth a pound of cure” has survived the centuries.

Chancellor Angela Merkel’s party may fear a fall from power if they commit German resources to supporting the union. It could happen. But if they don’t, their fall from power is guaranteed by the chaos that will follow. It may appear to be another case of Morton’s Fork, and the usual political response to all things unpleasant is to postpone the decision for as long as possible.

But that isn’t quite right, because while both options appear to be losing ones, one is far more costly. Merkel’s Christian Democratic Union needs to ask itself a question – do the members want to (possibly) go out as noble men and women who sacrificed themselves to save their country, their continent and their era from disaster, or do they want to be reviled through history as the stubborn little group of short-sighted little people who brought their houses down in catastrophe? German bund yields are right to be rising past US equivalents.

We realize that much of Germany hasn’t seen it that way. We read two lengthy pieces last week from Germany’s Der Spiegel, its prestigious weekly newsmagazine. The earlier article, written in October, focused overwhelmingly on what a mistake it was to let in Greece, that queer archaic country with its Byzantine economic system, and so on. There was exactly one paragraph on the cost of a eurozone breakup, though the authors admitted it would likely be fearsome. Filled with indignation about being hoodwinked and cheated, there was not a single word on the enormous economic benefit to Germany of the eurozone.

German exports have profited mightily from the euro, rising from 29% of GDP in 1999 to a breathtaking 47% in 2008. The Faustian bargain of the euro was that the richer countries, in particular Germany, got access to a cheaper, more export-friendly, yet still-stable currency that couldn’t rise against its neighbors in the Union. In exchange, the poorer countries got access to cheaper and better liquidity for borrowing. There are no innocent victims.

These theories were already put to the test three years ago last September. The American financial authorities got an “F” when they chose to believe the outrageous fantasy that a globally intertwined financial system could painlessly shrug off a massive unplanned bankruptcy by one of the world’s leading players. Yes, and no iceberg could ever sink the Titanic.

Our authorities didn’t want to do something that might be unpopular politically. By golly, it was time to stop “bailing out” those reckless bankers. Time to teach them something about moral hazard. Does that sound familiar? Federal Reserve Chairman Ben Bernanke protested that it might cost the taxpayers upwards of fifty billion dollars to stage a salvage operation of Lehman Brothers. The Fed has since expanded its balance sheet by over two trillion dollars in an effort to contain the damage, and U.S. deficits have soared. That fifty billion dollar savings didn’t survive a single day, not one.

Sixty-odd years ago, the U.S. launched the Marshall Plan to rebuild Europe, budgeting about five percent of US GDP to do so. That sum came on top of another five percent already just spent in post-war aid. A praiseworthy effort, certainly, yet it was also clearly in America’s self-interest to rebuild its trading partner and check Soviet expansionism. It was a great success.

It is time for Germany and the EU to stand up and deliver. It is time for Germany’s own Marshall Plan, in its own self-interest. It is time to stop believing the fantasy that the European debt problem can be solved cheaply or that others will pay for it. Yes, it will cost real money. It will cost far more money if the situation is allowed to explode. It is time to stop believing the fantasies that Germany can exit the eurozone cheaply, or that the Bundesbank could borrow in marks cheaply again after the German banking system has collapsed and the continent has plunged into black recession, taking most of the globe with it. You have had three years to study the results of this examination; to fail it now would be utterly inexcusable.

Germany can lead the EU back from the brink. If it does, asset markets will soar, the EU recession already underway will ease, and a new era will begin in Europe. Italy has just agreed to cut pensions and raise the retirement age. Stop playing the victim, Ms. Merkel. You have demanded sacrifice of every other EU country, are you prepared for your own? Protest the cost to the German taxpayer if you must, but the German taxpayer will be annihilated if you fail this test.

Step forward and the Union will step forward with you. Step backward and you will be at ground zero of the collapse. You will not only lose the next elections, but be reviled for the next hundred years as the leader of a band of small-town misers and fools who let their country burn to the ground out of fear that the price of water would go up if they put it out. Tear down this wall, Ms. Merkel. The whole world is watching.

The Economic Beat

As we usually do at the beginning of each month, we’ll begin with the latest jobs report. It was an interesting report, filled with crosscurrents and surprising analysts in different ways. On the whole we’d give it a grade of “good, but needs improvement.”

The headline number of 120,000 in the payroll part of the survey was close enough to the consensus of 125,000, but perhaps a tiny bit disappointing to those who had gotten excited over an ADP report earlier in the week that had estimated a much bigger gain of 206,000. The revisions were more encouraging: from 158,000 to 210,000 in September, and from 80,000 to 100,000 in October. Considering the European situation, these are decent results.

Indeed, one is left to wonder what might have been if we weren’t so worried about the EU. We didn’t add any production workers at all, on balance, with the gains almost entirely in retail trade, health care, and leisure and hospitality. As we have remarked in the past, the two chief characteristics of this strength, similar to 2007-2008, is the three categories comprise low-paying jobs that can’t be outsourced. The S&P 400 Industrials still aren’t hiring in America, not on a net basis.

In support of that observation are the payroll index, which showed a gain of only 0.1%; average weekly hours, unchanged for the third month in row and falling by a tenth at the non-supervisory level; average weekly earnings, which fell overall, and declines in the diffusion indices, with manufacturing falling below the neutral level. It all points to subdued personal income for November, though if people are taking second jobs to pay for Christmas it might boost the dollars a bit. Nevertheless, the data at the payroll level don’t show much earnings momentum going into 2012. This supports our ongoing thesis that apart from the top one percent, Americans are willing to step up for the holidays and not much else.

The household survey painted a brighter picture. It showed a drop in the unemployment rate all the way down to 8.6%, even though about half of this was due to people dropping out of the labor force. Even so, adding them back in to reach 8.8-8.9% is still better than the expected 9.1%. The survey also showed a good-sized gain of 278,000, though household estimates are subject to bigger revisions than the payroll sector. The drops in the number of unemployed were concentrated in the non-college degree sector.

One of the more interesting phenomena concerned the nature of hiring. Life for the long-term unemployed isn’t really getting better, but those who have been out of work for short periods are seeing better chances at getting a job. This buttresses a point we made recently when analyzing weekly claims data, namely that unemployment seems to have reached a kind of equilibrium.

Manufacturing has virtually stopped hiring (a gain of 7k combined over the last three months), and the gains in the seasonal trades are largely matched by losses in the labor force. Civilian workers are actually fewer than a year ago, and the drop in the number of unemployed over the last three months was neatly overwritten by the number of people leaving the labor force. That’s less of a recovery and more like the absence of contraction. The Fed’s Beige Book called hiring “generally subdued.”

The weekly claims data support this. Although the reported claims number rose to 402,000, this was partly due to one of the largest adjustment factors for Thanksgiving week in the last decade. Using last year’s factor, for example, claims would have been 394,000 (coupled with the usual upward adjustment to the previous week, that would have given commentators the chance to talk about claims “falling” again). On a calendar match, weekly claims continue to trend the way we wrote about two weeks ago: better than 2008-10, worse than 2004-07, better than 2001-02 and about the same as 2003 (though there was a slightly larger insured work force in 2003, which says something).

Another example of equilibrium came out of the ISM manufacturing survey for November. A great deal was made out of the result of 52.7, one of the globe’s only positive results of late, but it helps to look at the details. New orders didn’t “shoot up,” as many put it – the increase from 52.4 to 56.7 was instead mostly predicated on survey replies moving from the “lower this month” category into the “same as last month” category. Definitely not a surge of order activity.

Another example of equilibrium came out of the ISM manufacturing survey for November. A great deal was made out of the result of 52.7, one of the globe’s only positive results of late, but it helps to look at the details. New orders didn’t “shoot up,” as many put it – the increase from 52.4 to 56.7 was instead mostly predicated on survey replies moving from the “lower this month” category into the “same as last month” category. Definitely not a surge of order activity.

Production did show some good improvement, but there was also a big uptick in replies checking the “lower” box for employment. Perhaps most importantly from our point of view is that the sector expansion-contraction score was negative, with eight sectors reporting growth and nine reporting contraction. A good score is at least plus four or five and is usually double-digit positive during real recoveries. Price data was also negative, a further indication of subdued activity.

A big pocket of improvement came from Chicago: its PMI picked up to 62.6, led by a big increase in new orders. The Dallas Fed activity index improved slightly from the previous month to 3.2 (zero is neutral), but its production component turned negative, along with new orders, and employment softened too. The Beige Book summed it up by reporting “slow to moderate” growth for the country as a whole.

Housing was another mixed picture. There is some mediocre data being depicted – for about the hundredth time in the last few years – as showing a recovery is beginning. It could be, but it could just as easily be noise and the press trying to get something positive going. New home sales came in slightly below consensus for October, with negative revisions to the previous two months. The number of actual new homes for sale fell to another post-war low, while prices continue to crater, yet we saw some very excited commentary about this report because it improved over last month. With two months to go, it doesn’t appear that 2011 sales are going to top 2010.

The Case-Shiller report on comparable price sales showed another decline, with the year-on-year rate falling to (-3.6%) from (-3.0%) in September. However, the federal data (FHFA) showed a monthly increase and a smaller y/y decline (-2.2%); it misses foreclosures and the high end. Still, any bone is a good one in housing these days. Pending home sales for October showed a big jump, but with closings running well below pending lately, the markets don’t pay as much attention to the latter. Yet construction spending did move up 0.8% in October, led by private residential spending. The numbers are coming off a very low base, but there is a whiff of possibility around.

So long as the banks are still writing off lots of foreclosures or hiding big chunks of non-performing loans (NPL) every month, they will remain too scared to loan money to most of the population. Thus, the housing market remains moribund, and thus the banks end up generating more NPLs than normal. So long as the business is over-concentrated in the Gang of Four, we’re stuck with it, because they also have the bulk of the NPLs. This kind of binge-and-remorse cycle is nothing new in the lemming-like world of deregulated banking, but it’s the first time since the thirties that the banks have blown up the residential housing book. We’ve still a ways to go before amnesia can set in. However, some of the smaller banks appear to be picking up the slack.

One of the better reports was consumer confidence, and for that we can all doubtless thank the October stock rally. The former rose sharply from 39.8 to 56.0, still well below the historical average but quite a jump up and helping to fuel the week’s optimism. Chain store and motor vehicle sales continue on a modest upward trend. It’s still all 2% stuff, but that’s better than nothing.

Next week we’ll get the ISM services reading on Monday. Looking at the employment data, we’re going to guess at a modest improvement there too, which is also the consensus view. Factory orders are out the same day, but the durables report has already tipped a decrease. There isn’t much else the rest of the week – consumer credit Wednesday afternoon, some inventory data Thursday and trade data on Friday.

That will leave us all week to focus on the really big event: the EU summit on Friday. It will be preceded by lots of European data all week, along with visits from Treasury Secretary Geithner and others. They will all be trying to get more urgency into the Merkozy heads. We hate to say it, we really do, but if markets continue to rise at all into the summit, it just might backfire again. Can Merkel pull the trigger without Armageddon staring her in the face? Will she? Fingers crossed, everyone.

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