Will Congress go over the fiscal cliff? Yes, we've been going for decades, really since the social unrest of the 1970s.
Bridgewater's Ray Dalio believes four factors drive relative economic growth: competitiveness, indebtedness, culture, and luck. The returns from his machine-like investment process clearly indicate he is on to something as he notes that the most powerful influences of this relative income (and power) are 1) the psychology that drives people’s desires to work, borrow and consume and 2) war (which we measure in the “luck” gauge). Throughout history, Dalio advises these two influences have changed countries’ competitiveness and indebtedness which have caused changes in their relative wealth and power. He goes on to add that since different experiences lead to different psychological biases that lead to different experiences, etc., certain common cause-effect linkages drive the typical cycle of a nation's growth, power and influence - and that countries typically evolve through five stages of that cycle.
Against the backdrop of a tepid US recovery, Eurozone recession and stuttering growth across emerging markets, investors are beginning to focus on how the 'status quo' outcome impacts the odds of cliff-avoidance; which after all, if there is one thing economists agree on, it is that a US and global recession will ensue if the legislated tax increases and spending cuts worth roughly 3.5% of US GDP take effect next year. UBS believes that if the US economy dips into recession, operating earnings -which are near peak levels - could easily plunge by a fifth. Risk premia would climb, particularly because the US and the world have run out of policies that could lift their economies out of recession. Those factors point to significant downside risk (at least 30%) for global equity markets if the US falls off the 'cliff'. Yet the S&P500 remains within a few percentage points of its cyclical highs. Accordingly, as we have previously concluded, investors assign a very low probability to the ‘cliff’ and a 2013 US recession, which UBS finds 'darn surprising' that this much faith in common sense prevailing in Washington amidst such divisive politics. But for all the attention the ‘cliff’ deserves, UBS notes the fundamental challenge for the US (and many other countries) is to address fiscal stability as a long-term necessity, not a short-term fix.
Trish Regan and Adam Johnson do their best to hold themselves together in this sublime rant by 'Gloom, Boom & Doom's Marc Faber on Bloomberg TV as he sees Obama's re-election as "very negative for the economy". From his view that the market should be down at least 20% - and maybe 50%, to the implied ignorance of both of the candidates, he believes fervently that the "standards of living of people in the western hemisphere will continue to decline." Faber views Obama's re-election as one of many unintended consequences of market manipulation (since Democrat attacks on the wealthy were 'enabled' by their profiteering from Bernanke's money printing) and sees the need to protect one's assets "with a gun, a machine gun... or perhaps a tank." He concludes with a stunner as he exclaims his view doubting Obama will make it through the whole four-year term because "there will be so many scandals" since "there is so much smoke, there must be some fire!"
With Greece and Spain (and arguably Portugal and a few others) stuck in dramatic debt-deflation spirals, the political need for maintaining these nations in the euro far outweigh the economic 'benefits'. As UBS notes, looking at the euro area today, one cannot help but notice the parallels to Japan of the early 1990s. Europe today, as with Japan a generation ago, is an aging society with structural rigidities, pockets of corporate excellence, but wide swathes of inefficiency; but the two most striking similarities (and not in a good way) lie in the banking system (bloated from over-leveraging, under-capitalization, and bad loans); and fiscal policy (which is inherently pro-cyclical - as the politics of monetary union preclude national level stimulus - leaving ineffective monetary transmission channels unable to help fiscal failure). As UBS concludes, the current euro's similarities to Japan are key impediments to growth - and as such we should expect sclerotic economic activity for a five-year period.
The increasingly short-termist attitudes of both policy-makers, analysts, and investors leaves market and economic indicators in the US and Europe all anticipating some magic in 2013. If only we can get through the elections, the fiscal cliff, a banking union, a Spanish bailout request, Greek extensions; not to mention another round of weak earnings and a sliding Chinese demand backdrop. As SocGen's FX and Rates desk notes, the battle against disinflation in Europe is not over and nominal GDP outlooks remain far too optimistic - only highlighted by the morning's weak lending data. The moribund growth backdrop also begs the question what palpable difference any relief over Spain or Greece (if it comes) will do to the long end. The answer is probably not a whole lot.
The deleveraging has a long-way to go!
There were two major datapoints overnight: the first one came out early in the session, when the Chinese Flash HSBC PMI (not the official one), printed in contraction territory for a 12th consecutive month but jumped sufficiently to 3 month highs to give the algobots hope that China may be turning (it isn't: China, like the US has a major political event early November and all its data is more manipulated than ever). Regardless, this sent future rising to session highs until virtually yesterday's entire gap down was eliminated. The euphoria continued until several hours later we got composite European (as well as the most important German PMI data, and to far less relevant extent France, which always has been the dynamo in European economic growth), manufacturing and services PMI, both of which missed expectations or declined substantially, reaffirming that the German economy is getting dragged down more and more into recession even as continues funding the rescue of the periphery. As the chart from Markit below shows, German PMI is hinting at a solidly negative German GDP print, further confirmed by the German IFO business print which came at 100, a drop from 101.4 and below expectations of 101.6. Other secondary macroeconomic data was just as bad, which explains why futures are now well on their way to dropping back to their lows. Finally, today we get the FOMC statement, which will be much ado about nothing, and will merely serve as an appetizer to the December FOMC meeting, when Goldman (and Zero Hedge) now expected the Fed to expand unsterilized monthly monetization to increase from $40 billion to $85 billion (more on the shortly). Yet perhaps the biggest shift in mood has been coming out of our old friend Greece, where Troika negotiations, largely under the radar, are progressing from bad to worse, where the bond buyback plan was scuttled last night (as ZH reported sending Greek bonds 70 bps wider on the day and rising), and where the probability of another flash election, which can crash the precarious European balance in an instant, is rising with each passing day.
Entering the final quarter of the year, Lacy Hunt and Van Hoisington (H&H) describe domestic and global economic conditions as extremely fragile. New government initiatives have been announced, particularly by central banks, in an attempt to counteract deteriorating economic conditions. These latest programs in the U.S. and Europe are similar to previous efforts. While prices for risk assets have improved, governments have not been able to address underlying debt imbalances. Thus, nothing suggests that these latest actions do anything to change the extreme over-indebtedness of major global economies. To avoid recession in the U.S., the Federal Reserve embarked on open-ended quantitative easing (QE3). Importantly, in their view, the enactment of QE3 is a tacit admission by the Fed that earlier efforts failed, but this action will also fail to bring about stronger economic growth. H&H go on to break down every branch that Bernanke rests his QE hat on from the Fed's inability to create demand, to the de minimus wealth effect, and most importantly the numerous unintended consequences of the Fed's actions.
The ability of reflationary policy to mute the worst risks of debt deflation has been a source of enormous frustration for stock market bears ever since the 2008 collapse. Yes, the initial moderate rally out of the S&P500’s black hole was perhaps not so surprising in 2009. Bombed-out stock markets can always manage some sort of rally. But the ability of the rally to continue through 2010, and then 2011, and now 2012 has been quite vexing and painful for bearish investors. Indeed, the entire post-2008 market phase has now produced an era of consistently poor performance for hedge funds. Recent data, for example, shows that an incredible 90% of hedge funds are underperforming the S&P500 through mid-September. Will the pain continue? If OECD policy makers do in fact lose stock markets as the main transmission mechanism for reflationary policy, then trouble of a very serious nature will make itself known in the biggest way imaginable since the 2008 crisis began.
As we have painstakingly pointed out, rising equity markets in 2012 have mostly been a function of rising multiples applied to relatively stagnant earnings. While JPMorgan's CIO Michael Cembalest would have given odds no better than 1 in 4 of a 17% advance in the S&P this year, he does note that forecasting annual equity returns is an entirely treacherous (and we add foolish) exercise as real return variation has completely swamped industry expectations for the last 60 years. The traditional Graham-Dodd/Shiller valuation model makes equities look expensive currently, but Cembalest notes, valuations might not be the driving factor at this point. The debasement of money by the Fed has altered the calculus of investing for many participants, and not necessarily for the better. Of course, by driving interest rates down and promising to keep them there, a 7% nominal equity earnings yield (i.e., a 14 P/E) is transformed into a more compelling investment - but critically (especially for social and political reasons) the 'value' of this adjusted earnings yield is questionable given the earnings boom is derived from extraordinarily weak labor compensation and potentially unsustainable demand from Europe/China.
Spoiler Alert: They’re mostly still in office (so much for building suspense).
On October 3, 2008, 338 elected officials (263 House reps, 74 Senators and 1 President) took it upon themselves to save America from certain financial doom by passing the Emergency Economic Stabilization Act of 2008, completely ignoring the will of the American people, opting instead to fulfill a Thomas Jefferson prophesy:
“The end of democracy and the defeat of the American Revolution will occur when government falls into the hands of lending institutions and moneyed incorporations.”
~ Thomas Jefferson
The Federal Reserve is probably not ready to take the aggressive plunge into Nominal GDP Targeting, but it likely will. But if you think these measures are desperate, we have only just begun to push energy and financial systems beyond their capability. The launch of QE3 (and similar measures by the European central bank (ECB) in Europe) is like the crack! of a starting-gun to human psychology that carries the following, urgent message: Hey, humans – go get those resources quickly, before someone else does! Indeed, the most powerful lever for monetary policy remains our capacity for social competition. The open-ended promise to pursue a faster rate of growth at the expense of inflation, mal-investment, bubbles, and the environment places a new and fast pressure on human economies to perform.
September 30 was the last day of Fiscal 2012 for the US which explains why despite the barrage of debt issuance in the past month, the year closed with total debt of just $16.066 trillion, a modest increase of just $50 billion in the month. Luckily, moments ago we got the first DTS of the new fiscal year, which eliminated any residual confusion we had. As of the first day of FY 2013, total US debt soared by $93 billion overnight, and is now a record $16,159,487,013,300.35. One can see why Tim Geithner wants to push all the debt under the coach for as long as possible (and the scariest thing is that the actual increase in Treasury cash was a mere $11 billion). But wait, there's more. As a reminder, final Q2 US GDP was recently revised lower by $20 billion, which if we extrapolate into Q3 (leading to a nominal GDP print of $15.71 trillion), means that as of today, total US Federal debt to GDP is 103%. And rising about 1.5% per month.
Since 2007 our analysis has suggested the likelihood of economic outcomes that most have considered unlikely: significant and ongoing monetary inflation, policy-administered currency devaluation, substantial global price inflation, and an eventual change in how the forty year old global monetary system is structured. Most observers have viewed such outlooks as tail events – highly unlikely, unworthy of serious consideration or a long way off. We remain resolute, and believe last week’s movements in Frankfurt and Washington towards perpetual quantitative easing confirmed and accelerated the validity of our outlook. With QBAMCO's view that $15,000 - $19,000 Gold is possible, timing of the catch-up phase is impossible - though they suspect last week's events may be the catalyst that begins to raise public awareness of the link between monetary inflation and price inflation.
News may come, and news may go, but the fiscal policy implementation vehicle known as the market, and now controlled by the Political Reserve don't care. For those who do, here is what has happened in the past few hours and what is on deck for the remainder of the week.