Submitted by Rodrigo Serrano of Rational Capitalist Speculator
Wow! What a week! Volatility continues to grip financial markets and cause angst among both bulls and bears, a nasty meat-grinder of a market. This week goes to the Bulls.
Obviously most of the volatility this week, as has been the case for the past few, has dealt with what's going on in Europe. News that the BRICS countries may step in along with the IMF to fund a buyout of Greek bonds has demonstrated extraordinary political-will from the most unlikely of places. While a positive resolution with this plan may provide for further relief for financial markets (we rally further), a structural solution such as a fiscal union/Eurobonds remains obscure. In order to confidently be "exiting the woods", we need to see a structural solution in my opinion. Otherwise, periphery nations will remain subject to further austerity measures and sink into what is clearly a debt-trap (as I've feared for a while); deficit-reduction would result in further depressionary conditions and "less-than-expected" revenue for government coffers.
In my view, buying time only serves to worsen the situation. As the crisis has progressed, opposition towards a fiscal union has only increased. Had the proposition to form a fiscal union been put forward in 2010, when the crisis first presented itself, perhaps the odds of such a daring plan being adopted would have been better. Instead a band-aid approach was taken and the situation festered. A worsening economic backdrop and still no solution to the crisis is opening a "Pandora's-Box" of nationalism. Delaying a solution further allows more time for public sentiment to cross an "event-horizon" of sorts into to full nationalism, resulting in the ultimate rejection in the idea of a United States of Europe. The signs of this occurring are palatable.
I remain puzzled as to why much hype was made on the news that European Commission President Jose Manuel Barroso would be presenting a Eurobond construct in the coming days. Yes, the advent of Eurobonds would herald the much desired structural solution for the Eurozone, yet we just had the German Constitutional Court rule that Eurobonds were illegal. Investors (or perhaps the robots) seem to have forgotten what took place only a week ago. Furthermore, Merkel made clear this week, as she has the prior 4, that Germany is absolutely against Eurobonds. Who cares if a plan is being presented, as long as Germany isn't on board, we're back to square one. A drastic change of heart from Germany would need to take place in order for this plan to succeed. I don't see it happening as of now.
Finally, I remain quite wary of a positive resolution in the Eurozone due to my experience here at home. How can we expect 17 Eurozone governments to get on the same page and pass daring reforms if our own legislature failed to step up to the plate when it mattered most? Granted, Congress passed the reform after markets crashed. But my point is that if it was that difficult here, in the United States of America, it can only be more difficult in a region of 17 countries, not states.
On the bright side, talk of the EFSF being used as a Euro TARP, shows that officials are finally thinking ahead as they attempt to ring-fence a Greek default. If they are successful and contagion is averted (Spanish and Italian bond yields don't spike), it would certainly be bullish. China has continued to post impressive trade numbers and has navigated this latest round of turmoil remarkably well. China's continued growth remains a mighty arrow in the bull's quiver. If Eurozone contagion is averted, China may provide continued end-demand to keep the global recovery moving forward.
Curiously, while the Eurozone got all the attention this week, economic data at home was quite disappointing and went largely unnoticed. It seems that investors (or robots?) can only focus on one issue at a time. Forward indicators such as the ECRI and OECD point to a continued slowdown. Manufacturing gauges signal further weakness and expectations of future economic activity fell to a 30+ year low in the latest Michigan Consumer Confidence survey. The exogenous shock of plunging financial markets in August is permeating the economy. Granted, industrial production was positive versus expectations of decline, but 1 positive economic number out of more than a dozen isn't very bullish in my opinion. Will a resolution in the Eurozone come in time to turn the tide for the US economy?
So, despite all the negative news, markets are hanging tough. Why? I believe financial markets continue to have a "Moral Hazard" premium priced-in. The idea that governments will step in to save the day remains entrenched in the minds' of investors. There are signs, however, that this premium may soon be re-priced. Indeed, this week's rally has left much to be desired. Copper, nor the credit markets, have confirmed the move higher in equity markets. Breadth has lagged as well. These are signs that this latest rally isn't healthy. Should government authorities fail to come through and Eurozone contagion takes hold, financial markets would begin to compress this premium. A strong break of 1120 would signal that a re-pricing is ongoing. Overall, the global economy is at a crossroads. Until the Eurozone issues are structurally taken care of, I remain very cautious. Capital preservation remains the name of the game.
Weekly Bull/Bear Recap
+ The Eurozone will survive this challenge. Merkel and Sarkozy vow to keep Greece in the EU and not allow a ‘Lehman’-type event. If there’s any default, it will be done in an orderly fashion. Markets have already priced in one for Greece. Once it happens, it will be bullish for risk-markets as a resolution to the matter would be reached. Central Banks around the world have pledged to provide support for the European banking sector.
+ BRICS nations are in talks with the “Institute for International Finance” to pool their resources and lend capital to Greece in order for them to buyback their own outstanding debt at rock bottom prices, thereby reducing their outstanding debt, and averting contagion. This will help the Eurozone buy more time until the necessary structural reforms are put into place. While the bond-buying won’t solve the structural issues (Europe needs to become a fiscal union), progress is being made on that front as well. Taken together with Central Bank support, officals are beginning to think one-step ahead of the crisis.
+ China’s trade numbers prove that the country will continue to power the global recovery. Surging imports signal that their economy remains resilient in the face of monetary tightening. Even better, tightening is likely over as inflation measures peaked. The economy is experiencing a soft-landing.
+ Asia’s Development Bank sees a soft-landing scenario in China and the region as private consumption has buoyed much of its growth. This scenario, should it play out, would see the global economy avert a double-dip recession, resulting in an overall bullish outcome for equities.
+ Consumer spending metrics have held in remarkably well and is a signal that consumption remains irrepressible despite all the gloom and doom. Spending trends are different than consumer confidence. As long as the consumer doesn’t fall out of bed, the U.S. economy will remain in expansion.
+ Hard-data keeps pointing to a manufacturing sector that hasn’t fallen out of bed as proposed by the bears and some manufacturing surveys. Industrial production for August rose 0.2%, the fourth monthly increase, contrary to contraction signals from Empire, and Philly Fed indexes for that same month. Hard-data is what matters.
+ The economy has managed to grow even while consumers continue the deleveraging process. Consumers are slowly building a strong foundation by paying down their debts. Once debt levels are sufficiently reduced, they will feel increased confidence in their financial situation and consume more as the job market improves.
- Jobless Claims spike 11,000 to 428,000, the highest level in 2 months and bodes ill for the job market and the economy. Manpower publishes a report that points to more of the same. Strong growth figures won’t be coming as the economy remains at stall speed. The economy’s condition is on display in the NFIB’s latest Small Business Optimism Index. The job market remains extremely vulnerable to an exogenous shock.
- Bank of America announces that up to 30,000 jobs are set to be eliminated over the next few years. Wasn’t the market exaggerating about the poor health of Bank of America? Why then did they accept Buffett’s money? Why are they firing 30K workers? Why are they openly discussing bankruptcy for Countrywide? Where there’s smoke there’s likely to be fire. Same goes for SocGen. (—I hold a short position in financials)
- Yes yes we all know housing sucks, but now there are reports that foreclosure activity is set to increase late 2011/early 2012. An influx of properties in foreclosure will further place downward pressure on housing prices and inflict more damage to bank balance-sheets.
- The rich got hit where it hurts, investment markets. Consumer confidence for this group deteriorated significantly last month according to the Gallup Poll. Note that the wealthy are responsible for a significant portion of consumer spending growth, which underperformed in August relative to expectations. In regards to the commoner, the situation is even grimmer. Future expectations as per the University of Michigan consumer confidence survey fell to the lowest levels since….1980 (yes, that’s more than 30 years).
- The global recovery continues to show signs of significant slowing. Australian business confidence slumps to the lowest level since April 2009, while austerity plays havoc with Italy’s industrial output. The OECD Composite Leading Indicators (CLIs) for July are pointing to a significant slowing in global growth. China’s Shanghai Composite Index remains in a downtrend. Finally, copper is hanging on key support levels by a thread and has not confirmed this latest equity market rally. — On the Eurozone front, pure pandemonium: the market wants Eurobonds yet Merkel is still not playing ball; Germany unexpectedly delays debate on the EFSF; Finland still demands collateral; Greece’s next tranche payment is unexpectedly delayed forcing them to tap an emergency fund. The Eurozone turbulence is beginning to critically injure the global recovery.
- The following months look to reflect more of the same for the manufacturing sector, a clear approach to stall speed. The Ceridian-UCLA Pulse of Commerce, a leading indicator of manufacturing activity, declined for the 2 consecutive month. Meanwhile, the Empire Manufacturing report, a survey of manufacturing conditions in the NY area, showed increased weakness. Its employment sub-index fell into negative territory for the first time this year. The Philly Fed Index has been in contraction for 3 consecutive months.
- Inflation at the consumer level remains at uncomfortably high levels and will hinder the Fed’s ability to come to the aid of falling stock markets. Core-CPI, the preferred measure for the Fed, rose to 2.0% YoY and discards deflation as a reason for continued monetary easing. If QE gasoline, which caused increased risk appetite, is unable to be deployed, a key prop for the equity market will remain absent.