David Rosenberg: "Despair Begets Hope"

Presenting the best weekly self-contrarian segment from everyone's favorite Gluskin Sheff-based skeptic - David Rosenberg:


... Over half of the 2012 price advance has been reversed in barely over a month as the broad market drifts down to its lowest level since February 2nd. The Financial Times makes the point that the 10-day relative strength index at 29.2 is deeply into oversold territory. The Canadian TSX index is officially in bear market terrain, having declined 21% from its cycle high (posted in April last year) and is back to levels prevailing on October 2011.

Fading risk appetite is also underscored in the credit markets where BB-rated corporate spreads have widened to 450 basis points from the recent low of 420bps. Until we see some resolution to the latest round of euro area angst, one can reasonably expect spreads to widen further, but we would look at this as a nice buying opportunity as the link between the problems there and corporate default rates here is extremely loose. The fact that gold and other commodities are slipping while core government bond markets — gilts, bunds and Treasuries — are rallying strongly suggests that deflation risks are getting repriced into various asset classes. Greek bonds are trading at pennies right now and implicit probabilities in peripheral bond markets are highly discounting exits from the monetary union by year-end. Spanish bond yields have blown through 6% (Italy getting closer too) and 10-year spreads off Germany have hit a new record high of 485bps.

This is where the LTRO has proven to have actually been a dismal failure. Domestic banks used the program as a carry trade to play the yield curve and are now choking on losses on the sovereign government bonds they were enticed to buy. So thanks a lot, Mr. Draghi — ECB policies are at least partly responsible for why it is that euro area bank shares have sunk all the way back to March 2009 lows. Non-domestic investors have been dumping the peripheral government bonds just as the Italian and Spanish banks have been loading up — these foreign entities, we see in the FT, have been net sellers of Italian government bonds to the tune of 200 billion euros in the past nine months and 80 billion of Spanish debt over the same time frame. And guess what? They can unleash even more supply damage because they still own roughly 800 billion euros worth of combined bonds of both basket-case countries.

The most bizarre quote we have seen in quite a while came from a strategist in the FT. Get this:

We can take comfort from the fact that while the Greek electorate are against austerity, the support for staying within the eurozone is even stronger".

I can replace that with this real-life comment:

We can take comfort from the fact that while my three sons are against doing their homework, the support for getting a passing grade is even stronger".

How utterly lame.

If the Greeks want to stay in the eurozone, it's probably because they know they can continue to suck at the teat of the Troika. More bailouts please and on easy terms since "austerity" is the new dirty nine-letter word globally.

The best lines actually came from the FT Lex column:

"All balled-out eurozone countries will ultimately have to decide whether they can make the fiscal adjustments and achieve economic growth more quickly in, or outside, the euro. That is where Greece now finds itself."

Now that is a thoughtful comment.

There was another really good zinger in the Markets and Investing section. To wit:

"it's naïve in the extreme to think you can limit the knock-on effect. As soon as Greece leaves or defaults, contagion will pass like a cannon going off in Spain".

That was from an executive at a U.K. bank.

Arvind Subramanian penned a truly brilliant piece in the FT as well, titled Why Greece's Exit Could Become the Eurozone's Envy. In a nutshell, Greece's challenge is that it is woefully uncompetitive and as such needs wages and prices to adjust sharply lower. You either do that organically or you devalue the currency — which then sharply boosts exports and fosters import substitution. Of course, the initial impact is recessionary and deflationary, but only for one to two years, if history is a guide, followed by a boom. This is exactly what happened to Asia a decade ago. As Arvind concludes, "the ongoing Greek tragedy could yet turn out not too badly for the Greeks. But tragedy it might well be for the eurozone and perhaps the European project".

Indeed, the cost estimates I have seen published for the euro area would be in the neighbourhood of 400 billion euros — in terms of immediate direct financial losses. Second round impacts are far more difficult to assess, but would be enormous. While there are a myriad of legal complexities surrounding a Greek departure, it is not an impossible task. The bigger issue would be how the ECB would manage to ring-fence the banks in Portugal and Spain and prevent a contagion.

But let's talk about what we do know with some certainty.
The Greeks voted against the status quo. It isn't working for them. An election is likely around mid-June, and the party in the lead is dead-set against the initial bailout terms. The government, meanwhile, runs out of cash by early August when a bond payment comes due and that could well be the trigger for default and exit. It is tough to see this process being orderly — confusion, turmoil and volatility all come to mind. But if we do get a cathartic event, we will be able to buy assets for our client base at excellent prices. There always is a silver lining. You just have to find it.

We also know that Angela Merkel this far is not being swayed by her party's recent electoral setbacks — at least that is the indication we are getting from her latest rhetoric.

So how does all this play out?

  1. The Troika work out new less onerous terms for Greece and in return there is no exit. The problem, though, is that Greece's fundamental economic woes do not go away. And other bailout countries will look for similar treatment. This sets a bad precedent.
  2. The Germans finally acquiesce on the Eurobond issue — a common fiscal policy backed by the country's balance sheet. The risk here is that Germany no longer receives AAA status. But the whole crisis comes to a head.
  3. The ECB engages in multi-trillion debt monetization and acts as the buyer of government bonds directly. This will undoubtedly have unintended consequences, but would also stop the crisis in its tracks.
  4. Greece defaults and leaves the union. This prospect is increasingly getting priced in, including the contagion risks.

All the while, the Eurozone recessionary pressure continues unabated — highlighted by the 0.3% sequential decline in March industrial production, dragging the YoY trend to -2.2%. This was the worst performance since December 2009.

It is against this backdrop that austerity is falling by the wayside across Europe. The FT is filled with headlines like these:

  • Swedish Opposition Takes Lead in Polls
  • Dutch Austerity Consensus Starts to Unravel
  • German Poll Victor Succeeds in Catching the Wind of Change
  • Hollande Faces Tough Test on Budget Shortfall

Even Canadians are getting in on the act, with the Globe and Mail running with a lead front page story that says Quebec Student Revolt Boils Over (And these students pay just about the lowest tuition fees in the world! But hey — this is my entitlement!).

I have to admit that when I see this land in the WSJ —Brown Warns Californians: Taxes or Cuts — I sense that America is moving out of denial and much more quickly into acceptance than the Europeans are on the road to fiscal reforms. Jerry Brown is talking about a doubling in his planned spending cuts (remember, he is a Democrat) and an increase in top marginal income tax rates and sales taxes too. He needs to close a budget gap projection that has widened to $15.7 billion from $9.2 billion in January with draconian measures. Guess what? Despite the unpopularity of these belt-tightening proposals, the polls show that 54% of the Golden State residents are willing to accept them with a stiff upper lip. Hopefully, this will resonate at the federal level before long.

Look, we are talking about Governor Brown proposing cuts to welfare, health care for the elderly and social services. At the same time, he is imposing extra taxes on the "wealthy". Everyone is going to feel the austerity to varying degrees. And listen to what he said to his detractors:

The fact is, California has been living beyond its means. The United States of America and its federal government has been living beyond its means. This is a day of reckoning and we have to take the medicine.

This, from a true blue Democrat. It would seem safe to say that the U.S.A., and California for that matter, is not Greece, Spain, Portugal or Italy. Denial is no longer an option and austerity is not some dirty nine-letter word.

But make no mistake, as any Canadian who endured the fiscal squeeze of the 1990s — it's no fun to go on a debt diet but you sure feel healthier once it's over. In the interim, very weak economic growth Will be in store for an extended period of time.

Adding to all this fragility is the latest softening in the Chinese data flow. Electricity consumption in April was basically flat from a year ago — it was +7.2% in March and +11.7% in April 2011, so talk about a sudden slowdown. Yikes. The growth in rail cargo volumes has been sliced in half compared to a year ago and residential construction has fallen 4.2% from year-earlier levels. Import growth has vanished —just +0.3% YoY in April versus consensus estimates of +11%.

Again, however, a silver lining — with Chinese growth clearly tailing off, oil prices have come down and with that ... gasoline. Nobody's talking about four or five dollars at the pumps any more.

As I said, Americans are out of denial even as the Europeans begin to shun the painful road towards fiscal probity. An overwhelming 71% of U.S. citizens polled rated economic conditions as being "poor" in a just-published USA Today/Gallup poll. But a 58% plurality are bullish on the future. And so am I. Change occurs at the margin and generally begins at the political level.

The grass roots at the state and local government realm are leading the charge. Whether or not you agree with or even like Jerry Brown is immaterial. When you unveil a tough fiscal plan that displeases everyone — well, that's called leadership. Whoever the next president is — interestingly, the poll shows Romney's favourable-unfavourable rating at 50-41% which is in line with Obama's 52-46% comparable reading — he should take a feather out of Jerry Brown's hat. Spending cuts, means-testing entitlements, tax increases (a sales tax makes great economic sense), raising retirement ages for Social Security, and closing the myriad of tax breaks — all are in order.

Note that after being tied in February, the GOP are now up six points (50% to 44%) in terms of Congressional support. Interestingly, 55% also said the economy would get better in the next four years if Romney got elected (27% said worse) while 46% said the same about President Obama (37% said worse). So if the election does turn out to be more about the economy than a debate about what sort of bully Mr. Romney was when he was a kid, then perhaps there is a legitimate shot that we will see a one-party-take-all come November which may well be what it takes to get things done and done quickly in Washington. The days of gridlock being good are long gone. Go back to the Canadian experience with one party rule in the 1990s — it was time for decisive action, not checks and balances.

I've said it once and I'll say it again. And believe me, this is no intent to wrap myself up in stars and stripes. But there is a strong possibility that I see a flicker of light come November. The U.S. has great demographics with over 80 million millennials that will power the next bull market in housing, likely three years from now. After an unprecedented two straight years of a decline in the stock of vehicles on the road, we do have pent-up demand for autos. I coined the term "manufacturing renaissance" back when I toiled for Mother Merrill and this is happening on the back of sharply improved cost competitiveness. Oil production and mining services are booming. Cheap natural gas is a boon to many industries. A boom in Chinese travel to the U.S. has triggered a secular growth phase in the tourism and leisure industry. The trend towards frugality has opened up doors for do-it-yourselfers, private labels and discounting stores.

As tough as the near-term outlook may be, start to think that it is 1979 again — dark days with inflation excess (today it's deflation), heavy regulation (in industry then, banking today), unionization (today it's a fragile labour backdrop), geopolitical uncertainties (Iran then ... and Iran now), global debt crises (Latin America then, Europe now), high unemployment (then and now), and depressed investor sentiment ('Death of Equities' found its way to the BusinessWeek cover that year...and while the ultimate low was in the Fall of 1982, scaling in was not really a bad idea at all for long-term investors, considering what happened for the next 18 years. I mention that because of the lead editorial in yesterday's New York Times which was titled End of the Affair? Burned and Mistrustful, Americans are Falling Out of Love With Stocks).

To be sure, sentiment is not yet at such a depressed low, neither are valuations (nor dividend yields as high). Be that as it may, it was a huge mistake to have superimposed the awful 1966-1982 period of economic sclerosis and secular bear market (when Japan. who "borrowed" — more like "stole" — U.S. technology and hence garnered global export market share as a result ... sort of sounds like China for much of the past decade) into the ensuing 16 year period because let's face it, the 1980s and 1990s ended up belonging to America.

Few folks saw it at the time. But it's worth remembering, especially now as we face this latest round of economic weakness and market turbulence. It is exactly in periods of distress that the best buying opportunities are borne...and believe it or not, when new disruptive technologies are formed to power the next sustainable bull market and economic expansion. Something tells me that we are just one recession and one last leg down in the market away from crossing over the other side of the mountain. And believe me, nobody is in a bigger hurry to get there, than yours truly. At the risk of perhaps getting too far ahead of myself, but you may end up calling me a perma-bull (at that stage, I must warn you, folks like Jim Paulsen will have thrown in the towel).