Does anyone know what exactly, if anything, was accomplished in Europe last week? Angela Merkel proclaimed the agreement a “breakthrough to the stability union…using the crisis as an opportunity for a renewal.” I suppose that is possible but the devil is in the details which were conspicuous mainly by their absence in the agreement announced Friday. The agreement requires countries to run budgets with no more than a 0.5% structural deficit but fails to provide a concrete definition of “structural”. Budgets will have to be submitted to the EC for approval but the enforcement mechanism is something left to future negotiation. And there is the minor detail that the agreement does not include all the members of the EU. The Brits opted out and three other members – Hungary, the Czech Republic and Sweden – said, we’ll get back to you after we consult our parliaments. Which brings up another question – what kind of approval is needed from each country to enforce the agreement? It obviously isn’t an amendment to the EU treaty since it won’t involve all the countries, so how is this binding on the agreeing members? Will it have to be approved by each country’s parliament? If so, this may be even less than meets the eye.
Even if the agreement does move the EU closer to fiscal union in the long run, it did very little to address the short term issues. The only significant change was the acceleration of the establishment of the ESM but that was already widely expected. The fund will still be capped at 500 billion Euros which sounds like a lot of money until you think about the magnitude of the debt problem. Mario Draghi remains an enigma, throwing cold water on the idea of more ECB bond purchases at his press conference Thursday but buying Italian bonds anyway – if press reports are to be believed – after hailing the agreement reached Friday as “a very good outcome for the euro area, very good.” Draghi is obviously good at the political power game and is keeping his options open. If there is any faltering along the way to the final deal – supposedly to be wrapped up by March – he can use the threat of stopping the bond purchases to keep everyone in line. Merkel and Sarkozy may be the ones at the microphones announcing deals but is is Draghi holding the whip.
The real problem in Europe is a lack of growth and this agreement does nothing in that regard. Budget discipline is certainly a good thing in the long run, but the structure of any plans to reduce deficits are important if they are to be effective. Italy’s program announced last week was heavy on tax increases with some public sector reform but the pro growth portions were timid and only 1/3 of the total package. If Europe is to escape its fiscal problems, more aggressive growth policies and real cuts in current spending – rather than tax increases – will be required. Moving Europe toward pro market, pro growth reforms is not going to be easy. Last week’s agreement may have been a breakthrough on process – emphasis on may – but it accomplished nothing with regard to the only long term solution – more growth.
The same types of pro growth and budget reforms are needed in the US too but our situation is not nearly as dire as Europe’s. Our fiscal situation is at least slowly moving in the right direction. Spending as a % of GDP has peaked and come down slightly (due to a rise in GDP) and if growth continues, should continue to improve as spending on items such as jobless benefits fall. Meanwhile, federal revenue is rising, up 7% over the last year. More impressive is a 22% rise in income tax receipts which seems to conflict with other indicators of income and job growth. I suspect that a lot of these statistics will be revised higher in coming months and years. Just as the recession, after revisions, turned out to be worse than thought at the time, so will the recovery likely be judged in a better light once revisions are taken into account. We better hope growth continues because with an election next year, any budget deals are off the table for at least another year and probably more like 18 months.
For now, based on the incoming economic statistics, the US economy is still growing despite the obvious slowdown in global growth. Last week’s reports were almost uniformly positive. That could change of course, but as I’ve pointed out before, recession in Europe – absent a banking crisis – shouldn’t be significant problem for the US economy. As for China, despite all the rhetoric, our trade with China is even less than Europe. China is still a very poor country and has plenty of tools at its disposal to increase productivity and therefore growth. They’ve already started easing monetary policy as inflation readings cool a bit. In fact, a cooling off in China might prove beneficial to the US to the degree it reduces upward pressure on commodity prices. I am concerned about the slowdown in the global economy and it will have some effect on the US but for now, it doesn’t seem to be enough to push us back into recession.
Factory orders fell 0.4% in October but both durables and non durables were somewhat skewed by special factors. Durable orders were down 0.5% mostly due to a drop in aircraft orders but with Boeing announcing big orders in November that seems likely to be reversed next month. Non durables were down 0.3% but mostly due to a drop in prices for energy products. I don’t want to minimize the report but this is October data and new orders were up in the more recent ISM report. One note of caution was a rise in inventories, up 0.9%. Wholesale trade numbers also showed an inventory rise but the stock to sales ratio is still low at 1.16. The trade figures for October showed a smaller deficit with both imports and exports falling from the previous month. The improvement was led by the petroleum gap which continues to shrink, down almost 10% on the month to $24.4 billion. The worsening in the non petroleum gap was mostly due to a reversal of the weird gold export numbers. As I noted at the time, gold exports jumped in September and that was reversed this month. I have no explanation for the month to month volatility. (John Chapman has a more detailed look at the wholesale trade and international trade reports on the blog)
The ISM non manufacturing report was a slight disappointment at 52.0 but still above the 50 level that indicates expansion. Employment was the most disappointing sub index at a contractionary 48.9. New orders were slightly higher at 53. Backlog orders remain weak at 48.
Goldman and Redbook both reported pretty large dropoffs in retail same store sales the week after Black Friday. Year over year gains are still respectable at 3.8% and 3.2% respectively. Consumer sentiment also rose in the mid month report to 67.7, at the high end of expectations. This reading is still very low but may bode well for future consumption. Consumer credit expanded again in October, up $7.6 billion and it was once again primarily in non revolving credit, a reflection of auto sales strength. Revolving credit was also slightly higher for the second consecutive month.
Mortgage applications rose 15.3% last week with both purchase and refinance applications responding to lower rates. Purchase applications have been slowly rising the last few months but are still at very low levels compared to the housing boom. The housing market continues to slowly – very slowly – improve.
Jobless claims improved significantly last week, dropping to 381k, the lowest since February. I’d like to get excited about it but I’ve learned to take reports this time of year with a grain of salt due to the seasonal adjustments. We’ve had a lot of false starts with this data in the last year so I’ll wait for more confirmation of the trend in the weeks ahead.
Stocks were up last week but still volatile with the European developments. Stocks rose after the announcement of the fiscal agreement but as noted above, I’m not sure it really means all that much. We’ll have to wait and see how sentiment develops in the coming weeks. There does seem to be a bit of Euro fatigue setting in though and the agreement may be enough to allow traders to ignore it for the rest of the year and concentrate on doing enough to justify their bonuses. Technically, the S&P 500 is above a rising 50 day MA but still below the 200 day MA. A decisive move above the 200 day MA could trigger a lot of short covering and deliver the much hoped for Santa Claus rally. Emerging market and European stocks were down slightly on the week.
Commodities were down on the week while the US dollar index rose slightly. Gold was also down and continues to look very toppy. REITs were up in line with the stock market but we remain underweight due to valuation issues. Our overall allocation is still conservative with a bullish bias on stocks. Our largest stock allocation remains the US with smaller allocations to emerging markets and Europe. We will need more confirmation that the US economy is re-accelerating before committing our remaining cash. If the US economy continues to perform well, I expect European and emerging market stocks to play catch up to the US as expectations regarding the depth of the slowdown moderate.
Overall, the outlook is fairly constructive but we did get some earnings warnings last week. Dupont and Texas Instruments both reduced their outlook for 2012 last week and earnings estimates for the 4th quarter are coming down. Both Dupont and TI cited customers reducing inventories rather than a drop in final demand. Expectations are now at 10.1% earnings growth in the quarter, down from 15% at the beginning of October. The biggest drops in estimates are for materials and financials. Financials are considered the most sensitive to the Eurozone problems but earnings for the sector are still expected to rise by 18% in the quarter. It is a comment on the depth of the negative sentiment that US stocks have remained resilient in the face of declining earnings estimates. I’ll be watching this closely over the coming weeks. More earnings warnings may be the canary in the coal mine.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org
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