The consensus view of the recently announced European fiscal deal is that it was a failure and indeed there are a lot of problems with the agreement. First of all, it isn’t really a deal yet. There are still a lot of details to negotiate and it will still need to be approved by the legislatures of the countries involved. Second, there doesn’t appear to be an enforcement mechanism to ensure that the agreeing countries adhere to the fiscal targets. Without a way to enforce the limits the new agreement will be as toothless as the original treaty’s fiscal limits that have been expediently and repeatedly ignored by everyone in Europe, Germany included. Lastly, it doesn’t appear to have changed the mind of the ECB with regard to the purchase of periphery bonds. So, if the fiscal deal was a failure, how do we explain the recent market action?
Italian and Spanish note prices rose again last week. Spain’s two year note yields are at 4 month lows while the yield on Italy’s notes have dropped for three straight weeks. French and Belgian note prices also rose last week even as the threat of rating agency downgrades loomed over the continent. European bonds have continued a rally that actually started even before the fiscal deal was announced:
It isn’t just the short end of the curve rallying either. 5 and 10 year note yields have also dropped, although not as much as the yield on short term paper (yield curves are getting steeper). A number of explanations have been offered for the rally with the most popular being the recent actions of the ECB to support the banks of the Eurozone – the so called “back door bailout”. These actions include a rate cut, a reduction in the quality of collateral they will accept and the extension of loans with three year terms. Along with the coordinated actions of the Fed and other central banks recently, Europe has been flooded with liquidity. European banks have essentially been given the green light to borrow from the ECB at 1% and buy government debt with much higher yields and earn the spread. Europe’s banks have also been selling off foreign operations and loan books to US and Asian banks further freeing up capital.
More important than the ECB’s actions, in my opinion, was the signal the deal sent to markets, that Europe – and more specifically Germany – is committed to saving the Euro. One of the great mysteries of the European debt crisis has been the incredible resilience of the Euro which until the last few weeks had refused to fall. One of the reasons the Euro hadn’t fallen, in my opinion, is that the market perceived that there was a high probability that the weaker countries would be forced to leave the common currency. Eliminating Greece, Portugal, Spain, Ireland and Italy from the Euro would have left a stronger core anchored by Germany and other fiscally conservative northern countries. Now that the probability of break up has been lessened, the Euro is seeking a lower value that better reflects the prospects of the entire Euro area.
None of this is meant to imply that the crisis is over and it’s all blue skies ahead for the Eurozone. There is still a lot of work to do to resolve the fiscal crisis in the periphery – and in the core for that matter. Portuguese and Greek bond yields have not fallen and a Greek default still seems more likely than not. There is also a lot of debt to be rolled over next year across all of Europe and no guarantee that demand will be sufficient to keep yields at their current levels much less lower. A lower Euro might help some – my friends who travel a lot are already talking about Europe getting cheaper – but it does nothing to lessen the intra-European differences in labor costs and productivity.
Over the longer term – assuming the commitment to the Euro is maintained – the changes being forced on Europe are positive for future economic growth. The public sector will have to be reformed as deficits are reduced and with little fiscal wiggle room countries will be forced to pursue alternative measures for growth. These will likely include a liberalization of rigid labor markets and other free market reforms. All the PIIGS, with the exception of Ireland, rank low on the economic freedom scale and there is ample room for improvement that will be positive for growth. Making it easier to start a business, easing access to capital, deregulating industries and privatizing government enterprises will all improve economic freedom and therefore growth. With the IMF and the EU looking over their shoulders and tax cuts off the table for now, the PIIGS will have limited choices on how to improve productivity and growth, but there is plenty of potential with the right policies. The European debt crisis may not be over but momentum seems to be moving in the right direction.
The US economy continues to surprise the pessimists. Last week’s data was again better than the consensus expectations led by the manufacturing reports. I have remained fairly positive about the US economy over the last few months despite the widespread calls for a return to recession but I must admit the European and – now obvious – Chinese slowdowns are enough to give me pause. I believe the US is still the dog that wags the tail of the global economy but Europe and China are important trade partners and their troubles will have an impact here. The question is whether it will be enough to cause a return to recession and to be frank, I have no idea. There are way too many moving parts to the US and global economies to make definitive judgements about the future. If that wasn’t true, central economic planning would work and the Soviet Union would be thriving.
For investors, the question of the effects of the European and Chinese slowdowns is even more complicated. Are markets currently priced to reflect the full extent of a severe European recession? Or are current prices too pessimistic? Too optimistic? Even with foreknowledge of the depth of any European recession it would be impossible to know how all the other investors in the market view the future. This time of year we see numerous articles and research pieces on the outlook for the coming year. In my opinion, these prognostications are of dubious value and at Alhambra we abstain from crystal ball gazing. We take the data as it comes in, observe markets, attempt to discern the prevailing sentiment and then make rational judgments about the allocation of our portfolios. But we can’t predict the future. And neither can anyone else. I recommend you take all the predictions you see over the next few weeks as seriously as you do the daily horoscope.
Now, on to last week’s data. The Goldman and Redbook retail reports both showed weakness in the previous week. Year over year same store sales are now down to 2.9% in both reports. This isn’t concerning yet but if the weakness continues it will start to get my attention. The official retail sales report for November also showed weakness with the month to month gain at 0.2%. However, both September and October were revised higher partially offsetting the weakness in November. Ex-auto and gas the gain was also 0.2% so the weakness was fairly evenly spread. Inventories do not seem to be a problem though. Business inventories rose 0.8% but sales were also up so the inventory/sales ratio remained steady at a healthy 1.27.
Several reports indicate that inflation is moderating. John Chapman has detailed coverage of Import/Export Prices and the PPI and CPI reports so I won’t rehash it here but suffice it to say that while prices are rising more modestly recently, we are both worried about the potential for future inflation. The Fed’s expansion of the monetary base represents a danger that we can’t quantify but seems substantial.
The manufacturing sector continues to lead the recovery such as it is. Both the Empire State and Philly Fed reports were significantly improved from last month. The NY Fed survey rose to 9.53 from last month’s 0.61 and most of the sub-components were positive. New orders flipped from -2.07 to +5.1 while shipments were very strong at 20.87. Employment also changed direction from negative 3.66 to positive 2.33. The only negatives were a drop in unfilled orders and a rise in input prices. The Philly Fed version was also strong at 10.3 for December versus November’s 3.6 indicating an acceleration in the rate of expansion. New orders accelerated from 1.3 to 9.7 while employment and shipments remain in positive territory. Of special note was an acceleration in backlog orders to 7.2 after months of contraction. These more recent reports offset what was a generally weak Industrial Production report, down 0.2% in November.
Last but certainly not least was the jobless claims report for the week. As I’ve said in the past, I don’t trust the reports around holidays due to the seasonal adjustment problems but the recent drop in claims is significant. Last week claims fell to 366k the lowest since May 2008. This report also compares favorably to the non-seasonally adjusted numbers for the same week last year, dropping about 60k. One of the reasons I pay so much attention to jobless claims is that they are highly coincident with the stock market. Stocks move higher with falling claims and vice versa. The recent divergence between these two forward looking indicators will need to be resolved with either higher stock prices or a spike in claims. Let’s hope it is the former.
Stocks were down last week with the S&P down a bit less than 3%. European and emerging market stocks fell slightly more but sentiment is very negative on these markets and I think it is significant that these markets are holding for now above the lows of early October and late November. Of more interest to investors than stocks were the moves in the US dollar, the Euro and commodity markets. The dollar has been moving higher against almost all currencies recently and now against gold as well. While that has positive long term implications, in the short term it could be interpreted as an indication of impending deflation. I have said many times that we will know that economic policy is improving – or expectations are improving – when we see the dollar and stocks rising with gold falling. There is no doubt that the dollar is improving and gold has now fallen below its 200 day MA for the first time since early 2009. Stocks have been outperforming gold since late August. It is too early to call this a long term trend but it is encouraging.
We made no changes to our portfolios last week and are still conservatively invested with a healthy allocation to cash. I remain modestly bullish on stocks but not enough to get fully invested. The economic outlook is clouded by a few forward looking indicators, primarily in the credit markets but the overall view for now is fairly positive. As for next year, as I said above, we don’t try to predict the future but the one thing I’m pretty sure of is that election year politics will impact the markets. The jockeying around extending the payroll tax cut right now is only an opening remark in the economic debate that will dominate the campaign next year. I feel comfortable only in saying that markets next year will, as every year, fluctuate.
This will be the last Economic & Market Review of the year. My wife and I will be heading to Chicago next week to spend the holidays with our daughter. I’ll still be watching the markets and following the news flow though so if anyone in the Chicago area wants to meet up and talk markets, economics and whether the Bulls have a chance against the Heat this year, let me know.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: email@example.com
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