Is the Greek debt crisis over? Based on the stock market reaction last week one is tempted to say, yes, finally the Greek problem has been solved. Stocks sold off early in the week when it looked as if the deal might not be fully subscribed but recovered as European leaders managed to twist enough arms to get the deal done. In contrast, based on the trading price of the new bonds Greece will issue as a result of the debt reduction deal, the answer is an emphatic, no. The new bonds will go into actual circulation this week but trading in the when issued market started last week with the bonds trading at roughly 20 cents on the Euro. That equates to a yield of about 17% – still the highest in Europe – and at least for now indicates that bondholders expect further, large writedowns. The European debt crisis may have been papered over by the ECB for now, but it is far from over.

The European economy is either in recession already or headed there very quickly. The ECB last week forecast a contraction of 0.3% for the year but I suspect that may prove to be more wishful thinking than forecasting. Reports last week showed the European economy contracted by 0.3% in the 4th quarter and that is probably just the beginning. One side effect of the ECB’s recently completed LTRO lending program will likely be a credit crunch. With long term financing, European banks have no incentive to clean up their balance sheets and start lending again. They’ll just use ECB financing to sit on sovereign bonds, collect the spread and hope to be in better shape when the cheap financing ends. I suppose US and Asian banks could step in to fill the void but that seems unlikely as long as there are better growth opportunities elsewhere.

More monetary easing in Europe appears to be off the table for now as well. ECB head Mario Draghi is already feeling the heat from the Bundesbank to pull back some of the liquidity and inflation remains stubbornly above the ECB’s 2% target. Draghi made it pretty clear after the ECB meeting last week that the onus is on governments to do the heavy lifting on growth. While some countries are moving in the right direction – Italy comes to mind – the process of liberalizing Europe’s economies will take years. In the meantime, slow growth is probably the best that can be expected and even that will be difficult to achieve in the near term.

If Europe were the only problem facing the global economy, I would probably be more positive about the investment outlook. Unfortunately, Europe may only be the tip of the iceberg. China last week announced that they were targeting 7.5% growth for the year which I suspect is more a recognition of reality than a plan. Just today China posted a massive trade deficit for the month of February. While there are some seasonal effects in the numbers, it is also confirmation that export growth is slowing rapidly. Countries dependent on Chinese growth are feeling the pain. Brazil reported growth of 0.3% in the 4th quarter – after a slight contraction in the 3rd – and the year over year growth rate is down to just 1.4%. The anemic growth prompted the Brazilian central bank to cut rates by another 0.75% – despite an inflation rate still over 6% –  for a total of 2.75% since they started cutting 5 meetings ago. Further confirmation of the Chinese slowdown came from Australia which grew just 0.4% in the 4th quarter and 2.3% for the full year.

Which brings me to the US economy where the outlook seems to get murkier by the day. Last week’s employment report was widely accepted as a continuation of recent jobs growth but some of the details are troubling. The mild winter weather this year means the seasonal adjustments might be making things look better than they really are. Over the last 5 years, on average almost 500,000 people have been stuck home due to weather in February. The BLS does a seasonal adjustment to take that into account but this year that number was only 178,000. Some quick math would seem to indicate that employment may have actually contracted last month. Imagine for a moment how the stock market would have reacted to a negative payroll number Friday. Not a pleasant thought is it?

The employment report Friday did have some positive aspects. The labor force participation rate rose 0.2% as the number of employed rose by 428k and those not in the labor force fell by 310k. The number of job leavers rose by 92k (indicating confidence they can find another job quickly) and all the longer term unemployed numbers dropped. In the establishment survey, temporary help rose by 45.2 which is usually a leading indicator for permanent employment. The only goods producing category to drop was construction while manufacturing rose by 31k.

For the week though, the worrisome reports outnumbered the positive ones. The Goldman retail sales report showed same store sales growth down to just 1.7% year over year, Factory orders fell 1%, new jobless claims ticked up to 362k from 351k, wholesale sales fell 0.1% and inventories climbed 0.4% (although the inventory to sales ratio was unchanged) and the trade deficit worsened as export growth slowed to 1.4% (year over year export growth to China is basically 0) and imports rose 2.1% mostly on the back of higher oil prices. In what I believe was the most ominous report, productivity and unit labor costs for the 4th quarter were revised to show labor costs rising much more rapidly than previously thought and productivity growth under 1% (see here for more details).

If productivity is stalling and wages are rising, as seems to be the case, the outlook for stocks becomes much darker. Since the bottom in 2009, S&P 500 operating profits are up almost 95% but revenue is up only 1% in the same time frame. Profit margins have expanded because large US companies have produced basically the same amount of goods with fewer workers – i.e. productivity has risen. With productivity gains stalling and wages rising, US companies will need to see sales gains to keep profit margins high and total profits rising. With Europe, China and the emerging market economies slowing, that may prove more difficult than complacent stock investors now expect.

I don’t want to get too gloomy though. There were some positive data points last week and the US does still seem to be in the midst of a cyclical recovery. The ISM non manufacturing index rose 5 tenths to 57.3  and the new orders component jumped to a very strong 61.2. Backlog orders moved up 3.5 points and back above 50 to 53.  And the employment reading was a strong 55.7. The Redbook retail report contradicted the Goldman report with year over year same store sales growth of 3%. Consumer credit expanded again by $17.8 billion with all of the rise in non-revolving credit (a positive indication for car sales) while non revolving credit contracted (credit cards). One cautionary note about credit though; we are now only $70 billion from the all time peak in July of 2008.

How all this affects stocks, bonds and commodities in the short term is hard to say because of the monetary backdrop. While the ECB may be on hold for a while I have little doubt they’ll be back at some point. China is already easing and the other emerging markets – such as Brazil as mentioned above – are following suit. The Fed floated a trial balloon last week about further bond purchases, this time supposedly sterilized through reverse repos, so they may not be done yet. All that money creation may be enough to keep the “risk on” trade going for a while but the likely long term effect can be seen in that productivity and unit labor costs report I mentioned above. It’s called stagflation and it isn’t a pretty picture.


For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at:

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