Thinking Things Over     May 20, 2012

Volume II, Number 20:  Eurozone Agonistes…Again 

By John L. Chapman, Ph.D.     Washington, D.C.

The tragedy of unemployment rates well north of 20% in Greece and Spain, 15.3% in Portugal, 10% in France and Italy, and so on is mirrored in negative GDP growth rates across most all of Europe, and massive loss of wealth: French stocks are barely 20% above their 2009 lows, for example, while the Bolsa de Madrid’s leading index shows Spanish equities now flirting with a seven-year low (by comparison, the S&P 500 is, even after two weeks of heavy selling, roughly double its 2009 recession trough).  The G8 summit meeting this weekend come with leaders’ calls to “save the Euro” by backstopping Greece yet again in order to prevent contagion to Spain and elsewhere.  This is a fool’s errand and only another impediment to global recovery.

On January 3 we issued a report looking ahead to 2012, and evinced deep concern (though not yet panic) over Europe’s economic torpor. Part of that commentary is worth recounting, in offering an assessment of the latest developments there that have impacted U.S. equities and the economic outlook here:

Eurozone Agonistes: a recession, and some surprises – though not a meltdown — yet. There are only bad and worse choices left for Europe….. The bottom line for investment analysis is this:

  • Eurozone bourses, down in double digits in 2011, will be down again in 2012. The entire continent is a “short” for now.
  • Exposure to the U.S. may well be more psychological than financial, but will be more severe than the optimists think. Hence part of the U.S. equity market performance in 2012 is predicated upon what happens in Europe; a melt-down there would lead to a big swoon here.
  • We think the European Central Bank (ECB), whose balance sheet has ballooned to 3.55 trillion Euros (a 20% jump in the last three months), will support sovereign borrowing far more explicitly in 2012 than they have let on so far. It will not contain but will cap borrowing costs for the periphery countries, and in time will engender long term stagflation in much of the Eurozone. But the key point near term is that the ECB will help to forestall a meltdown in Greece or Italy near term, and Spain or Portugal later.
  • Having said that we confess this is a “weak-form” conviction on our part. That is to say, investors should understand the real risk and implications of, say, an Italian default. $2.4 trillion in Italian debt at the moment, with $500 billion needing refunding this year as well as new spending needing deficit financing, pushes Italy closer to a point of no return. Again, we expect ECB “help”, and some ramp-up of the back-stop funding mechanisms (the ESM and EFSF) as well as IMF support, so 2012 may pass as did 2011.
  • In the long run, the laws of economics cannot be annulled, however. Much of the Eurozone must suffer absolute declines in standard of living, and a wave of defaults in the banking sector, and likely more than one of the countries, seems certain. The future is ultimately unpredictable there but the 17-nation Eurozone will not survive intact, and long-term torpor and social unrest seem assured for many countries there.

Alas, that stark future is now for much of southern Europe, and things remain difficult in much of the rest of  the 27-member EU as well, from Belgium to France to Holland to the U.K.  The floundering Greek economy is not helped by the ongoing (and predictable) political instability there, and the stream of news out of Spain — Europe’s 4th largest economy — is all bad: the Bank of Spain announced Friday that the insolvent loan ratio in the nation’s banking system has eclipsed 8.3% to levels not seen since the deep recession of the early 1990s there, thus ratifying Moody’s downgrade of the big Spanish banks last week.

Europe Affects U.S. Investor Confidence — and U.S. Markets

Given the ongoing troubles in the other “PIIGS” countries, the U.K.’s recession, the election of Mr. Hollande in France and his anti-capitalistic policy strategy, and uncertainty over German willingness to continue to underwrite lifelines to the recalcitrants, U.S. equity markets have been hit.  Since reaching a four-year high on May 1, the Dow Jones Industrial Average is off nearly 7%, and is now up only 1.2% for 2012.  Twelve of the last thirteen trading sessions have been losers, the first time that has happened since 1974 (incredibly, given the early ’80s and 2008-09).

Nervousness has returned to U.S. markets for some bad news here at home as well, especially in the wake of disclosed trading losses at J.P. Morgan north of $2 billion (and indeed, rumors are now that the figure may approach $5 billion by the time all trades have been unwound).  JPM‘s shares are trading nearly 28% below where they were six weeks ago; while the bank’s $190 billion in equity capital (and $18.8 billion in 2011 net earnings) should allay investor fears of any banking system contagion, JPM’s stellar blue-chip reputation for infallibility and tight internal controls, combined with the fact — little reported in the press — that JPM’s losses have been on hedges against a falling bond market, thus signalling slower growth in the U.S. — have stoked fears on Wall Street.  Given all this, where do we stand?

On one hand, the continuing news stream about the U.S. economy continues to mostly impress, if not amaze, in what may well be one day seen historically as the most anemic recovery in U.S. history.  Wednesday, for example, the Federal Reserve announced that industrial production increased +1.1% in April (+0.8% after revisions), and is up +5.2% in the past year.  Manufacturing was up 0.5% (+0.2% after downward revisions), and in the last 12 months, auto production is up +27.1%, while non-auto manufacturing is up +4.2%.  Capacity utilization increased to 79.2% in April, while manufacturing capacity is back above its 20-year moving average at 77.9% now.  These macro-performance data are positively stunning in a world starved for good news, and should — should — in a normal world anyway, signal incipient demand for new capital investment and sustained corporate profits moving forward.

Meanwhile, there was other good news in the past week: inflation held steady in April and is up 2.3% year-over-year (though again, we expect this figure, already above the Fed’s “announced” target of 2%, to move higher in the years ahead, regardless of trade-weighted gains to the dollar), while retail sales were up slightly as well (+0.1% in April).  And housing starts were up impressively (+2.6% in April, and up 29.9% from a year ago, with eight consecutive months of gains); housing starts on an annual basis are still less than half the anticipated need for 1.6 million new units by 2016, thus signalling future growth on the horizon that will impact GDP and job creation positively.  

What all this adds up to is a U.S. economy that, while subject to fits and starts, is growing in the 2-2.5% range (though 1st quarter 2012 GDP may well be revised below 2% due to lower inventories).  With no recent bad news domestically that would knock 7-8% off U.S. equity market capitalization — and, while we disdain the alchemy of market technicians, we cannot see where any overvalued sectors would have provided rationale for profit-taking — no rising war talk, declining commodity prices, and no new news from Asia, the recent sell-off is mostly about Europe. 

 And here, in hindsight, the problem is clearly seen: a monetary union in fact, but conforming fiscal policies (including budget deficits to be held to less than 3% of GDP in each country) only in theory.  Interestingly, economist Phillipp Bagus (author of the must-read Tragedy of the Euro) has pointed out that for some years prior to the actual implementation of the Euro in 1999, interest rates across the continent had largely moved toward convergence: 

Chart I. Interest Rate Convergence Post Maastricht Treaty (1992) and Pre-Euro      Figure 1    Source: Phillipp Bagus, Universidad Rey Juan Carlos  

And indeed, post 2000 they nearly did converge right through the crisis.  This set up a massive transfer of wealth from the rich countries (e.g., Germany) of northern Europe toward the periphery countries, and Bagus’ insight is that it has been a nearly 20-year process.  Countries like Greece that could borrow at, effectively, German Bundesbank-driven interest rates and solid credit could increase government spending and the size of their public sector, pari passu (to be fair, Spain was an exception: the larger amount of the debt increase came through private sector borrowing growth and higher leverage for consumers and businesses, particularly in their housing sector).  But the recession unearthed the lack of adequate capitalization in these economies to support higher levels of public sector spending, with consequent demands on public sector fiscs and current calls for “austerity.”   

The Next Few Months Will Provide More Reason for Investor Ulcers

How this all ends is anyone’s guess, but we will hazard a few:

(1)  The weekend summit meeting has produced an Obama-Hollande entente for more spending and less austerity: “balanced fiscal consolidation”, as the U.S. President calls it.  In the short run, how this plays out is indeed entirely in the hands of the Merkel government in Germany.  And the Germans may indeed acquiesce in yet another round of effective bail-outs, for both prior beneficiaries (Greece [twice], Ireland, and Portugal so far, to the tune of more than $500 billion) and Italy and Spain in line.  But there is a limit to German patience: the last round of bail-outs at the close of 2011, with clear need for fiscal re-ordering in these countries, produced no real changes of substance outside Ireland.  The German anhalten to continued subsidization of fiscal profligacy in the PIIGS will, when it happens, signal the formal exit of Greece, first, from the Euro.  When it happens — and there is increasing chatter that it may be this summer after Greek elections —  there will be a downdraft to global equities, including in the U.S.   

(2)  Regardless of when this happens, there will in the immediate term be more expansion of the ECB balance sheet, perhaps dramatically so, in support of sovereign-issued debt in Europe (until the Germans effectively end this).  This will necessitate increased swaps with the Fed, and further quantitative easing (whether called “QE3” or not).  In turn, this will drive asset prices higher, further inflating a serious bubble in the U.S. bond market.  The dollar will gain on a trade-weighted basis in the months ahead thanks to this continuing torpor in Europe and its unsettled path forward. 

(3)   Ongoing convulsions in the Eurozone and poor prospects in the U.K. and elsewhere may mean another two years of low or zero growth there.  But as tiny Iceland has now seen, there is a silver lining to all this:  the self-same prospects for a brighter future following fiscal disaster, extant in Adenauer’s Germany in 1948 or Sweden in 1992, are forming once again: a pro-growth investment climate in a regime of sound money is in the future economic firmament, necessitated by a rational body politic and rationalized political economy.  The sooner this happens, the better, for all concerned.  Meanwhile the challenge for investors, of course, is managing wealth through the difficult transition in the time ahead, to those sunny uplands of tomorrow.  At the very least, this extraordinary environment we are now all living through calls for out-sized excellence in diversification, and a global perspective on the markets.     

Note to readers: Last week we wrote part one of a two-commentary on monetary reform, following the House Subcommittee on Domestic Monetary Policy’s hearing on the Fed’s dual mandate and its future.  The explosion of news out of Europe prevented us from writing part two this week, but we will follow soon on this — it is of course a timely topic given what is presently happening in the Eurozone and around the world.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

Click here to sign up for our free weekly e-newsletter.