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Friendly Takeover
And now, for a couple of days, every wiggle in the market will have something to do with the European summit. Rumors and statements and denials are already flying thick and fast. None of it sounds like it is something that is likely to immediately precede a “Grand Plan” to save Europe.
S&P put the EU on Creditwatch negative. I thought we sorta already knew that was going on when 15 of the 17 Eurozone members were on the watch list, but the EU being broader than the EZ I suppose doesn’t make that outcome automatic.
The ECB, said officials who are not part of the ECB but have “knowledge of policy makers’ deliberations”, is considering new ways to stimulate lending by the effectively-bankrupt institutions they call “banks”. Among the methods reportedly being considered is the possibility that the ECB might loosen collateral criteria so they can take junkier junk from the banks for cash. Other brilliant ideas (although probably none so brilliant as this one) are also being tossed about.
There was a report late in the day, shortly before the stock market closed, that the G-20 might get a new $600bln IMF lending problem. There was apparently little thought of where that money might come from, since the IMF was also saying that it “may need more cash resources to help finance a newly created lending facility.” It’s hard to pony up $600bln when you’re looking for the last $120bln. In any event, the IMF promptly denied the rumor that they’re readying new money.
The rumors seem more promising than the concrete news relating to Europe. For example, it is the case that Merkel and Sarkozy have called for Eurozone countries to have common corporate tax rates. This sounds like a great idea if they converge on a low rate like Ireland’s, but one suspects – since France is known to be annoyed at Ireland’s naked ploy to attract business – that the intent is to have tax rates converge higher. That seems like a fertile ground for disagreement. But the bigger issue is that the Big One-and-a-Half (Germany and France) have proposed, essentially, that all Eurozone countries agree to have their fiscal budgets approved by Berlin and Paris. France, which is hardly in a position to make any demands right now, is on the podium mainly because Sarkozy is Merkel’s buddy and because if Germany makes this proposal alone it looks like the sovereign equivalent of a “friendly” takeover of one corporation by another.
There are only two pieces of good news there. (1) A continent basically managed by Berlin would have a chance of making things work and becoming another great power, instead of the mish-mash of conflicting interests that mark a decision-by-committee approach. (2) At least it wasn’t a proposal for a hostile takeover.
It is early yet but I give the France/Germany proposal about a 5% chance of being accepted by other European nations. I initially wrote “1%” and then I remembered to correct for overconfidence bias. But it’s a long shot however you want to call it.
That doesn’t mean there won’t be warm fuzzies coming out of the summit, although I am skeptical there as well. But I have to say I am absolutely terrified to be short stocks even though (a) they’re overvalued by quite a bit unless profit margins have permanently widened and (b) I have trouble thinking of a way out of the European crisis that doesn’t end with at least a couple of key defaults or restructurings and/or a long period of sub-par growth. Partly, that’s the “don’t do anything in December that you can’t live with until January” effect, but partly a concern that either the politicians will come up with something seemingly-positive to say along with big smiles, or the market will simply react positively to whatever they have to say.
The fact that I am terrified to be short probably means it is time to do so, but meanwhile I am merely less-long than my neutral position. But I am also still short a small amount of bonds via TBF. Our firm’s four-asset model is completely out of stocks and TIPS (with a real yield of -0.05% on the 10y) and therefore overweight cash and commodity indices.
What’s This All About?
For most of this year, market action has not been about the economic news. It has been about the Fed. It has been about Greece. It has been about Portugal. It has been about Italy. It has been about France, French banks, and the relationship between the French President and the German Chancellor. It has been about Germany.
It has been about the U.S. debt ceiling and the Swiss zero interest rate floor. It has been about the IMF and what they said most lately. It has been about the ECB. It has been about offhanded remarks by Trichet or Draghi or Monti or Berlusconi. It has been about the rating agencies. It has been about the IIF (the who?).
And now, not even those things matter.
Over the weekend, the Italian Prime Minister announced mild austerity measures that prompted the former PM to immediately declare that a confidence vote is needed. Gee, that’s a good start on the road to sustainable fiscal policies! The IMF approved a €2.2bln loan tranche but expressed an opinion that Greece is in a “difficult phase” at the moment. And Merkel and Sarkozy had a pre-meeting before the Euro summit later this week – it was to be a secret discussion, and word was released that there would be no ‘result’ from the meeting until whatever was released later in the week after the summit.
Somehow, they forgot that last part. Merkel and Sarkozy came out in favor of a ‘new’ treaty for the European Union. Or maybe for the Eurozone. Sarkozy says they’d like the rules to apply to the entire 27 members of the EU, but it was essential that the new treaty – which is likely to be considered an unconstitutional restraint on sovereignty in a number of countries – with automatic penalties for breaching terms would apply to all 17 Eurozone members.
I still don’t see anything bullish in those news items. Making the rules for participation in the EU or EZ more stringent, even if it was the right thing to do, isn’t anything that will affect the economy in the next, oh, two or three years at a minimum. It would probably be a Euro-bullish event, even though it is hard to believe given the coddling that Greece has gotten that an economy in crisis would ever be threatened with expulsion for breaching an “automatic penalty” provision (or for refusing to pay the penalty). In any event, the current treaty took many years to get into place. It is going to be hard to swap out. (Maybe a money center bank could do a “treaty swap,” receiving the current terms and paying the desired terms?)
Yet, stocks shot higher on the open. Related markets moved in sympathy although less convincingly. Year-end illiquidity cuts both ways. Late last month, with stocks poised at 1200 in the middle of the multi-month range, I thought that the technical situation favored a potentially messy selloff since selling might beget selling into a market where no one had interest in buying at year-end. We got a selloff, but there was enough liquidity (and enough engineered ‘good news’) to arrest and reverse momentum. Now equities are rallying, and for no other reason than that they’re already rallying – and equity fund managers are being forced to buy in lest they miss a year-end ‘melt-up’ that is becoming more and more plausible even though the reasons for it are more and more elusive.
Evidence for the momentum-driven nature of this rally appeared in the afternoon. S&P announced that 16 of the 17 Eurozone nations have been placed on CreditWatch negative (it would have been 17 of 17, but they think they’re already on top of Greece) pending the outcome of the EU summit on December 9th. Doubtless the result of the CreditWatch, which ordinarily means there is a 50% chance of a downgrade within 90 days, may also have something to do with the amount of political pressure brought to bear…but then, I’m a cynic. This is shocking, if only because it includes all of the AAA countries on whose joint and several credit all plans seem to depend. Everyone knew that considering France a AAA was questionable at best. Some felt that Germany might be dragged down eventually depending on how much they played the role of being the Sherpa of Europe. But the Netherlands, Finland, Austria, and Luxembourg must be seriously annoyed, because they have assiduously defended their fiscal positions and resisted committing treasure to the defense of the European dream. All of which to say: this is going to be a fun summit!
Stocks initially reacted sharply, with the Dow dropping 140 points or so. Bonds rallied back to near-unchanged and commodities erased the early gains. But then stocks started to rally again. This is nonsensical. The odds of something productive coming out of the summit, which is now more critical than ever, just dropped substantially (to be sure, there may well be some cheerful talk, but the probability of getting the Dutch and Finns to go along even with a pro forma announcement has got to be lower today than it was yesterday). S&P just told Europe that if they want to save the periphery, they do so at the peril of their sovereign ratings and the ratings of their corporations as well (since a corporation cannot have a rating above that of the sovereign).
But the market is illiquid, and that means it is likely to keep on going until the eventual outcome is so obviously bearish that fund managers are willing to take some tracking error on the chance that the market might break before year-end. I know that if I was compensated on the basis of my relative performance I personally wouldn’t want to be very far from my benchmark on December 9th. However, if the next zig-zag becomes obvious that day, it will be hard to change positions very quickly in an illiquid market. I suppose the thing I’m really sure about is that I wouldn’t want to be short gamma!
A Serving of Leftovers
The market on Thursday didn’t correct from Wednesday’s rally. I find this curious, although it may be that longs feel they have some protection from the fact that Friday’s Employment Report is likely to be stronger than was generally expected a week ago. There wasn’t much news of the variety that has lately been moving markets – no central bank action, no Grand Plans, no rumored bank failures. I thought that, in such a circumstance, mere gravity would pull equity prices lower.
Economic data was fine, but not terrific. Initial Claims rose to 402k, which is a mild surprise at odds with recent positive indicators but certainly within the range of normal variation. The print above 400k has bad optics, but excruciatingly-slow improvement seems to be the order of things at the moment. ISM was a bit better-than-expected, but the 52.7 print puts it still below June’s level. Car sales were strong. M2 fell $35bln; I feel duty-bound to report the decline in M2 since I’ve been detailing the relentless rise for a while now. The year-on-year rise in M2 is still at 9.5%, and we’ll have to see if this is more than a one-week zig-zag. The release is for the week containing Thanksgiving, so there may well be some seasonal volatility associated with it. One week’s money numbers don’t matter much anyway, but it bears watching over the next few weeks.
None of these things mattered much to the markets. Weirdly, almost every market closed with small losses. 10-year note prices fell as yields rose 2bps. Crude Oil fell -0.2%. Grains fell -0.5%, Livestock -0.5%, Softs -0.3%, Precious Metals -0.5%, Industrial Metals -0.7%, the dollar -0.1%, and the S&P -0.2%. That’s odd, but not particularly significant – basically, markets were all near-unchanged and just happened to all close on the red side.
Since there were no new developments of note, I have a couple of ‘leftover’ thoughts I will share.
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The first thought addresses the speculation, heard in some quarters, that the equity rally of the last couple of months has been due to expectations of QE3. I am not a believer in that theory, especially since history says that equities tend to perform poorly when inflation is rising from low levels and QE, for whatever it is supposed to do to growth, certainly increases upward pressure on inflation (that was, after all, one of the reasons the Fed gave for implementing QE2 when they did – to prevent deflation). But it is always difficult to refute speculations about why the market behaved the way it did.
But here’s the thing. If QE3 is on tap, it isn’t the equity market that should be the primary beneficiary. Commodities are the asset class with the highest “inflation beta,” and the asset class one would expect to be the prime beneficiary of a reflationary policy. For example, in the nine-month rally from August 27, 2010 (when Bernanke first raised the possibility of QE at Jackson Hole) to April 29, 2011 (when both commodities and equities peaked), the total return of the S&P was 29.11%, the total return of the DJ-UBS Commodity Index was 33.31%, and the S&P GSCI rose 48.64%. Commodities beat stocks.
But since the rally from the stock market low on October 3rd has taken the S&P up 13.71%, the DJ-UBS has risen only 3.99% and the GSCI 11.75%. Stocks are convincingly beating commodities. If this is a QE rally, it shouldn’t be led by equities. On the plus side, this implies that if the market starts to smell QE3, both stocks and commodities have plenty of room to rally!
The second most-plausible-sounding reason for the rally is optimism over circumstances in Europe. But if that’s the case, it hardly seems as if the rally ought to be substantially in place since circumstances are a mite tenuous to say the least. Unless you want to score the situation by the sheer number of plans put forth, rather than by the number of concrete plans with clearly-defined steps that have been ratified by all parties (that number would be…zero), the condition of the Eurozone is manifestly worse now than it was two months ago.
I don’t have the answer, although “animal spirits” seems to fit better than those other two explanations.
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Second thought: how would a European recession affect the fragile U.S. recovery?
Of course, if Europe experienced a major recession it would likely drag the U.S. into recession as well. Aggregate exports to Europe from the U.S. are around $300bln, so a 10% decline in European GDP would shave a couple of tenths off of U.S. GDP from direct effects; there would also be significant secondary effects transmitted through other trade partners and it could well cut U.S. growth by enough to touch off a mild secondary recession.
But that isn’t what worries U.S. policymakers. The bigger concern is ‘contagion’ caused if large financial institutions in Europe fail and this leads to failures here. We’ve all read plenty about this (and the bottom line seems to be that no one knows how bad it would be, even if it were to happen that a systemically-important institution was actually allowed to fail in an uncontrolled way).
I have another concern. Ratings agencies fret constantly about the Debt/GDP ratio, which is an income statement concern. It’s analogous to the size of a mortgage you can sustain given your income. But what else do lenders look at when considering your creditworthiness, or that of a corporate client? They’ll also look at the balance sheet – your assets. And here’s my thought: on the balance sheet of the U.S. (which incorporates the balance sheets of all her citizens and companies), there are a lot of investments in European equities, corporate bonds, and sovereign bonds. “Foreign Direct Investment” in Europe (which includes only “the ownership or control, directly or indirectly, by one person of 10% or more of the voting securities of an incorporated business enterprise or an equivalent interest in an unincorporated business enterprise” according to a footnote in this link to a Congressional Research Service piece), was around $2 trillion in 2009 at historical cost. Note that’s the voting securities, so it excludes corporate bonds, and excludes sovereign bonds as well. And it excludes all smaller ownership in business enterprise, such as through equity ownership. So we are talking about large numbers.
What happens if there are significant defaults, bankruptcies, sovereign restructuring or default, and “deleveraging” in Europe? Obviously there’s a large direct wealth effect, which could be expected to impact consumption in the U.S. directly. But if I’m a lender to the U.S., don’t I also care about the asset side of the national balance sheet? I wonder if, even if authorities prevent banks from imploding in a messy fashion, sovereign defaults could significantly impair U.S. credit as well on a longer-term basis. (My sense is that this is probably thinking far too intricately about problems when the main problems in such a case are likely to be big, blunt, and obvious, but one of the reasons I write this commentary is to explore ideas like this.)
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Third thought: I keep hearing about how the economy is experiencing a ‘debt deflation’ cycle, a la Fisher. This seems odd, because I would think a ‘debt deflation’ cycle would involve…deflation. According to Wikipedia’s explanation of Fisher’s formulation of a debt-deflationary spiral:
- Debt liquidation leads to distress selling and to
- Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
- A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
- A still greater fall in the net worths of business, precipitating bankruptcies and
- A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make
- A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
- pessimism and loss of confidence, which in turn lead to
- Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
- Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
So it seems to me that we have a few minor problems with describing what is happening and what has been happening in the economy as a “debt deflationary” spiral. One is that we have had nothing that looks like deflation (unless you want to consider when headline inflation dipped negative on the basis solely of a decline in energy prices); core inflation never got terribly close to deflation. The second problem is that quite contrary to the prescription for a rise in real interest rates, real rates are negative all the way out to ten years – an almost-unprecedented occurrence.
Whatever you want to call what we’re going through, it is most assuredly not a debt deflation cycle.
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Some quick thoughts on the Employment number tomorrow. The consensus estimate for Payrolls is 150k, but after ADP printed above 200k expectations are clearly higher than that. I think if Payrolls are only 150k it is going to be a disappointment. A print above 150k, though, will mean it’s the highest production of new jobs since April. If we get something over 250k, which is certainly not out of the question, it will be the highest non-Census-flattered figure since before the 2008 crisis. I think we will get something better than what the prior consensus was looking for, but unless we beat 250k I think the folks holding gains on the week will look to book some of them into the weekend.
Given the decline in the “Jobs Hard to Get” index of the Consumer Confidence report, in theory the Unemployment Rate could rise (Consensus: 9.0%, unchanged) because fewer people may be discouraged and some may have gone back to looking for jobs. It never seems to work that way, though.
