Politicians the world over spoke last week and the market did what it normally does in such cases, mainly go down. First up was the Republican debate which proved beyond a shadow of a doubt that the two leading contenders have their hair stylists on speed dial. Then came President Obama with his speech to a joint session of Congress that proved beyond a shadow of a doubt that his speech writers are spending way too much time watching infomercials. Pass This Bill Now! Last came the protestations of Greek Finance Minister Venizelos that his country would not default on its debts which brings to mind a quote most often attributed to Otto von Bismark: “Never believe anything in politics until it has been officially denied.” *
While Venizelos may believe his country won’t default, the market disagrees and I do too. Greek 2 year notes are yielding over 50% and that has default written all over it. The fact is that Greece cannot pay back what it owes – at least not in Euros – and some form of default is probably inevitable. How it happens is anyone’s guess at this point, but Germany appears to be tiring of playing deep pocket Dad to the rest of Europe. Juergen Stark resigned from the ECB Friday in protest of their purchases of peripheral debt and German Finance Minister Schaeuble has said in no uncertain terms that Germany will not approve more funds for Greece until they fully implement the required austerity measures. Could Germany leave the Euro? That is one of several possible outcomes in the long term, but for now, a direct Greek default seems more likely. Indeed, based on press reports, Germany is already preparing measures to support their banks in such an event.
A Greek default in isolation seems manageable. European banks have already written down their Greek debt although some have taken deeper cuts than others. The International Accounting Standards Board recently criticized some banks for writing down their Greek debt insufficiently. BNP Paribas, for instance, wrote down the value of their Greek bonds by 21% while RBS and most of the German banks took a full 50% haircut. As best I can tell, US banks exposure to Greece is limited to less than $50 billion.
The problem though is that no one believes the European situation will be resolved by a Greek default. It is believed – and I don’t disagree – that if Greece defaults it is only a matter of time before other countries follow suit. Portugal, Spain and Ireland are in dire straits and Italy isn’t much better. If a multiple default scenario unfolds, the losses at European banks and the blowback on US banks could be considerably larger. Direct bank exposure to PIIGS debt totals over $2 trillion across Europe and the US with about $640 billion of that at US banks. Additionally, US banks have indirect exposures to Europe through holdings of European bank debts and cross guarantees. The extent of that exposure is impossible to quantify.
The larger question facing investors is how these bank losses might affect the global economy, which is already slowing as I’ve noted here repeatedly over the last year. How much additional slowing would occur from widespread European defaults? That is hard to say but Germany is Europe’s main source of growth and they are dependent to a large degree on exports to the rest of Europe. 6 of their 8 largest trading partners are in Europe with France the largest at over 10%. As for the effect on the US, about 15% of S&P 500 revenue comes from Europe and US exports to Europe are running at a $265 billion pace so far in 2011. $50 billion or so of that is with Germany. Europe is one of our largest trading partners and a slowdown there will have an effect here regardless of whether US banks are hit. Investors are not unaware of this though so the stock market has already discounted at least some slowing in Europe. Whether it has fallen far enough to discount it fully – or even more than fully – is something we won’t know except in hindsight.
Of equal importance to the US economy is the state of our own economic policies and on that front, I have little positive to report. President Obama’s speech last week was disappointing on many levels. The policies he offered were mostly just more of the same temporary policies that have already been found wanting. As has been the case going back to the Bush administration, the politicians seem to think that if they just offer some temporary support to the economy it will eventually revert – magically – to its previous growth state. The results of these past attempts at temporary “pump priming” are nothing short of dismal and even if Congress were to pass the entire package, as Obama repeatedly urged, to expect better results is the triumph of hope over experience. We need deep and fundamental reforms that seem unlikely in the current political environment. The blueprint for growth is well known: simplify the tax code and broaden the base, reduce regulatory complexity, control government spending and run a sound monetary policy. It worked for Reagan, it worked for Clinton and it will work again. Unfortunately, none of it seems likely soon.
So, where does all this leave investors? We remain very conservatively invested and may get even more conservative if growth continues to weaken. I am, however, continuing my search for silver linings in our economic cloud. At some point, markets will have fully discounted the bad news and those with the courage to buy will be rewarded handsomely. Bottoms are rarely obvious at the time – remember March of 2009? – but they always come. Buy low, sell high can only work if you exercise the first part of that equation.
The economic data last week wasn’t all that bad and largely confirmed our view that the economy is slowing but not yet exhibiting the signs of recession. Of course, as 2008 proved that can change quickly so we remain cautious about the outlook. We are quite concerned about the European situation and more specifically about any EU response that might come in the wake of a Greek default. We believe the defining event of the 2008 crisis was not the Lehman failure but rather the TARP led government response to the failure. It was the uncertainty of government action that produced the cliff dive of economic activity. Any response in Europe to defaults needs to be quick and decisive. We aren’t very optimistic that would be the case.
On to the weekly data. The ISM non manufacturing index actually rose in August to 53.3 which means that growth actually accelerated slightly. That is nothing short of amazing considering all the events of that month but that’s what the data says. The Goldman and Redbook retail sales reports were contradictory with the former reporting a slowdown and the latter an acceleration. I’d say split the difference in the two figures and say that sales trends aren’t changing much. The growth in same store sales has been between 3 and 4% for most of the year and while that isn’t great, it isn’t recession either.
The Fed’s Beige Book also confirmed our muddling through thesis:
The Beige Book prepared for the September 20-21 FOMC meeting indicates that there is no double-dip recession and that the economy continues to expand, although at a “modest pace.” However, some Districts noted mixed or weakening activity. Overall, the report confirms the view that the recovery continues but at a very sluggish pace. Consumer spending is up somewhat but largely on motor vehicle sales. Manufacturing is growing but at a slower pace. Housing is still flat and depressed. Most Districts characterized commercial real estate and construction activity as weak or little changed, but improvements were noted in several areas. Labor markets were generally steady, although some Districts reported modest employment growth. On the inflation front, the majority of Districts reported fewer price pressures, but input costs continued to rise in select industries.
On the housing front, purchase mortgage applications ticked slightly higher but the level of activity is still very depressed. The trade deficit narrowed in July due to a surge in exports to a new record and a drop in the petroleum deficit. Wholesale inventories rose 0.8% in July as accumulation slowed but not as much as sales which were flat compared to June. The inventory to sales ratio is still low at 1.17. Lastly, jobless claims basically held steady at 414k. This low 400s level has been the norm for months now and is indicative of an economy with little job growth.
For now, nothing has changed with regard to the economic outlook which we see as weak growth for as long as current policy remains in place. While we don’t expect much in the way of fiscal policy changes any time soon, it does appear the Fed is preparing for some kind of change in policy. We can’t know for sure what it will be but the most likely is a policy similar to the Operation Twist used in the early 60s. That would have the Fed going further out on the yield curve, selling short term Treasuries and replacing them with longer term bonds. We believe this policy would be ineffective as stimulus and would have little impact on the economy. This is not a monetary problem and can’t be fixed by the Fed. With the politicians firmly focused on their own jobs, we don’t expect to see anything soon that will help Americans find ones of their own.
If you’d like to receive this free weekly commentary by email, click here.
*Note: While this quote is most often attributed to von Bismark, it more likely comes from Claud Cockburn, a journalist, communist and Soviet agent. Whether he used it in reference to Soviet or Western misinformation I don’t know, but it seems pretty universal when it comes to pronouncements of government officials.