(By Darrel Whitten) The shock that hit the world economy in 2008 was on a par with that which triggered the Great Depression in the 1930s. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed…yet. Now as then, never has so much been staked on politicians "doing the right thing", but as history has repeatedly shown us, elected politicians have a disturbing talent for group-grope, gridlock and general chaos just when decisive action is most required. If the fate of the equity market is indeed in the hands of Euro, US and even Japanese politicians, stocks are headed for a rough ride indeed.
The talking heads in the financial media treat the absolute mess in Euroland as if it were a minor irritant. "If only this Euro thing would settle down, my stock picks would be working". Unfortunately, the "Euro thing" combined with criminal negligence by the U.S. Congress in failing to resolutely address the US "fiscal cliff" as they jostle for advantage before the November elections as if it were political business as usual. The fallout from this Euro thing is already beginning to permeate the global economy, with the World Bank and other international agencies trimming their forecasts for the global economic expansion, and warning that both the developed and the developing nations will be negatively affected by the Euroland crisis and its impact on the global economy.
Global stock markets beginning with the strongest, i.e., the U.S., are again breaking down, like they did in 2010 and 2011 on yet another global growth scare. After unsuccessfully trying to hold its 50-day EMA, the S&P 500 last week broke down below its 200-day EMA. The S&P 500 benchmark is now down over 15% from its April 2, 2012 high, compared to the "sell-in-May" corrections of 16% and 17.6% respectively in 2010 and 2011. In both those cases, it took additional stimulus by the FED to renew the rally (QE 1 and QE 2), while the rally from the October 2011 low was instigated by a similar move by the ECB and its two LTRO 3-year loan program (in two tranches, the latest being February 2012).
By S&P 500 major sector (sector SPDRs), the financials led the S&P rally from the September-November 2011 lows, followed by consumer discretionary and technology. The energy sector peaked before the general market and is now basically where it was when the rally began late last year. The only sector now holding its own is the traditionally defensive utility sector, which never really participated in the 2012 rally in the first place.
Greece Euro Exit. If Greece Thinks its Bad Now, It Could Get a Lot Worse
Greece as the first line of defense against Euro contagion is increasingly looking like a lost cause. The capital flight from Greece is becoming a deluge, with flows from individuals and corporations reaching 4 billion Euros a week since the May elections. Greek banks have already lost some 30% of their deposits since late 2009 and everyone is wondering why not more has left. Greece is to hold new elections in June, as the May elections resulted in political chaos and the collapse of the prior government when the majority of Greeks voted against austerity measures imposed by the Euro Trioka. But Greece may already be out of time, as the government will run out of money in six weeks.
The economy has shrunk by 8.5% in the last year, more than a fifth of the population is out of work and youth unemployment is almost 54%. The country has already been bailed out twice by the EU and International Monetary Fund, and the EU, ECB, IMF Trioka has run out of patience with a fractured government, even as they continue to insist Greece should stay in the Euro. The main beneficiary of the May elections was the hard-left Syriza coalition, who came in a surprising second on a promise to tear up the Trioka's austerity deal with Greece in lieu of additional funding support. The Greek radicals think the Trioka is bluffing, believing even the Germans need Greece in the Euro and will never throw them out.
It is almost certain, however, that Greece will not get more money to pay its debts if it refuses to take the bitter reforms and austerity medicine. While insisting that the ECB's "strong preference" is for Greece to stay in the Euro, ECB President Mario Draghi acknowledged that Greece could leave the euro area and signaled policy makers won't compromise on their key principles to prevent an exit. ECB Executive Board member Joerg Asmussen said that if Greece wanted to remain in the Euro, it had "no alternative" than to stick to its agreed consolidation program. As far as the Germans are concerned, German Finance Minister Wolfgang Schaeuble said, "the (rescue) program is agreed. We need a (Greek) government that's capable of making decisions," and "if (Greece) wants to stay in the Euro, they have to accept the conditions." The IMF's Christine Lagarde recently stated that "If the country's (Greece) budgetary commitments are not honored, there are appropriate revisions to do, which means either supplementary financing and additional time or mechanisms for an exit, which in this case must be an orderly exit."—in other words, honor your commitments to reforms and austerity or leave the Euro.
The ECB has reportedly stopped routine funding operations with four Greek banks because they are basically insolvent. What is left is Emergency Liquidity Assistance (ELA) that is channeled through Greek's central bank. Greek banks have already exhausted their collateral used for loans from the ECB. A refusal by the ECB to ease rules would amount to expulsion, forcing Greece "to issue its own money," i.e., drop out of the Euro monetary union. Greek polls indicate most Greeks want to stay in the Euro, but also don't want to have to endure the pain of the debilitating austerity required for more assistance. According to Greece's deputy prime minister Theodoros Pangalos, "What (the anti-bailout forces) are really asking from the EU is not just to pay our bills, but also to pay for the deficit which we are still creating". For the Greeks, there are no good choices, either staying within the Euro or leaving.
The Trioka is betting that the specter of what will happen to Greece if it drops out of the Euro is motivation enough for its people to drink the bitter austerity medicine, while Greek's radicals are betting the Trioka doesn't want to find out how much Euro-wide contagion and financial market mayhem would be caused by a Greek withdrawal. The Greeks and the "Club Med" countries however continue to underestimate the depth of Germany's inflation/debt dependency phobia.
Further, if you think the situation in Greece, Spain or Portugal is bad now, revisit Germany in 1930, when chancellor Heinrich Bruning became known as Germany's "hunger chancellor" because of his stiff austerity programs. Germany had borrowed so much during the boom years that when bad times came and it really needed the money, it had exhausted its credit lines and loans were no longer available. After Germany's banking system collapsed in 1931, it really got bad. Production plummeted another 20% over the next six months and eventually shrunk to only half 1928 levels and putting one-third of the labor force out of work. People were starving to death. In either case, the crisis could drag on for years, if the experience of 1930s is any indication. Granted, Germany was much more important to the global economy in the 1930s than what Greece is today, but Greece is a key fulcrum for much more serious Euro contagion.
Greece Euro Exit = Stock, Euro Rally?
Ever helpful with a positive spin on a bad situation, some global investment banks now say that global stocks and the Euro could stage a strong rally if Greece drops out of the Euro. This is based on the assumption that the ECB, the FED and the BOJ would pull out all the stops like they did in 2008~2009 to flood the international financial markets with liquidity, triggering a massive short squeeze on those betting against the Euro and the Club Med countries. Under this scenario, the ECB would slash rates, launch QE and back-stop Spain and Italy with mass bond purchases, bank capital injections and a pan-Euro system of deposit guarantees. Further, as suggested above, a Greece return to the Drachma turns out to be a disaster, thereby a strong deterrence for Portugal, Spain and others from also dropping out of the Euro.
Worst Case Scenario is Greece Successfully Withdrawing from the Euro
Ironically, the worst outcome for the Euro and monetary union would be a double whammy, where authorities fail to control EMU-wide contagion, yet Greece somehow manages to claw its way out of crisis and make a success out returning to a devalued sovereign currency, as Argentina did after breaking the dollar-peg in 2002. In this case, the Euro would fall dramatically on the assumption there were more drop-outs to follow.
Last week, financial markets were discounting the worst case scenario, as the Eurostoxx 600 banks index hit a fresh low, below the 2009 trough, and German Bund futures hit a fresh high as everyone in Euroland scrambles to get on the bus to Berlin.
Speculators have been pounding the Eurobanks, and the plunge in Euroland bank stocks accelerated as Moody's downgraded a batch of Spanish and Italian banks. The outflow from Greek banks, as noted, is already becoming a deluge, while there is noticeable outflow from other Club Med banks as well, with all the haven money flowing in the direction of Berlin--thus the new high in Bund futures. In other words, there are now effectively two Euros, Euros of "hard currency" Germany, Netherlands, Luxembourg and Finland, and "worthless" Euros in Greece, Spain or Italian banks.
|Hat Tip: FT Alphaville|
The Euro for the first half of the crisis remained above the fray, because there was no serious talk of any Club Med country dropping out. The Euro did however peak against USD in May 2010 during the first growth scare and is now down some 14% and is breaking support hit this January on optimism about the ECB's LTROs. It is also plunging against GBP, as Gilts have also become a haven. The most amazing feature of EUR is that it has yet to return to parity with USD, still some 22% away.
|Source: Pacific Exchange Rate Service|
The U.S. Fiscal Cliff: As Big a Threat as the Euro Crisis?
In late February of this year, Fed Chairman Ben Bernanke started warning lawmakers about the looming "massive fiscal cliff"—i.e., a) the expiration of Bush-era tax cuts, b) a 2% payroll tax holiday, c) extended unemployment compensation, c) and $1.2 trillion automatic spending reductions related to the U.S. debt ceiling, etc., the U.S. economic recovery is toast. U.S. economy to its knees if Congress cannot agree before January 1, 2013. The IMF is so worried that U.S. lawmakers will drive the U.S. economy over this fiscal cliff that it ranks the possibility as a threat equal to that posed by the Eurozone Debt crisis.
Economists, which usually don't agree on much of anything, agree that tax hikes and spending cuts will drag down economic growth in 2013, yet the estimates vary; a) Moody's Analytics predicts the fiscal drag next year could be to closer to 1.5 percentage points of GDP, b) the Congressional Budget Office calculated the impact at 3.6 percentage points of GDP in fiscal 2013, while Morgan Stanley economists belief the fiscal drag could slash 5 percentage points off 2013 GDP, versus expected GDP growth over only around 2%--i.e., if the fiscal drag turns out to be greater than 2%, the U.S. gets flat or minus growth in 2013, which is definitely not what U.S. stock prices are discounting.
Further, there are also suggestions of a U.S. government shutdown before that when the new U.S. fiscal year begins on October 1, 2012. The strong proclivity of already grid-locked U.S. lawmakers will be to "kick the can down the road" instead of addressing these pressing policy issues before the November elections, meaning the "fiscal cliff" is more likely to be averted at the last hour by a Congressional vote for a short-term band-aid to renew the expiring programs for at least the first quarter next year. For example, Gregory Meeks, a Democratic congressman from New York, said politicians "are aware" of the cliff, but that nothing will happen during campaign season, although he tried to assure the audience that Congress would avert disaster by, as usual, always "waiting until we get close to the wire" before seriously addressing the issue.
Individual Investors Looking Pretty Smart by Shunning Equities for Bonds
Euro crisis and U.S. fiscal cliff help explain why U.S. individual investors have continued to shun equities and equity funds, even though the "smart guys" were warning them that moving into bonds with bond coupons at historical lows was a bad idea.
Lipper data for April and March show flows into stock and mixed equity funds of $2.4 and $6.2 billion respectively, compared to bond fund inflows of $20.6 billion and $30.0 billion respectively. Further, if individuals had listened to the "pros" touting risk-on in the first quarter of the year, they would be nursing losses as the S&P 500 peaked in April and is now down about 15% from that peak. Conversely, the TLT
long-term TB ETF is up nearly 30% over the past 12 months, the Bund futures ETN (BUNL
) is up some 18%, and even the "bug in search of a windshield" Japan government bond
ETN (JGBL) is beating the S&P 500 merely by not going down. Further, over this same 12 months, the S&P 500 has never outperformed the TLT or the BUNL at any time, even temporarily
Japan GDP Surprise Virtually Ignored by Stock Prices
Japan announced a surprisingly strong Q1 calendar 2012 GDP number, indicating annualized growth of 4.1% versus street expectations of 3.5%. Stock prices however were not surprised. Basically, the 25.7% rally in the Nikkei 225 from late November 2011 to a March 2012 high of 10,255 already discounted this recovery. Investors are also very aware that the GDP number is coming off a very depressed GDP number for 2011, when Japan's economy was hit by its own perfect storm of a) a once-in-100 year massive earthquake and tsunami,b) a nuclear crisis, c) severe flooding in Thailand that further interrupted Japanese manufacturing's global supply chains and d) an electricity supply shortage.
Investors are also aware that the Q1 number is about as good as it gets
in terms of the growth pop on the rebuilding of the devastated Tohoku
area. Japan's 2012 Q2 and Q3 GDP growth should slow to 2% and change, while Q4 growth could slip back below 2%, i.e., not very good incremental momentum. Both foreign investors (who now have been selling for four consecutive weeks) and domestic investors are concern the Euro crisis and slowing US growth will result in another test of historical highs in the USD/JPY and EUR/JPY rate, and Japan still has to survive another summer of what could be a serious electric power shortage, particularly in the Kansai region, where the shortage could be as much as 15%.
That said, the benchmark Topix
and Nikkei 225
are again selling in aggregate at below stated book value, meaning any lifting of the heavy pall now hanging over Europe could produce a nice rebound in Japanese stocks. The problem is that investors do not know exactly when.
Some brave brokers like Credit Suisse are suggesting that the most crushing balance sheet de-leveraging and recession in modern history is ending in Japan. They see growing evidence that after 20 years, the Japanese corporate sector is finally "healing", and focus on three signs: (1) the corporate sector is no longer reducing debts or increasing cash; (2) private investment is no longer declining; and (3) ROE and ROIC are gradually recovering (though from depressed levels). At the same time, Japan's labour productivity growth rates continue to offset the poor demographics, while competitiveness, innovation and complexity indices remain strong.
The implication is that Japan's corporate profits could surprise on the upside (growth of over 20% is currently expected in FY2012) in 2012 and going forward, despite the waning reconstruction boost to Japan's GDP.
On the bearish side of the ledger, everyone is aware that a slowdown will and already is crimping a recovery in Japan's exports, both direct to China and within the region. Lombard Research has a piece out that observes the China slowdown will hit Hong Kong, Taiwan, South Korea, Australia, Japan, Indonesia and India the hardest, in that order. The Euro crisis is also hurting growth in Asia through Euroland banks, which heretofore had been a big factor in regional trade financing.