Rudiger Dornbusch, MIT economist
What was previously unthinkable becomes possible, and then probable, with surprising rapidity.
Apparently, when you are in a serious road traffic accident everything slows down and events seem to happen in slow motion; but despite this, you are incapable of acting fast enough, or judiciously enough, to avert disaster.
This is kind of how the economy feels to me right now – we are in a slow motion wreck, each day moving more tortuously towards the brink. But because it’s all happening at glacial speed, every day the market doesn’t decline you have 24 hours and incessant media coverage urging you to second guess yourself.
Take the pulse of the economy and the credit markets with some of the charts in this post…then compare it to the jittery but relatively benign equity markets……One of them is likely wrong.
Do not think that equity performance in October is a non-conforming data point, precisely the opposite. Rallies of the order of magnitude we saw last month are historically associated with counter-trend rallies in a bear market. The Dow had its 3rd best month in 115 years; the two better months were both during the Great Depression. Let's not get ahead of ourselves....
The economy grew at a 2.5% rate in Q3, so what? In Q2 2008 it grew at 3.3% - this is rear view mirror investing. We need to look at leading indicators, because they are actually predictive, and through that prism, the picture is far from pretty.
Let me have a go at estimating where the consensus is; from there an investor can decide if he has a variant perception and attempt to express a profitable contrary view.
Mr Market is saying....
- The US economy is showing good signs of stabilisation with incremental data containing “positive surprises”.
- Weakness in Asia will be offset by a policy response from politicians and central bankers who have much more wiggle room than their western counterparts.
- A European recession will be shallow rather than endemic, with eurozone policy action becoming increasingly concerted. A Euro recession is already fully discounted in the regions equities.
Don’t mention a banking or currency crisis.
For me, the slowdown is global. I still think we’ll have recessions in the US, Europe and the UK within the next few quarters. Not that this really matters as the economy has not actually recovered from the initial debt collapse of 2008, we just dosed ourselves up for a while. We can't see the forest for the trees.
As Mohammad El Erian said last week, "The big exposure to Americans is the general exposure to the equity market. You cannot be a good house in a bad neighborhood, that's just a fact. The equity market is the house, and the global economy is the neighborhood. So if the global economy takes a leg down, the equity market is going to take a leg down too."
As the ECRI head Lakshman Achuthan put it, the decline in economic activity is “pronounced and pervasive” and they see “contagion amongst the leading indicators”.
Now, what I find most instructive about this video is the mocking tone of the CNBC presenters. Here is a man who has a near perfect forecasting record, primarily because he doesn’t make a call until he is extremely confident in its accuracy. Despite this, Steve Leisman mocks him with analogies to “cauldrons” and “witches brews”, consistently interrupting and haranguing him in a way that disrupts his getting his message across. Compare and contrast with the sombre reverence that Nouriel Roubini or Robert Prechter may have received in Q3 and Q4 of 2008. Consider also the unflustered response of the ECRI head – he definitely seems like a man who is sure he will have the last laugh. We're not ready to hear his message yet.
The source of my car crash analogy is the ever insightful Mohammed El-Erian; he has a fantastic analogy for the current market climate.
Market participants are in the backseat of a car which is being driven by policy makers. Looking into the front seat we see that the policymakers are bickering between themselves, they are unsure of where they are going or even which map (fiscal or monetary) they should be using. Furthermore, we can see that they do not have their eyes completely on the road despite the all enveloping fog outside clouding visibility; they are looking at each other and they are looking into the backseat asking market participants “How am I doing?”. This metaphor encapsulates some of the confusion and fear that our journey involves.
New sovereign names are being dragged into the fold as the Euro collapses in unison. The only 2 countries not currently (yet?) experiencing their own mini credit crisis are Germany and the Netherlands, not surprisingly the economic zone’s 2 creditor nations. It is a fact that these 2 countries are not of sufficient size to deal with the problems of the rest. The centre can only hold and support the rest if it is of sufficient scale and possesses sufficient will - both are in question. When Europe’s slow motion crisis began in Q4 2009 commentators were comfortable that the PIGS could be supported by a coalition of Germany, France and Italy. Now we are hearing that Germany and France can support the PIIGS, despite the newly involved Italian bond market being the third biggest in the world.
Well......look at the French yields, in a matter of days France could be in the dangerzone too. An aside on that note, what on earth was that bond downgrade story which was released and then pulled in quick succession? It seems like just a matter of time.....
A Key Metric is the yield differential between the French and German bonds. French interest rates on its 10yr bond rose to 3.72% this week. That is about 1.9% over German bonds. Just a few years ago that difference was less than 20 basis points. That is the market clearly indicating concern about French debt.
But yet policymakers do not yet seem to comprehend the gravity of the situation as shown by continued attempts at point scoring across the aisles, the call for the Greek referendum by Papandreou and Sarkozy lashing out at anyone who expresses exasperation. Policymakers and central bankers have a problem - they have been trained all their lives to think they can solve everything and that no problem is beyond rescue. They underestimate market forces every single time.
Chris Pavese at Broyhill Asset Management said the following...
“The current condition (in Europe) has all the elements of the classic “prisoner’s dilemma” where there is temptation for each party to deviate from agreement at every step of the way, even if it ends up being extremely counterproductive to everyone. The evidence speaks for itself – approaching two dozen “Summits” over the past two years and we are no closer to resolving the problem of too much debt, with more debt. Instead, we are a lot closer to the end of the European Union as we know it. European policymakers may still prevent a disorderly sovereign default with a “grand and comprehensive” solution, but they cannot prevent the recession which is already in progress.”
The crisis entered a new phase of acuteness in late October as evidenced by the charts below.
From Jonathon Tepper...
“One of the main reasons for the disparity is that Libor panel CDSs, i.e. the credit default swaps on the banks that participate in the interbank lending market, have shot up to levels beyond what was seen during the Lehman crisis. The CDSs are telling you that people have grave doubts about the solvency of the interbank lending market.”
[i]“Something is rotten in the state of Denmark.”[/i]
[i]“Heaven will direct it.[/i]
Hamlet Act 1, Scene 4
If only the problem was just Denmark......However, it seems Horatio may have been re-incarnated as a French Policy Advisor.
In short, bankrupt governments are doing everything in their power to keep bankrupt banks on life support, while bankrupt banks try to prop up bankrupt governments. This reminds me of Herbert Stein's law - "If something cannot go on, it will not go on."
Who is going to buy all these bonds!?
Italy has 220bn Euros of bond issuance planned for 2012, the financial sector is going to need 400bn plus, the EFSF will need to issue lord knows what in lord knows what format.
The EFSF struggled to get away just a 3bn Euro auction a week or so ago! The whole premise is that they will be able to fund the EFSF at low rates but the market doesn’t seem to want to swallow it. The rates paid on the tiny issuances so far are clearly higher than expected and most worryingly, trending upwards!
If investors are unwilling to buy bonds from these governments today, who will buy EFSF bonds backed by the same governments when they have already been judged un-creditworthy?
Everyone has had a pop at the EFSF for it's many flaws but one of the best was Chris Rice from Cazenove's attempt...
"The latest solution is laid bare as yet another failed attempt to skirt round the basic question required to solve the crisis – greater union or break up.
Some of the details are utterly bizarre....But perhaps most bizarre of all is the EFSF itself. Asking foreign governments, such as the Chinese, not as rich as those of the eurozone, to invest in a vehicle in which they will bear the losses the Europeans don’t wish to bear is quite frankly a joke. My suspicion is that it will never get off the ground."
The (Temporary) Resolution
Quantitative Easing. The Germans are driving the car, they have reached a fork in the road where they must decide between their hard money principles (a Euro Break Up) or their commitment to the Euro (Fiscal Union). I think that they will opt to protect the latter and print a lot of money, which will of course cure all ills. Of course. No unintended consequences because central bankers plan for every outcome. QE, along with valuations, is probably reason enough to be bullish on EuroZone equities and I will cover that in a future post. At this moment I'm "minimum bullish" Euro equities.
As John Mauldin summarized wonderfully...
“Europe has too much sovereign debt, which is on the books of its banks, which have too much debt; and there is a huge trade imbalance between core and peripheral Europe. All three problems must be solved in order to prevent the Eurozone from imploding. And while the debt is the “sore thumb” today, the trade imbalance is the biggest problem. As I outlined in Endgame, it is impossible for a country to balance its government and business deficits while running a trade deficit. This is an accounting identity and is true for all countries at all times. Greece and others are in a monster predicament. No amount of austerity will work until their labor costs drop (for both private and government workers) and their trade deficits are brought into alignment.
I pointed out that the Eurozone must find at least €3 trillion (give or take) to pay for the sovereign debt “haircuts” and bank losses. Some argue it is only €2 trillion and others argue for €6 trillion. Whatever it is, it is such a large number that it cannot be found by borrowing or creating a special fund. The ONLY way to deal with it is to allow the ECB to print, essentially putting a floor underneath Eurozone bonds, especially those of Italy and Spain, both of which governments are too big to save by conventional means.”
Portfolio Positioning for this – Long Gold, Short EUR/Long USD, tentatively long European Equities (currency hedged) and higher cash balances.