Equity markets around the world have been under heavy pressure this month from a widening European sovereign debt crisis. The following commentary addresses short-term opportunities and long-term issues facing investors in light of this latest European sovereign debt crisis. There is no denying that several key charts are flashing technical caution and send an important message about global economic activity. As of this writing the important Shanghai Composite is down 34% from its August peak while the Reuters/Jefferies CRB (Commodity Research Bureau) Index has fallen 16% since January. Both are near key 50% retracement levels, which if violated, could harken moves back to the lows seen during the height of the most recent recession. The charts for several other markets are also flirting with major topping formations. That being said, corporate profits in the United States have been very strong, as the impending austerity slowdown in the European economy and stronger dollar have yet to meaningfully impact American bottom lines while companies are still reaping the benefits of prior cost-cutting measures. United States exports to Europe are still three times larger than to emerging nations, so one could argue that stocks are simply readjusting to the revised prospects for the world’s real economy. Despite the haircut for European weakness, the U.S. recovery remains intact as does the emerging market growth story.
The consensus opinion suggests that this is still a cyclical bull market phase within a longer secular multi-year bear market backdrop. The U.S. equity market is closely tracking the pattern of similar prior crisis events according to research from Morgan Stanley. They examined 19 major secular bear markets across a variety of assets concluding that the median of these bear markets showed a 57% decline over 30 months, followed by a rebound rally of 71% over 17 months. From October 11, 2007 to March 6, 2009, the S&P 500 fell -57.69%. From that March low to the April 2010 high, the S&P 500 rallied 82.94%.
Although the S&P 500 was down 14% from its April high to the May 25 low, Standard and Poor’s also notes that the average post-war bull market correction is roughly 15%. Some giveback is therefore not unusual given the parabolic rally. We think that it is important to remember that foreigners continue to flock to U.S. assets such as treasury, agency, and corporate bonds. Europe is in disarray and Asia is raising interest rates to cool off red-hot property markets. That leaves the United States as the leading (albeit fragile) recovery story backed up by an accommodative monetary authority (heading into a mid-term election).
With some of the lowest inflation readings since the 1960s, gasoline prices are actually falling heading into the busy summer driving season. And the crisis in the euro has pushed U.S. mortgage rates to generational lows (as the flight to quality for Treasury bonds has pushed interest rates down)—both positives for wobbly U.S. consumers.
Perhaps most importantly, Standard and Poor’s reports that no bull market of the last 60 years has ended sooner than 26 months. Bull advances typically peter out after two years, and we are still just 15 months into the current rally. The third year of the closely-watched four-year presidential cycle (historically the best period for equities) also still lies ahead.
The S&P 500 at its May low was more than three standard deviations below its 50-day moving average, historically a severely oversold technical level. Therefore, we believe that odds favor a summer rally, and we have been using recent weakness to strategically add exposure and remove defensive hedges.
The End Game
Analysis of the ultimate end game is now as much of a question for political scientists, sociologists, and demographers as it is for fund managers and economists. We are living in a fully policy-contingent investment environment.
We have frequently referred to the work of Harvard professors Kenneth Rogoff and Carmen Reinhart, co-authors of the book, This Time is Different, to help put the financial and sovereign debt crises into perspective. That’s because their work spanning 800 years of data reveals that debt crises follow a highly predictable pattern. Government debt crises often predictably follow banking crises and bailouts. Against that backdrop, the latest flare-up appears to be one in a series of expected “after-shocks” since the garden variety historical crisis has lasted 6-7 years before a healing economic expansion.
While one can debate the starting point, we prefer to use the summer of 2007 (beginning with the Countrywide bankruptcy) as the flashpoint event and the Lehman Bros. bankruptcy in the fall of 2008 as the “big one” – placing us not yet three years into the current cycle. In our mind, the current European sovereign crisis simply represents another chapter in the global deleveraging story.
This debt cycle is clearly different on a variety of levels given its global nature and therefore potentially even more prolonged due to the unprecedented level of government deficits, intervention and stimulus. According to Rogoff and Reinhart, debt default or restructuring has become a rarer event over the last 30 years as the preferred policy prescription has been to combat debt crises with more debt (simply shifting it from private to public hands). It is also unclear how many derivative instruments and how much leverage is linked to that mountain of sovereign debt (although likely significantly less than the amount tied to securitized mortgages, for example). But if there is one thing that rings true across time it is that debt works until it doesn’t – and when it stops working, even the slightest hiccup (such as a failed government bond auction or ratings agency downgrade) can trigger potentially massive disruptions. Increased volatility inevitably accompanies the hangover phase of all debt binges. Choices and options (albeit often less bad) exist roughly until interest payments exceed tax receipts or revenue sources.
Policy makers are learning that it is much harder to bail out countries rather than companies. Banks can be recapitalized and given the runway to grow their way out of their problems. Countries, on the other hand, generally can’t grow their way out of distress despite efforts to devalue their currency and stimulate exports. At some point, a country must swallow the bitter pill of austerity through broadly shared sacrifice or default/restructure its debt obligations. The promise of post-war Europe rests on the notion that it is possible to engineer a more egalitarian and humane technocratic administrative state. That notion is now being severely tested.
It is troubling that some European political leaders remain in denial, confusing cause (unsustainable debt) with effect (negative market opinion). Short sellers and speculators are easy scapegoats and allow European politicians to deflect attention from their own failed policies. But this rhetoric does a disservice to the European public by implying that these problems can be fixed through criminal justice or regulatory enforcement rather than real reductions in the state spending.
Investigations into the recent so-called Wall Street “flash crash” (May 6, 2010) still have not found evidence of trading errors or system malfunctions. However, there is no doubt that an odd confluence of events that day led to the dislocation in liquidity and evaporating bids. Governments around the world must therefore be careful of the unintended consequences caused by potential range of short-sale instrument bans including less liquid (and therefore more volatile) markets as well as a reduction in the ability to hedge risk. The historical inefficiencies and corruption among some of Japan’s closely-held corporations offer an example of what can happen without market discipline.
Eerily reminiscent of the fall of 2008 here in the United States, lending between European financial institutions has slowed as banks have grown increasingly reluctant to accept certain collateral, including questionable sovereign credit. Spanish banks, for example, are saddled with large mortgage-related losses and provide little transparency for outside investors and fellow institutions. At least European policy makers can benefit from the experiences (and multiple missteps) of their U.S. counterparts. For all those who rail against tougher accounting standards or stress testing for financial institutions both here and abroad, we would simply note that there is a cost.
How can leaders restore market confidence? First, declare war on public debt and educate the public on the negative consequences associated with it, such as dramatically elevated volatility as markets will hold their collective breath from one debt auction to the next. Second, allow markets to work here in the U.S. without feeling the need to relentlessly intervene with more deficit-financed benefits and programs. Yes, that means allowing asset prices to move in more than one direction and will require swallowing some bitter short-run medicine in exchange for long-term stability. Do political leaders on either side of the Atlantic have the will to claw back any of the generous unemployment, education, pension and health benefits that citizenry has grown accustomed to voting itself for 60 years? For all the backlash against governments from Sacramento to Athens, the ultimate responsibility and decision resides with the citizenry who can simply replace their representatives with those willing to promise more.
For example, many have speculated that France’s legal retirement age of 60 will be raised. Public sector unions across Europe reject suggestions that retirement ages should be increased, instead favoring tax increases (on others). As a gentle reminder, the top U.S. marginal tax rate rose from 25% to 80% during President Franklin Roosevelt’s administration. We agree with the sentiments of John Rutledge, eloquently summarized in a recent Wall Street Journal editorial: “Tax rates matter. And what matters about them is what activities get taxed, not who gets taxed. When you increase the tax rate on an activity, you get less of it. The only question is how much less of it you will get.”
There are some encouraging signs, however. In the United Kingdom, debt reduction was the most prominent issue throughout the recent election campaign. British leaders were able to quickly cobble together an odd coalition government apparently eager to roll up its sleeves and get to the business of difficult choices. A healthy dose of skepticism is certainly in order but at least the British have a cultural history of shared sacrifice to draw upon. In addition, Germany has admirably added new debt rules to its constitution and has proposed a budget austerity program for next year in an attempt to set an example to the rest of the euro zone. We would simply note that the long-standing budget deficit rules clearly laid out in the EU stability and growth pact did little to discourage profligate spending from its 16 common currency nations.
For all of the flaws exposed in the EU’s common currency architecture, we believe that some critics underestimate the strong cultural commitment to unification, particularly on the part of the German and French people in light of the last 100 years of European history. A weaker euro benefits Germany’s strong export sector, and the common currency prevents Germany’s neighbors from engaging in trade wars through currency devaluation. Finally, in light of the missteps and experimentation of Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and others during the 2007-2008 crisis, the European Central Bank should be given the opportunity to engage in its own inevitable trial-and-error process.
The wrangling in Europe simply represents the ghost of Christmas future for Americans, who will someday face their own difficult choices.
Here in the United States, the Federal Reserve has not even begun to shrink its balance sheet to the pre-crisis level by selling any of the $1.4 trillion in mortgage-finance agency debt and mortgage-backed securities that it has purchased under its emergency authority. The Fed is also currently provided swap lines to Europe to help foster dollar liquidity and help shepherd the Europeans through their financial crisis – a sign of just how interconnected our financial systems have become.
So far, the American response has centered solely around regulatory reform rather than our own austerity program. Critics contend that Washington’s proposed sweeping financial reform legislation does not address two of the root causes of the fina ncialcrisis: real estate and underwriting. That’s because many believe that we can’t reform Fannie Mae and Freddie Mac for fear the housing market is still too fragile. Together with the Federal Housing Administration, Fannie and Freddie guaranteed 96.5% of all new home loans last quarter. And Senator Judd Gregg (R-NH) told CNBC television that the newly formed consumer financial protection agency “will define lending on social justice purposes instead of safety and soundness purposes.”
In many respects, Europe’s woes represent a wake-up call and an opportunity for America’s political class. The European press frequently complains that ratings agencies have employed a double standard when evaluating America’s unfunded federal mandates and underfunded state pensions. And while the dollar’s recent strength reaffirms its global reserve status, its goodwill is not unlimited or immune. The end game ultimately comes down to this: the legitimacy of the state, whether in Europe or here in the United States, is created by the will or consent of its people. At current debt levels, almost all experts agree that it is not possible for nations to entirely tax, regulate, devalue or grow their way out of the problem. For the first time in the post-war era, the people will need to consent to less. Markets are watching. The world is watching.
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