Tuesday, December 13, 2011

Following Germany...to Where?

In spite of continued strength in the leading economic indicators we watch, the market can’t seem to muster a sustained rally. Furthermore, market volatility is extremely high, with the market seemingly locked in crisis mode in spite of strong corporate profits and an over-priced bond market. What’s keeping the stock market cheap is the crisis in Europe.

Europe’s banking crisis is somewhat different than the 2008 U.S. bank crisis. At the height of the bank panic, a run on the banks occurred where banks could no longer tap the U.S. bond market for capital. Banks couldn’t roll over debt. The resulting lack of “liquidity” threatened to spawn a full-fledged bank run. The government stepped in with bank-backed funding (TARP funds) to reassure bank customers and creditors. Ultimately, TARP halted the panic and eventually the vast majority of the banks were able to pay the government back, with the government making a profit.

Unfortunately, many believe that the problem in Europe stems from those institutions being insolvent, meaning that shareholders could be wiped out and borrowers won’t be fully repaid. In general, we don’t know if this is true. In the case of Greece, at least, it is definitely true. Greece can’t afford its current debt burden, so the owners of Greece bonds will definitely lose principal unless they are bailed out by someone willing to come to the table with a checkbook.

The Germans are one of the few entities with a big enough bank account to fund the bailout, but oddly enough the Germans aren’t anxious to subsidize the losses of its Eurocurrency partners.

Germany isn’t the only country working to resolve the problem. France, and others, are also working overtime to save the euro. Although neither camp wants to trash the euro, the two alternatives being considered are polar opposite prescriptions for how to resolve the crisis.

Our view is that the German plan – whatever it is – will prevail.

Germans (legalistic believers in the rule of conviction) advocate that the rule of law should determine what happens next. France and others in the creditor class (expedient believers in the rule of responsibility) believe that the end justifies the means. Aware of the suffering that would occur if the crisis isn’t resolved soon, France feels a responsibility to prevent economic catastrophe by whatever means are available. Germans want to use the current treaty to force the spendthrift nations to live within their means in order to protect lenders. Troubled free-spending nations in Southern Europe want to print money a la the U.S. “quantitative easing” policies in order to inflate their way out of debt.

It’s not a matter of right and wrong. People have values. Money doesn’t. Money, in and of itself, is value-less. Nor is it merely a matter of expediency. In the short-run, the best solution is to hit the printing presses. However, as the Germans remember, bad short-term fixes can have dire long-term consequences. While the socialists in Southern Europe push for a quick fix, the Bundesbank fears the hyperinflation which might result from a continuation of spendthrift policies.

As several experienced analysts have observed, it rarely makes sense to bet against the Bundesbank.

My best guess is that Germany won’t cut a check to Greece, per se, but eventually Germany will give the OK for a Quantitative Easing program in Europe. Europe can follow the Federal Reserve’s lead and simply buy up the outstanding debt of the troubled countries, assuring borrowers a market for Italian and Spanish debt.

Germany will not agree to this plan until it has extracted a price from the spendthrift countries that led them into the crisis. At summit after summit, Germany is enforcing the adoption of new austerity measures and tighter banking controls on other EU members. All but the United Kingdom have agreed in principle, although getting country-by-country approvals will take months.

These are not easy measures for Greece, Italy, France and the other EU member countries to adopt. They must be doing it for a reason, however. I believe that they are adopting these new policies with the understanding that once these policies are in place, Germany will step up to the table with much needed help. I believe that Germany is holding approval of a quantitative easing program hostage to these austerity and responsibility measures.

In the end, however, Germany must be holding out a carrot. Otherwise, why would the other countries agree to such politically costly treaties?

Until the final solution is in place, the risk is that a large bank could fail. It could happen any day, and one large failure could trigger others. Time is not the friend of a crisis.

Some have estimated that Europe needs to roll over or borrow nearly $250 billion in 2012. In the past 12 months, estimates are that the region has only succeeded in borrowing $17 billion. Somehow, despite markets that are effectively closed, Europe needs to find investors willing to risk nearly 15 times more money in 2012 than was wagered, unsuccessfully, in 2011. All the while, austerity programs and the near certainty of a new recession in Europe from sovereign spending cutbacks and bank credit-tightening make these investments much more risky next year than was the case in 2011.

Do you see anyone out there with a checkbook looking to make an investment in Europe? China took a pass. Republicans in the Senate have given a thumbs down to the idea that IMF funds (from the U.S.) be used. The Central Banks are on board, but the traditional political institutions outside of Europe won’t stand for it. Traditional fixed income investors aren’t going to fund the Old World until the entire region steps up to back the bonds of individual countries. Buyers of Spanish debt are on strike until they know that someone, other than Spain, is willing to back those bonds.

Until agreement is reached on a solution, yields are likely to ratchet higher until they are high enough to attract equity money into the arena. However, once the sovereign risk is taken out of the equation, Spain, Italy, Greece and others will once again be able to access the market.

Germany can say, all day long, that the current treaty won't allow the region to backstop individual countries.  In reality, either an ECB-backed bond or some form of quantitative easing IS the end game for Europe, but Germany won't approve the plan until it has won concessions from its more profligate partners.  It is blatent brinksmanship, but in a distressed situation the lender gets to write the rules.

The euro has been an interesting indicator. While the U.S. market goes up with each meeting in Europe (and there have been a lot of them), the euro itself is getting ready to re-test lows and is likely a better indicator of eurosummit achievement (or lack thereof).

However, once the solution is unveiled, the market could easily “melt up.” But will it melt up FROM current levels? Or back TO current levels?

In any event, we remain in a high risk market. We have reduced (but not eliminated) risk in equity oriented accounts. While the chances of a melt down and a melt up are roughly equal, the PAIN involved in a meltdown would drastically outweigh the happiness felt if we were to melt-up. Furthermore, judging by the price action of the Eurocurrency itself, the trend remains down, at this moment, so we remain on high alert.

The good news is that this is occurring in the background at a time when the U.S. economic turnaround is marching forward. In the long run, the good news surrounding the potential for a full U.S. economic recovery outweighs the headlines overseas. In the short run, all asset classes seem to be correlated, so it’s hard to imagine a crisis in Europe not coming back to haunt U.S. equity investors.
 
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate. 

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

Changing From Worse to Bad

U.S. businesses are doing remarkably well, so much so that it feels to me like the Great Recession is slowly morphing into a new, different, and better stage of recovery. The U.S. stock market seems like it wants to rally off of very low valuations, but concerns about the European debt crisis are a giant overhang preventing the rally from gaining momentum. It feels like the weight of the world is on the shoulders of Germany’s Angela Merkel as she tries to negotiate a settlement to this crisis.

Back home in the U.S., the economy feels like it is coming out of a recession. Consumer confidence is low, but retail spending is reasonably strong. Corporate America has been in recovery mode since June 2009, but the tepid recovery has restrained hiring. Consumers are hampered by both high unemployment and punitive savings rates (what economists now call “financial repression,” which describes the Fed’s practice of forcing rates down in order to subsidize the recapitalization of the banking sector).

The great news is that the problems in the U.S. seem to be evolving from one of excess supply to one of not enough demand. We are moving forward from The Great Recession to a run of the mill recession. With a little more activity, we could move beyond recession to recovery. But, hey – this is America! If there’s one thing we still know how to do, it’s shop!

Since 2007, the economy has been dealing with an excess of housing inventory. At first, we just built fewer units. Soon, however, unqualified borrowers who should never have received loans began receiving foreclosure notices, pumping up the inventory of foreclosed but not yet sold homes. By 2009, the excess inventory had shut down the U.S. building sector. A million construction workers lost their jobs and a huge segment of the U.S. economy closed down. Bank regulators forced banks to call loans on struggling builders, wiping out all but the most deep pocketed firms.

The recession we face in 2012, however, looks much less daunting. Although the inventory-to-sales ratios are still high, the “problem” has shifted from the numerator to the denominator. Home inventories are still a bit high, but nothing like the levels seen in 2009. If economic activity was anything near normal, and household formation wasn’t in collapse, then the industry might be fairly close to stabilizing.

At a Grand Junction Chamber luncheon this week, Richard Wobbekind, the Senior Associate Dean for Academic Programs at the University of Colorado, agreed that household formation as been far below norm, and that an employment recovery would dramatically improve the construction industry’s supply/demand balance. He also agreed with the notion that the recession we’ve experienced for the past three years, as a result of supply excesses, will look a lot different than the slow growth period ahead of us, which results from a lack of economic vigor.

Stimulus efforts in 2009 failed to revive the U.S. economic engine. We are now much closer to economic equilibrium. Real estate inventories are down. Over-leveraged businesses were forced into foreclosure by the banks, while low savings rates have encouraged consumers to de-leverage as well. Only the government sector lags in the de-leveraging department. If regulatory or monetary stimulus were used, today, I think that they would have a much improved chance of succeeding. In 2008, we applied the wrong type of stimulus, at a time when the economy was just too moribund to keep going once the stimulus ended.

In spite of continued strength in the leading economic indicators we watch, the market can’t seem to muster a sustained rally. Furthermore, market volatility is extremely high, with the market seemingly locked in crisis mode in spite of strong corporate profits and an over-priced bond market. What’s keeping the stock market cheap is the crisis in Europe.
 
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, because of the crisis in Europe, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .