Market Fantasy Versus Economic Reality

Talk is All That Holds it Together

Wall Street serves as our daily barometer of US economic health; a financial Cuisinart that digests arcane reports and data on profits and growth, current news events and global politics, and forms a distilled indicator of confidence or uncertainty, courteously served up to the public at large at the end of each business day.

So, if you were a Wall Street titan, what would you make of the current facts:

According to the PMI Index, output from the European Union (EU) has dropped for the sixth straight month, and at the fastest pace since 2009. Germany, the EU’s largest economy, saw output fall for the third straight month. Surveys show that business confidence is dropping in Germany, while the European Central Bank (ECB) has seen demand for loans fall precipitously throughout the EU region. Great Britain just announced that growth contracted at a worse than expected .7 percent in QII, more severe than QI, makings hopes for recovery this year more difficult to realize.

Greece just announced that its economy will contract by seven percent this year, worse than the five percent contraction that was expected. Greece has been in recession for five years and Greek unemployment has spiked to 25 percent. The new economic news blows a whopping $37 billion hole in the financial rescue plan negotiated with the EU in March. The only viable solution now is for additional loan forgiveness, this time by sovereigns, which will violate the terms of the original Greek bailout, something that Germany has consistently said that it is unwilling to do. Citibank is now forecasting a 90 percent chance of Greece exiting the EU.

Spain just announced that it recession has deepened. The economy contracted .4 percent in QII compared to a .3 percent contraction in QI. Spanish unemployment is now at a staggering 24.6 percent. For those Spaniards under 25, the unemployment rate is 53 percent.

While the Spanish government negotiates with the EU on a $121 billion bailout for its distressed banking sector, there are reports that Spain’s 17 autonomous regions are planning to seek a bailout from the central government,an action  which would overwhelm Spanish finances and require an EU bailout of the fourth largest economy in Europe. All of this has factored into Spain’s ability to borrow on the open market, with the benchmark ten-year bond now commanding more than 7 percent; an unsustainable rate for longer term financing.

In Italy, unemployment has hit a 30-year high. Economic growth, currently about 1.4 percent, is projected to weaken considerably and become negative in 2013. Like Spain, Italian ten year bond yields have spiked close to the danger zone of seven percent.

So, this week, in response to these developments, the ECB Chairman, Mario Draghi, made a public statement that the Bank would do “whatever it takes” to save the Euro. That was followed by strong statements by Angela Merkel and Francois Hollande that they would protect the Euro as economies continue to drown in a sea of debt.

Pretty strong stuff.

However, the German central bank – the Bundesbank – is strongly opposed to anything that would allow the ECB to directly underwrite the sovereign debt of member states. The Bundesbank knows who would be on the hook for all those trillions of euros in fresh loans to the “free loaders” in southern Europe. That puts the German Central Bank on a collision course with the ECB.

As that debates begins again, German political sentiment against underwriting the EU is very clear from German actions on measures already announced by the EU. The European Stability Mechanism (ESM), designed to provide financial support to Member states of the EU in distress, is stuck in the German version of the Supreme Court. No decision on the constitutionality of the Germany’s participation in the ESM (and that participation is the linchpin) is due before September. And that matters. The bailout of Spanish banks?  That is tied directly to the ability of the ESM to providing funding, which it cannot do until the Germans buy-in.

Politically, it is crucial to keep in mind that the most recent Bundestag approvals for EU bailouts were carried not by a majority of Angela Merkel’s government, but with a majority of the opposition party, the Social Democrats.  In a parliamentary system, that kind of dealing brings down governments. Germany may very well be at the outer edge of what it is willing to pay for European integration.

So what are the pronouncements of EU leaders become, but empty words?

But that is just Europe.  In India, Forbes is reporting that economic growth will be at “stall” speeds through 2015. In China, the engine that kept global markets moving during and after the financial crisis, growth has dropped from an expected 8.1 percent. to 7.6 percent. While that would be phenomenal growth for any other country, given China’s population, single digit growth figures area a danger sign. Chinese growth has not been this low since 2009. That does not take into account many analysts who believe China is fudging its books and that growth is actually much lower.

And then consider the United States.

Yesterday, the Commerce Department announced that US GDP grew at a measly 1.5 percent in QII. That is down from a revised (and unimpressive) 2 percent in QI, which itself was only half the growth of QIV of 2011. The trajectory is clear.

 Manufacturing, which had been a bright spot for the US economy, is weakening. Durable goods orders fell by 1.1 percent in June when long order cyclical items such as military equipment and aircraft are taken out. This represents the third decline in four months. If you consider that Europe still accounts for 20 percent of what America exports, and that Europe is effectively in recession, then the immediate future for this sector is bleak.

 While we wait for the July unemployment numbers as the first window in to QIII economic performance, we can observe that job growth slowed to 75,000 a month from April through June, down from healthy 226,000 pace in the first three months of the year. Unemployment is stuck at 8.2 percent, with the broader U6 category (which includes those who have dropped out of the workforce altogether, or those who can only find part time work) stands at 14.9 percent.

In addition, the Obama administration announced that the 2012 budget deficit will top $1.2 trillion. That means that during President Obama’s term, the US added $5.4 trillion to the national debt, more than two times as much as President George W. Bush added during his full eight year term. Public Debt to GDP is now fast approaching 100%.

As US businesses look at the disintegrating European market, policy matters closer to home are also influencing economic decisions, complicated by an election year.

There is no US budget in place for 2013, which begins on October 1st. That opens the door to the type of “partisan brinksmanship”  that fueled business uncertainty during the debt ceiling debate last summer. Republican leaders in the House are looking to pass a Continuing Resolution (CR) that would fund the government at current levels through February 2013, effectively taking this volatile issue off the table for the fall campaign. However, it is unclear whether Tea Party conservatives in the House would support a CR that did not cut spending. There are also rumors that Democrats would love nothing more than a budget food fight in the middle of the campaign that would allow President Obama to position himself as the defender of the middle class. Right now, uncertainty continues.

Even if Congress does reach agreement on temporary spending, the “fiscal cliff” of automatic spending cuts that were agreed to after last years debt ceiling debate, and the expiration of the Bush tax cuts and the payroll tax, pose a clear and present danger to the economy. The Congressional Budget Office has stated that if nothing is done to prevent the tax increases and spending cuts, it would drag down 2013 GDP by 4 percent or more, potentially tipping the US into full fledged recession.

While conventional wisdom holds that the lame duck Congress that will convene after the election will simply extend all existing measures until the new Congress takes power and makes sense of the situation,  it may not be as easy.  Senator Patty Murray made headlines two weeks ago stating that Democrats would not allow any deal on taxes that did not include tax increases for those making more than $200,000, something Republicans are adamantly against.

And the very substance of the presidential campaign serves as an incentive for businesses to take a wait and see approach, thus impacting the five months.

If President Obama is re-elected, Obamacare, with its taxes and ponderous regulations, will stand. Higher taxes, increased regulation and government spending will continue. There is unlikely to be any tax-entitlement deal that can credibly cope with the US debt bomb that is fast approaching, undermining US finances.

If Mitt Romney is elected, Obamacare is likely to be repealed or substantially modified. smart regulation will replace activist regulatory structures. The tax system will be reformed, trading tax breaks for broader rate reductions, lowering the corporate tax to make companies more competitive. Moreover, Romney will end temporary policies that create uncertainty (cash for clunkers, payroll tax cut) and institute certainty into the tax and regulatory structures so that businesses can plan effectively.

The choice is so stark that it is in the best interest of business to wait out the outcome of the election before making any major commitments to expansion or hiring.

So, back to the beginning. You are a Wall Street titan and this is the news you are considering.  Which way would you believe the markets would go?

Yesterday, the DOW topped 13,000 for the first time since May 7, up 188 points.  The rally was attributed to the strong Euro announcements and perversely, a firmer certainty that the weak economy would lead the Federal Reserve to lower interest rates again.

That rationale is simply divorced from reality.

Plan accordingly.