The Return of Risk-Off! Europe Unsolved, US Slowing, China Done With Stimulus

The Return of Risk-Off! Europe Unsolved, US Slowing, China Done With Stimulus

Great job by our pal Jonathan Lederer, who hit the nail on the head in his most recent market commentary.  He actually published this piece Friday morning, as the markets were going ballistic – too bad I didn’t get the piece published until this morning!  Oh well, as long as you’re not short-term trading (and who should be in these markets, after all), his comments and outlook are still quite prescient.  Big thanks to JL for allowing us to republish his excellent piece in full!

Lederer PWM Financial Update & Outlook – European Debt Crisis Edition

By Jonathan Lederer, President, Lederer Private Wealth ManagementLederer Private Wealth Management

On the heels of the latest European summit announcement, the financial markets were in full “risk-on” mode Thursday. The S&P 500 stock index increased by nearly 3.5%, the MSCI Emerging Markets Index rose 6%, and the German DAX index rallied more than 8%. This strong upside move of course occurred the day after I was featured in The Sacramento Bee recommending that investors steer clear of European stocks until we see a resolution to the European debt crisis (those wishing to read the article online can click here). Thurs-day’s rally notwithstanding, I am still holding true to my belief that now is not the time to be investing in European equities.

As longtime Lederer PWM readers know, I have maintained a defensive posture in client portfolios since late April. While this strategy paid dividends through the end of September, it has led to a modest drag on relative performance this month, when the major stock markets have rallied between 10-15%.

Despite the temptation to chase this recent rally by deploying cash into riskier assets, I intend to remain defensive because I do not believe the recent moves will be sustained on a longer-term basis. Although several strategists for whom I have the utmost respect are now convinced that this rally has legs through year-end, each still shares my concern that the global economy is going to slow heading into 2012. Therefore, I think we will see more attractive entry points by early to mid-2012.

Can the Recent Rally Be Justified?

After the massive September sell-off led to shorter-term oversold market conditions, it did not take much to trigger an October rally. Among the reasons the markets have moved higher were expectations that the following would occur:

1) Policymakers would meaningfully address the European debt crisis by implementing a credible “shock and awe” approach to prevent a systemic collapse;

2) The United States would avoid a recession this year;

3) The Federal Reserve would unleash another round of quantitative easing (QE);

4) The Chinese would shift their focus from curbing inflation to stimulating growth.

I am not convinced that any of these expectations will come to fruition anytime soon.

The European crisis has not been solved.

I do not think that Thursday’s policy announcement means that Europe is out of the woods by any stretch. I remain concerned about the European situation for the following reasons:

  • Sovereign bond markets not yet convinced: Sovereign debt defaults, austerity measures, and bank recapitalizations are deflationary events that will almost certainly trigger a European recession (if Europe is not already in a recession). Thus, I was not surprised that, even in the midst of the sizable rally Thursday, Italian and Spanish sovereign bond prices failed to confirm the euphoria.
  • Fighting fire with fire: The plan to increase the size of the European Financial Stability Fund (EFSF) bailout fund by leveraging it up seems fraught with potential disaster. Fighting fire (excessive debt levels in peripheral European countries) with fire (a leveraged bailout fund) is not typically the way to solve problems.
  • The devil is in the (lack of) details): The details of the plan still have not been fleshed out. Such has been par for the course ever since the European debt crisis erupted last summer – announcements that lack details trigger a short-term rally followed by an eventual realization that structural problems have not been solved.
  • No mandated structural reforms: With respect to the structural problems, they will not be going away anytime soon. Thursday’s announcement will do little to change the fact that Greece, Italy, Portugal, Spain, and Ireland (to an extent) lack competitive workforces (i.e., their wages, adjusted for productivity, are still too high to compete effectively with Germany and the Asian exporters). In my opinion, policymakers have once again kicked the can down the road, enabling these welfare states to once again delay much-needed reforms.
  • Greek debt still too high: Given the propensity of the Greeks, Portugese, and Italians to overpromise and under-deliver with respect to mandated debt and economic growth targets, I am not convinced that this time will be any different. Moreover, the optimistic assumption is now that Greece, post-50% default, will bring its debt-to-GDP ratio down to 120% by 2020. This figure is not necessarily reassuring considering that many sovereign debt defaults have historically occurred at much lesser debt-to-GDP levels.

Furthermore, the Greek debt default is supposed to be done on a “voluntary” basis. While certain players will no doubt “volunteer” due to pressure applied by political officials, the European Central Bank, International Monetary Fund, and other European sovereign governments, who in aggregate hold roughly 40% of Greek debt, are unlikely to agree to such haircuts. Thus, the Greeks’ debt load may not drop as much as expected.

This recent rally after the European policy announcement reminds me a lot of the market’s reaction back in 2008, when the TARP was passed in the United States to provide government capital injections into the banks. The S&P rallied more than 10% that day before eventually dropping another 30% during the next six months.

The U.S. economy is likely to slow heading into 2012.

Stock market bulls were also relieved Thursday to see that the U.S. economy registered solid growth in the third quarter. After initial fears that the United States had entered into recession shortly after the August debt ceiling debate and ensuing sovereign debt downgrade by Standard & Poor’s, the fact that the economy grew last quarter certainly was viewed positively.

However, upon closer inspection, I think some caution is warranted because the 3Q growth drivers were more temporary in nature. First, the solid 2.4% (annualized) increase in consumer spending, which comprises roughly 70% of U.S. economic output, occurred largely because of a decline in the savings rate. As Gluskin Sheff’s David Rosenberg notes, the savings rate fell from 5.1% to 4.1% last quarter, enabling consumer spending to still increase in the face of declining real (net of inflation) disposable income growth.

Rosenberg has observed that such large shorter-term declines in the savings rate frequently have coincided with an economy that has just suffered a financial shock (think of the scare caused by the recent debt ceiling debate and S&P downgrade) and/or that is on the verge of entering a recession. What typically occurs during the ensuing quarters is that the trend reverses, and the savings rate moves back up as people become more defensive given the economic slowdown. Considering that real personal income, excluding government transfer receipts, was down 0.6% (annualized) last quarter, and considering that consumer confidence is near historically low levels, I am concerned about an impending slowdown in consumer spending if history repeats itself and the savings rate moves back up.

One of the other bright spots in the 3Q GDP report was nonresidential investment, which increased at a 16.3% annual rate. While the figures definitely were impressive, it is important to remember that these expenditures likely were influenced by the expiration of the generous investment tax credit on December 31, 2011. Thus, businesses almost certainly “front-loaded” these capital expenditures to take advantage of the tax credit. I therefore expect a deceleration in nonresidential investment spending at the beginning of 2012.

Given the more temporary factors that drove 3Q economic growth, and given the likely cutbacks in federal, state and local government spending due to the potential expiration of various stimulus measures, I was not surprised to see that the Economic Cycle Research Institute (ECRI), a leading authority on business cycles, just declared that the U.S. economy is entering into a recession. It was a bold call for sure, but, in light of ECRI’s successful forecasting track record, I think investors should beware.

The Fed will probably not expand its balance sheet further unless economic conditions were to worsen materially.

Recent statements by Fed officials that they would consider increasing the size of the Fed’s balance sheet to purchase more assets have no doubt attributed to the market’s upside moves this month. With i) unemployment seemingly stuck at relatively high levels, ii) concerns about a looming global economic slowdown, and iii) a Congress not willing to provide more fiscal stimulus, some Fed members have said that they may deem it necessary to implement more quantitative easing (QE).

While we should never underestimate Ben Bernanke’s money-printing tendencies, I do not think even he would risk expanding the Fed’s balance sheet further unless the economic situation were to deteriorate significantly. Considering that the latest year-over-year consumer price inflation registered a 3.9% print while economic growth stayed positive, it would be more difficult to provide more monetary stimulus without risking greater inflationary pressures both domestically and in many emerging markets that peg their currencies to the U.S. dollar.

Moreover, recent Fed moves have not only generated controversy in the political arena, but they have also stirred debate within the Fed itself, as three Fed board members voted against recent Fed policy moves. This internal dissention is almost unheard of. Therefore, I do not think that the Fed is on the verge of more QE this year and would only expand its balance sheet if economic growth slowed considerably. For this to happen would mean that the equity markets would have declined materially from current levels.

The Chinese are unlikely to implement more stimulus unless the global economy were to slow down significantly.

In addition to all the other positive factors Thursday, investors speculated that a statement from Chinese Premier Wen Jiabao saying that China should “fine tune” its economic policy meant that China will soon shift its emphasis from curbing inflation to spurring growth.

As I have noted since earlier this year, the Chinese, like many emerging market economies, are struggling to contain inflation. In China’s case, consumer price inflation (CPI) has increased from 1.5% in January 2010 to 6.5% in July 2011. Rising food and energy prices have been the biggest culprits behind the rising consumer prices.

However, should U.S. and European economies slow significantly, there is a risk that Chinese export growth will fall substantially, adversely impacting the Chinese economy. Furthermore, there are concerns about the bursting of property bubbles in the larger Chinese cities. As a result, some analysts have been expecting Chinese leaders, who are in their final year in office and who want to leave a positive legacy before being replaced, will soon shift their focus to stimulating economic growth.

Like many other analysts, I do not expect the Chinese to significantly alter their policies unless the global economy were to slow down considerably. With rising social tensions in China, policymakers understand that inflation can fuel the fires of social unrest. It was not a coincidence that the 1989 Tiananmen Square protests occurred shortly after Chinese inflation spiked from 7% in 1987 to north of 18% in 1988. In addition, policymakers would like to see property prices stabilize in order to drive out some of the more speculative developers and real estate investors. Further stimulus at this point would exacerbate these inflationary pressures.

It is interesting to note that the price action in the Shanghai Composite stock index does not appear to confirm the view that more stimulus is on the way soon. Though the Shanghai Composite is up more than 5% this month, its move has lagged virtually every other major stock market in October. And, the Shanghai Composite remains down nearly 12% this year.

Though some would argue that the recent 15% rally in copper prices is an indication that the Chinese economy will pick back up again, one must remember that copper prices are still nearly 20% below their August 2011 levels.

Parallels with 2008?

In my opinion, this October rally is reminiscent of what occurred during the spring of 2008 after Bear Stearns collapsed. Back then, investors focused more on the short-term relief from the fact Bear Stearns got acquired via a fire sale (instead of declaring bankruptcy like Lehman Brothers did six months later) than on the underlying structural issues plaguing the financial system. Markets rallied nearly 15% in the two months after the Bear Stearns debacle (see Figure 1) before resuming their decline.

S&P 500 price chart November 2011 comparison 2008Click to enlarge.

While I do not think the markets will crash like they did six months after Bear Stearns collapsed, I do believe that the underlying structural issues in Europe will re-emerge and that the equity markets could re-test their early October lows by early to mid-2012.

Safety First

In this volatile environment, I consider preservation of capital to be a higher priority than speculation and am inclined to remain defensive until valuations appear more attractive. I strongly believe that we will see better opportunities in 2012 as the markets start to better reflect the global economic situation and the inevitable reduction in corporate earnings estimates {Despite the impending global growth slowdown, and with profit margins at historical highs, corporate earnings are still currently expected to grow at double-digit rates next year. I think these optimistic earnings estimates will start to get pared back next quarter.} Though we run the risk of getting left behind if this rally turns into a longer-term bull market, it is a risk that I’m comfortable taking in light of the global macroeconomic backdrop.

Jonathan Lederer is the founder and President of Lederer PWM. He provides clients with fresh perspectives coupled with valuable financial services industry experience.  For more market commentary from Jonathan, please visit his website Lederer PWM.

Lederer PWM cannot guarantee any of the forecasts presented in this article.