Comstock Partners, Inc.August 04, 2011
Suddenly It All Matters
A few weeks ago (July 7th) we wrote a comment entitled "Nothing Matters Until It Does".
Now it suddenly does all matter, although all of the problems every one is talking about today have been pretty obvious for some time. These include the economic slowdown, the coming fiscal tightening, the lack of any more powerful Fed tools and the turmoil in Europe.
What apparently triggered the current selloff is Washington's action on the debt ceiling and the recurrence of turmoil in Europe only two weeks after the announcement of a supposedly innovative solution. While the debt ceiling legislation backloads most spending cuts to the outer years of the ten year plan there is enough government spending cuts in 2012 to mildly reduce GDP for the year. However, when these are combined with the fiscal drag already scheduled to take place, the overall drag becomes more significant.
For the first stage of the deficit reduction bill the CBO has scored about $900 billion in spending cuts for the ten-year period including about $21 billion in 2012. While this isn't a lot it does slice about 0.14 percent off GDP. The second stage amounts to $1.2 trillion to $1.5 trillion in cuts over ten years, depending on whether the reductions are decided by the Congressional panel or by the automatic default mechanism. Assuming these cuts are also back loaded into the outer years this could result in perhaps another $20 billion in reductions to 2012. Again this is not that much, but combined with the first reduction, adds up to about a 0.3% reduction in 2012 GDP.
The problem is that when we add in the automatic expiration of temporary fiscal stimulus such as the 2% payroll tax holiday, emergency unemployment benefits and accelerated depreciation, GDP is sliced by another 1.4% or a total of 1.7% when combined with the deficit reduction bill. Considering that GDP has grown by only 1.6% over the past year, even a relatively small reduction brings us perilously close to no growth at all or even negative growth.
As for Europe, the continued soaring interest rates on Italian and Spanish bonds has forced the authorities back to the table only a scant two weeks after what was billed as an historic solution to the problem. The ECB announced that, after a four-month hiatus, it was again buying sovereign bonds. Two weeks ago EU leaders reached an agreement for a second massive bailout of Greece and additional innovative powers for its new bailout fund----The European Financial Stability Fund or EFSF.
However, EU President Manuel Barraso is already saying that the fund is too small and is urging reluctant EU leaders to boost its size. The fund was given 440 billion Euros, but the costs of helping Greece, Ireland and Portugal have already reduced the fund to fewer than 300 billion Euros. This not enough to pre-empt crises in Italy and Spain, and some countries are hinting at pulling back on previous commitments as well. Also today's announced bond buying program is only for Ireland and Portugal, not Italy or Spain. Furthermore, Italy and Spain, respectively, have the third and fourth largest GDPs in the EU and are therefore the third and fourth largest contributors to the bailout fund. Needless to say they are too big to be bailed out without bankrupting the rest of the EU. Thus 21 months after the Greek problem became evident the EU does not seem much closer to a solution than they were at that time and the threat of global contagion remains.
All in all, the continued U.S. economic weakness into July, the lack of major additional simulative monetary or fiscal tools and the never-ending turmoil in Europe has suddenly hit the market like a ton of bricks. An economic pickup in the second half and 2012 seems more unlikely, and earnings estimates will probably come down sharply as they did in 2000 and 2008. We still see rough sledding for the market in the period ahead as investor attitudes shift from "buy the dips" to "sell the rallies".