Comstock Partners, Inc.December 15, 2011
Market Facing Strong Headwinds
Most U.S. portfolio managers seem to view the EU sovereign debt crisis as they would a pesky mosquito that refuses to fly away. If only the mosquito would leave, the asset managers could concentrate on the U.S. where the economy is said to be showing so much improvement and stocks are incorrectly perceived to be cheap. Unfortunately, that is not the case. The EU crisis is part of a developed world credit crisis brought on by too much debt that must be deleveraged, a process that will take many years in both the EU and the U.S. It should clearly be realized that the EU debt problems are not going away soon, that it will impact the U.S. and that the U.S. economy has its own serious problems as well. In addition, there are signs that the global economy is slowing down as well.
The EU sovereign debt crisis is leading to greater fiscal austerity and is rapidly pushing most of Europe into recession. As was the case with subprime mortgages, this will not be an isolated event. The EU nations combined constitute the largest economy in the world and are major importers from both the U.S. and the emerging nations. A significant reduction of EU imports will therefore have a major impact on global GDP. In addition, the need for European banks to strengthen their balance sheets and raise capital will impair credit availability and world trade. Goldman Sachs estimates that the EU crisis could cut U.S. GDP by 1%. They state that "A reduction in the lending of foreign banks to U.S. counterparties could have a meaningful impact on U.S. growth."
A front-page article in today's Wall Street Journal states that European bank problems are already straining global financial markets. France's third largest bank, Credit Agricole SA, is leaving 21 of the 53 countries in which it operates. Germany's Commerzbank is negotiating to transfer suspect assets to a government-owned "bad bank". This is probably only the tip of the iceberg, as massive loan losses can severely impair the ability of the European banking system to function. Even a nation as far away as Australia has warned that the problems could impact the price and availability of credit.
The U.S. economy has its own serious problems as well, despite the improvement in recent economic releases. Consumer spending has been propped up mainly by a decrease in the household savings rate from 5% of DPI in June to 3.5% in October. For longer-term perspective, we note that the savings rate averaged 9.6% in the 1970s, 8.6% in the 1980s, 5.5% in the 1990s and 3.3% in the 2000s with a low near zero. In order to deleverage debts, the savings rate will have to resume its rise with the associated negative effect on spending. Consumers will also be restrained by the slow rise in DPI, continuing high unemployment, slow wage growth, lack of credit availability and low house prices.
Housing continues to be a serious problem for the economy. As a result of the robo signing scandal, foreclosures have been declining, but as these are being gradually cleared up, the backlog of potential foreclosures will emerge once again. Scheduled auction sales for November were up 13%, a nine-month high. As many as 6 million mortgage borrowers have missed payments, 3.5 million for 90 days or more. The majority of these defaults will result in foreclosure and resulting lower house prices. Housing is by far the most important asset for the middle class. Falling home prices mean lower consumer spending, reduced property tax revenues for local governments and less valuable collateral for small business loans.
GDP growth for 2012 is also likely to be pressured by tightening fiscal policy. The number of tax and spending measures expiring at year-end can reduce GDP by an estimated 1.7%. Of this amount, the 2% payroll tax reduction and the emergency unemployment insurance program account for 0.9%. If one or both of these programs are extended, the hit to GDP could be reduced, but only if there are no offsets elsewhere in the budget.
All in all, the negative fallout from the EU sovereign debt crisis and the outlook for the U.S. economy are likely to have a strong downward pull on the stock market. Rather than reflecting fear, the market seems unusually complacent as investors are overconfident that the world financial authorities can pull a rabbit out of the hat at the last minute. In fact, investors seem at least as fearful of missing the next bull market as they are of a major decline. Until we see major capitulation we remain bearish.