Comstock Partners, Inc.June 30, 2011
Europe's Southern Tier Still A Festering Problem
Investors have used the European action on the Greek crisis as a convenient excuse to rally from an extremely oversold short-term market. However, Europe's serious problems with its Southern tier nations are far from over. And this is occuring at the same time both the U.S. and global economies are slowing significantly, with no sustained recovery in sight other than a possible temporary uptick from an alleviation of the Japanese supply-chain problems.
All that the "bailout" of Greece accomplishes is the adding of further debt burdens on a nation already in trouble as a result of too much debt. At the same time it saddles Greece with a severe austerity budget that will sink its economy and make it even less likely to ever be able to ever pay off the debt. Essentially, the European nations are lending Greece the money to pay off the banks that made the ill-advised loans in the first place. In addition, since the funds will be loaned in tranches depending on Greece's actual implementation of specific austerity measures, the problem will remain in the news for some time to come.
Investors have focused so much on the Greek crisis that they have virtually overlooked the current weakness of the European economy. Spain's retail sales were down 6.6% in May from a year earlier. German retail sales in May were down 2.8% in April and down 4% since September. French retail sales were down 1% in each of the last three months. Keep in mind, too, that these are all nominal numbers not adjusted for inflation. At the same time the ECB has hinted strongly that another rate hike was likely next month, putting even more pressure on economic growth. It's also highly probable that the need to "save" Greece and prevent contagion to Ireland, Portugal, Spain and Italy is having a negative pull on Europe's wealthier nations.
The rest of the global economy looks fragile as well. In numerous recent comments we have focused on the slowdown in U.S. growth. Japan is already in recession. Together the U.S., Europe and Japan have about 50% of the world's GDP. The current conventional wisdom looks to strength in the emerging nations' economies as a bulwark against a global tailspin. However, the dependence of emerging nations' economies on the developed nations has been proven time and again and is still true today. Furthermore, leading emerging nations such as China, India and Brazil are undergoing serious inflation, leading them to tighten monetary policy and slow down their growth.
At the same time both monetary and fiscal policy are out of ammunition. We have now reached a point where further stimulus will not help while austerity will tank the economy. In our view investors are as unduly optimistic as they were in late 2007 when they dismissed the impact of subprime loans on the economy and earnings. Despite the slowdown, earnings estimates have not come down. Estimates for 2011 S&P 500 operating earnings are about $100. The last time estimates were at this level was early 2008. Actual earnings for that year eventually came in at about $50 and reported (GAAP) earnings were $15. We think that the market has been in the process of making a top since March and that the next important move will be down.