Comstock Partners, Inc.November 17, 2011
Euro Crisis At A Tipping Point?
The European sovereign debt crisis is rapidly approaching what could be a significant tipping point as it threatens to spread to the heart of Europe. In recent days Italian 10-year bond yields have soared to 7.22% and today Spain was forced to pay 6.975% at its auction. Even French 10-year yields have climbed to 3.71%, its widest spread over German bond yields since the Euro Zone was started. All of this has happened despite large ECB purchases of periphery country bonds over the last few months and the installation of technocratic governments in Greece and Italy.
The fear has now spread to the heart of Europe. Jennifer Mckeown, senior European economist at Capital Economics stated that, "Growing concerns about France threatens to take the Eurozone crisis to a new level. If a further rise in bond yields or large bank losses leave France unable to support the periphery, the burden on Germany and the few remaining 'core' economies might become too heavy to tolerate."
Although hopes were raised based on new technocratic prime ministers in Greece and Italy, any policy based on fiscal restraint and austerity will send their economies into further decline resulting in even higher deficits and bond yields. This could be accompanied by further defaults that send shockwaves through the global economy and financial system.
Despite the urgency, Europe's leaders still cannot decide upon the best course of action since all of the available options have potentially serious side effects on the economy and financial system at a time when Europe is already headed for a recession, if it is not already in one. EU industrial production for October was down 2% while Germany's ZEW (confidence index) has entered deep recessionary territory. The leading indicators for Italy and France have also dropped to levels indicating recessions in the past. Austerity unaccompanied by national monetary policy and the ability to devalue can only exacerbate this negative trend.
The problems appear to be spreading to the rest of the globe as well. Both Indian and Brazilian industrial production is weakening while their leading indexes are pointing down. Korean industrial production has been flat all year. Notably, the developing nations' economies are heavily export-driven, and Europe is an important customer for their goods, although there are undoubtedly country-specific factors at work as well.
The U.S. economy is far from immune. Yesterday a report from Fitch Ratings warned of the increasing risks facing U.S. banks from the European crisis. They said U.S. lenders "could be greatly affected if contagion continues to spread beyond the stressed European markets." Significantly, investors don't have a lot of transparency from U.S banks in terms of the amount of exposure to various entities or the ability of their hedging strategies to hold up under crisis conditions. They also have vivid memories of 2008 and are quick to jump ship on any hint of problems.
While U.S. economic numbers have recently improved somewhat there are still big hurdles ahead. Consumers have increased spending recently only by reducing the savings rate back down to a paltry 4% while personal income remains in the doldrums. The need for households to deleverage will keep consumer spending under pressure for some time to come. Unemployment remains elevated and housing won't pick up for some time. Headwinds to growth include the impending tightening of fiscal policy and the year-end expiration of the 100% depreciation allowance on capital equipment that undoubtedly shifted some capital expenditures into 2011 from 2012. The ECRI, which has a good record on accurately forecasting the economic cycle, has publically forecast a recession in the period ahead. Furthermore, in a study just released, the San Francisco Fed concluded that "the odds are greater than 50% that we will experience a recession in early 2012."
A large number of pundits believe that there is so much much fear in the market that it can only go up from here. In our view, however, the market has been in a trading range based on indecision and that there is every bit as much fear of missing the next bull market as there is of getting caught in a severe downturn. We continue to believe that the downside risks far outweigh the potential rewards at this time.