Comstock Partners, Inc.February 23, 2012
An Agreement That Few Believe
According to their own public comments, the EU, ECB and IMF do not have much confidence that their agreement with Greece will avert default. Instead they are apparently trying to isolate Greece, delay its eventual default, prevent contagion, and hope that somehow they can muddle their way out of a seemingly insoluble problem. Even at best, however, Europe will go through a recession, and possibly, a very deep one if everything doesn't go exactly right.
As everyone knows, the 2nd Greek bailout was approved by the EU foreign ministers and the Greek parliament. The EU will provide 130 billion Euros for Greece to meet its March 20th debt payment in return for promises of severe austerity, including higher taxes and cuts in government spending, wages and pensions. Greece already been in recession for the last four years, and the unemployment rate is over 20%. The required austerity measures are almost certain to make things even worse, and are likely to increase the government budget deficit despite the tax increase and spending cuts. With Greek elections scheduled for April, the polls show that support for the ruling coalition has already been declining while the left-wing parties opposed to austerity are gaining ground.
Although the officially stated goal is to reduce Greek government debt from its current 164% of GDP to 120% by 2020, it is clear that no one really believes it. The northern tier nations are skeptical that Greece will keep its promises after the election. The IMF said that the balance of risks is "mostly tilted toward the downside" and that even a small shock could accelerate debt "on an ever-increasing trajectory". ECB president Mario Draghi said "It is hard to say the crisis is over". Even the assumptions underlying the IMF's base case is incredulous. To get Greek government debt down to 120% of GDP by 2020, they assume no GDP growth this year and an average of 2.6% annually for the following seven years. Does anybody in his right mind really believe this is possible with higher taxes and drastic cuts in government spending, wages, pensions and employment?
While Greece is in worse shape than any other nation in Europe, austerity policies are being put into effect almost everywhere as countries grapple with trying to reduce budget deficits and get their fiscal houses in order. The EU Economic and Monetary Affairs Commission stated that "Negative feedback loops between weak sovereign debtors, fragile financial markets, and a slowing economy do not appear to have been broken". Although concern about Portugal, Spain and Italy has recently quieted down, it probably is only the eye of the hurricane that could easily return in full force.
As for the U.S., despite the recent improvement in the economic numbers, we would be cautious about assuming a return to normal growth. It is significant that Europe is America's largest trading partner, and that U.S. exports to Europe are virtually certain to drop. In addition most of the U.S export growth in the last two years has been to China, Korea, Brazil and India. Growth has been declining in those four nations as well, meaning that overall U.S. exports are likely to decline in the period ahead. In addition we note that of that inventories accounted for 67% of the 2.8% GDP growth in the fourth quarter. U.S. companies may therefore have to cut back production to bring inventories into line.
In addition consumers are still not in condition to increase spending significantly. The long process of reducing debt is still in its early stages. Real disposable income less government transfer payments has not been growing, and transfer payments have peaked. Median home values have dropped about 33% since the 2006 top and 19% of homes with a mortgage are underwater. About 60% of homes undergoing the foreclosure process have not been sold. As these come to market home prices will probably drop further. Although consumer confidence has been rising recently it still remains at recessionary levels. Average gasoline prices nationwide have now climbed to $3.57 a gallon from $3.20 in December, and are approaching the all-time high of $4.10. The geopolitical situation in Iran, Syria and the Mid-East generally contains the seeds of a potentially explosive situation. We note that past recessions have almost always been preceded by significant rises in gas prices.
Technically, the stock market is close to its 2011 highs. Sentiment has risen to levels associated with steep corrections or outright bear markets. The latest Investors' Intelligence survey shows 51% bullish and 27% bearish. About 85% of stocks are above their 50-day averages, while volume and new dally highs have been declining as stocks advance. The transportation stocks have been lagging badly. In sum, stocks do not appear to be discounting the potential shocks to the system from the U.S. and global economies or the unsettled geopolitical situation.