Ten years ago, I was on an airplane that had to make an emergency landing in Midland, TX due to an engine fire. I found myself surprisingly calm during the descent, reassuring myself that the jet could easily fly on the one remaining engine, and that we had capable people in the cockpit. As we touched down and slowed to a stop, everything seemed normal. Passengers were chatting, flight attendants were reassuring people that we would be de- planning shortly and, of course, tray tables were up. Then, the "captain" of our injured bird got on the intercom and yelled, "Everybody stay calm!!!"Suddenly, we were no longer calm. I grabbed my briefcase from under the seat in front of me (the one you are not supposed to grab), and several seconds later the pilot frantically yelled over the intercom,"Evacuate!!!" I was in the last seat on the plane, which made me the first person at the rear door to watch the locks pop off and the yellow slide inflate. It was a surreal slide down, and a surreal experience overall. As I sat in the terminal waiting for our replacement plane, I thought to myself: What type of leadership was that in a time of crisis? How much experience does this pilot have? How can I trust that he will ultimately get me to my destination? In short: Where are the adults? I later found out that, instead of keeping us better informed during the flight, the pilot was allegedly on his cell phone talking to his wife "in case he didn't make it." Unfortunately, that pilot's leadership qualities remind me of elected officials and central bankers of today in Washington and the 17-member Euro Zone. Despite their bestowed trust, they has shown incredible self-interest/self-preservation instead of leadership and direction for the betterment of their "passengers."

The Euro Zone ("Just One Look…That's All it Took")

The monumental failure of leadership on the east side of the Atlantic to address the European debt pandemic reached a tipping point on July 21st. This date marked the last minute approval of a second Greek bailout after weeks of contentious negotiations between German Chancellor Angela Merkel, French President Nicolas Sarkozy, and European Central Bank President ("ECB") Jean-Claude Trichet. The deal reached was dubbed elegant, but market participants "took one look" and immediately recognized that, amongst other things, the: (i) new enhanced bail-out fund for Greece and other distressed countries was still not large enough, (ii) new bail-out fund would not be in place until late September, if at all (all 17 member countries will have to unanimously approve it in separate votes in their home countries), and (iii) ECB was not given "lender of last resort" authority until the bail-out fund is in place (targeted for late September). In the days following the agreement, Italian and Spanish bond yields (their cost of borrowing) soared. Italy and Spain are "too big to bail" and "too big to fail" under the current structure. Even with the ECB given tacit "lender of last resort" authority Sunday evening, the 18-month Greek debt saga has finally spread to Italy and Spain, due to failed leadership. The U.S. and European equity markets began their descent on July 25th (see: Figure 1). Europe has no leadership in its most harrowing time since World War II.

 

 

The United States ("Never Say Yes, No, No, Never Say Yes")

After a "temporary" budget deal to fund the U.S. government was reached in early April, there was little doubt in most market watchers' minds that ultimate brinkmanship would follow. Once Treasury set August 2nd as the date at which the nation would run out of cash, both sides entered "Never Say Yes" mode. With every twist and turn of the "negotiations" over the summer it became increasingly evident that it would go down to the wire, and it did. The inadequate debt ceiling compromise reached on August 1st was met with immediate disdain by the markets (just like in Europe) due to its numerous failings including: (i) only calling for $2.1 trillion to $2.4 trillion in spending cuts over 10 years (far below the $4 trillion bogey Standard & Poor's called for), (ii) the $917 billion in initial domestic and defense spending cuts are back-ended, with very little in the next two years before election, and ostensibly can be changed by future administrations, and (iii) the additional $1.2 trillion to $1.5 trillion worth of cuts to be determined by the end of this year (and imposed over 10 years) will involve a convoluted process whereby a special bipartisan committee will come up with proposals by Thanksgiving, followed by a guaranteed up-or-down vote by Congress (without amendment) by December 23rd. If Congress fails to approve cuts on December 23rd, across-the-board spending cuts will be triggered to make up any difference between the committee number and the $1.2 trillion savings goal. This last piece, I suspect, was the straw that broke the market's back as it effectively extended the political fight for five more months. After a middling day of trading on Monday, August 1st, the S&P 500 fell 7.2% for the week – its worst week in two years. Adding insult to injury, Standard & Poor's downgraded U.S. sovereign debt Friday afternoon to AA+ from AAA, the first time the U.S. has lost its AAA credit rating in 70 years of coverage. The surreal, disappointing, embarrassing brinkmanship by American politicians that produced a flawed compromise and a debt downgrade is astonishing. The U.S. has no leadership in the most harrowing economic times since the Great Depression.

What Comes Next ("Uncertainty and Volatility")

• The S&P volatility index (VIX), often referred to the "fear" index, ended Monday, August 8th at 48.00, up 100% from 23.38 the previous Monday, and the highest level since since March 9th, 2009, the infamous financial crisis low day for the S&P 500, when it closed at 676.53.
• The full ramifications of the S&P downgrade will play out over time, but a range of government-related entities including Fannie Mae and Freddie Mac were downgraded Monday, and hundreds of municipal bond downgrades (an estimated $150 billion, or 3% of the total market) are probably at risk of downgrade, according to Municpal Market Advisors. The biggest risk is not to the municipal bondholders, but rather that the downgrades create a panic and raise municipal borrowing costs. The overall risk of the S&P downgrade may portend a big hit to consumer and business confidence which may result in a hit to GDP growth, already subject to downward revision.
• The 10-year Treasury yield has been falling for weeks (reaching its lowest point since December 2008 on Monday) at 2.33%. Part of this decline is a "flight to safety", but we believe the bond market (the "smarter of the two markets") is indicating an increased likelihood of another recession, possibly beginning as early as 1Q12. Annualized real GDP growth for 2Q11 was revised down to 1.3% recently, with 1Q11 revised down from 1.9% to an astonishing 0.4%. This low level of first half growth leaves us precarioulsy vulnerable to shocks, such as those seen recently, that could turn the economy back over into recession.
• QE 2 is over, most fiscal stimulus to states ended this summer, and payroll tax cuts and unusal long-term unemployment benefits end in December. The end of Fed-induced stock market pumping, along with "fiscal drag" from the final end of major fiscal stimulus, together provide a strong dose of uncertainty as the economy and markets move to a more "organic" mode. (Note: The Federal Reserve meets and speaks with the media today. What I call "The Fourth Branch of Government" could pull something out of its hat, but that hat is growing increasingly tattered.)
• After falling for nearly a year after the end of homebuyer tax credit, house prices have "stabilized" recently with large investor purchase volumes, but inventories are still very high and there are reams of foreclosures yet to hit the system. Consumer spending (as reflected in retail sales) is falling and real wages are stagnant. Unemployment remains extraordinarily high at 9.1%, with average monthly additions to the workforce below 100,000 when they should be 300,000 to 400,000 at this stage of recovery/expansion. In short: housing, the consumer, and unemployment are either worse or no better than a year ago.
• European leaders are going to have to come up with big solutions quickly to assuage investor concerns. In addition to the sovereign debt contagion, a second financial crisis is not out of the question if the ECB, in coordination with global central bankers, are not able to prevent highly-leveraged, undercapitalized European banks holding large amounts of Italian and Spanish sovereign debt from collapsing.
• Lastly, and most importantly, we now live in a financial world with a non-AAA rated economy at its core. This has never happened before and we don't know what the changes to our the world financial system wil be as a result. If that weren't enough, further downgrades by Standard & Poor's, Moody's, and Fitch are distinct risks and pose a multitude of uncertainties. Confidence is as fragile as it has been in nearly three years.

What We Recommend ("Stay Tactical, Short-Term, Precious, Safe, and Alternative")

• Tactical equity allocation ("buy and sell" not "buy and hold") achieved through active management and true long/short funds,
• Short maturity (less than two years) corporate debt of cash-rich U.S. large capitalization companies,
• Precious metals via funds that mandate holding the commodity in physical versus certificate form (note: we would be aggressive accumulators of gold on big pullbacks),
• Other select alternative (i.e., non-public) investments to avoid the frequent dislocations and vagaries of public markets,
• Cash (margin of safety)

Conclusion: "We Need Leadership...Not 'Calming' Words"

In the wake of this debt crisis sell-off, our political leaders need to come up with long-term structural ideas not only for budget cuts and tax reform, but for jobs, housing, education, infrastructure, real Wall Street reform, and long overdue comprehensive energy policy. Our nation is at the point of maximum pain and the time has come for big, structural solutions, not temporary fixes. Washington must be wrested from the rule of the banking oligarchs and all manner of lobbyists during this process or we will be digging out of the holes we have put ourselves in for much longer than we would like. Just as I was on the plane descending into Midland, I am still calm. But, I do fear the "calming words" and inaction of our leaders may make investors less so, and their complacency may continue to damage our economies and markets. "We will get through this" is not good enough. Strong action is needed to change our course.

 

 

 

(c) Cravens Brothers Wealth Advisors 
www.cravensbrothers.com