The conceit of Ancient Rome: In Imperial Rome, roads out of the city marked only the distance from the city, not to anywhere. All that counted was how far or near you were from it. The ECB adopts a similar centricity: all that matters is to keep prices stable. Nothing else. Which is why euro bonds continue to retreat with Italy and Spain hitting the 7% club for their 10-year paper. Unemployment can remain at 10% for three years. Growth can slow to 0.2%. (The German ZEW survey on economic conditions fell to its 2008 lows, barely above what it was in 1992 and 40 points below May of this year.) But while inflation stays above the 2% target, all bets are off to ease the pain.

 

And how hard would that be? The heart of the problem is that the ECB cannot buy government bonds without offsetting sterilization (i.e. lend as a last resort). Neither can it issue euro-wide bonds thus putting German credit risk behind Italy. Nor can it participate in auctions. That's the way the rules were set. And that's why the ECB holds only €175bn of crisis-country debt compared to the Fed's $2,800bn balance sheet. Italy has €307bn of bonds maturing in 2012. That could be refinanced at levels 200bp below the current 6.9% level if there was coordinated central bank action to counter a classic buyers' strike. It is likely to happen but not yet. And that begs...

 

Why is the euro not weaker? Because it's not as bad as it looks:

1.       Europe as a whole does not have a balance of payment crisis, which is the normal trigger for a currency run. The three largest current account surplus countries of Germany, Netherlands and Austria have a combined surplus $40bn greater than the three weakest (France, Italy and Spain). So Europe is a capital exporter and has no trouble financing itself externally.

2.       Capital flight has not taken hold and where it has, say in Greece, euro deposits are moving from one national bank into another, with no medium of exchange. The same goes for the high volume of inter-euro trade.

3.       The latest fundamental equilibrium exchange rates (a nice cheat sheet that calculates the FX rate at which imbalances and capital flows are indefinitely sustainable) shows the euro overvalued by only 2%, compared to the US$ overvaluation of 10%. The Swiss have helped to support the euro through the CHF defense policy announced in September. However gloomy one is about the periphery, the euro is driven by the excess savings and surpluses of its successful core. Or more simply, there are plenty of flow buyers of euro and not enough speculative power to drive it down.

Odd then, that we have a series of solvency and economic crises without a currency crisis. But not unprecedented. Think to the US in 1984 and Japan, well, now.

US performance in the wings: Another week of improving performance and avoidance of the recession scare (which we never bought into). The Empire Manufacturing index had its best month since May and future business conditions shot up 32 points to 39 (that's 48% of businesses saying conditions will improve vs. 9% who say they won't). That's a nice move and came with a 7% increase in retail sales and 4% rise in industrial production. Inflation numbers came in lower than expected with core at 2.1%. This is what it looks like:

 

Quite why we all got worked up by 2% inflation is only because there are monetary hawks who see every twitch as a threat to bond investors. If we're to have higher levels of demand and economic activity, we should greatly desire more inflation. Meanwhile, inflation sensitive assets remain unconcerned:

Productivity Gains: We've mentioned in the past about the huge productivity gains in US manufacturing and industry. It shows up in high levels of corporate profitability, earnings, low real wages, etc. All a bit cerebral. So here's how one restaurant chain, Brinker (EAT) [1] does it. New ovens from Middleby (MIDD) [2] need less attention and cleaning yet cook multiple foods faster and more precisely. It is "conveyer-ized" technology. At a capital cost of $90,000, one oven recoups labor savings in less than 18 months and increases margins by 100bps. It's a microcosm of what is going on in the US economy. Innovation and tight management. Low labor needs. All that's missing is more aggregate demand.

 

Bottom Line: Difficult to see real direction. A technocrat's bounce follows a credit or contagion warning. The markets are weary. We still trade the GT10s and quite happy to take ticks rather than points. And buy the high cash flow stocks.

 

Sources: Peter Jones, Zentrum für Europäische Wirtschaftforschung, Peterson Institute for International Economics, Federal Reserve, Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Barclays Capital, US Census Bureau, US Bureau of Commerce, Bureau of Labor Statistics, Bloomberg, Der Spiegel, Sentinel Asset Management, Inc.

[1] No Sentinel Fund held a position in Brinker International, Inc. (EAT) as of November 18, 2011.

 

 

 

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www.sentinelinvestments.com