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“We live in a technological golden age but in a monetary and fiscal dark age. While physicists discover the so-called God particle, governments print and borrow by the trillions. Science and technology may hurtle forward, but money and banking race backward.
Jim Grant1
“The further we dug into the way TARP was being administered, the more obvious it became that Treasury applied a consistent double standard…When providing the largest financial institutions with bailout money, Treasury made almost no effort to hold them accountable, and the bounteous terms delivered by the government seemed to border on being corrupt. For those institutions, no effort was spared, with government officials often defending their generosity by kneeling at the altar of the ‘sanctity of contracts.’ Meanwhile, an entire different set of rules applied for homeowners and businesses that were most assuredly small enough to fail.”
Neil Barofsky, Bailout (2012)2
Difficile est saturam non scriber.3
Juvenal
The logic of the financial markets can only be understood as anti-logic. The worse the economy does, the higher the stock market moves on hopes that the Federal Reserve will institute another round of stimulus. The S&P 500 is up 10% for the year while the tech-heavy Nasdaq is enjoying a 13.5% rise despite the high-profile collapse of the social media sector. U.S. investors are hoping and praying that Ben Bernanke and his colleagues will come to their rescue with another round of quantitative easing this week. Their European cousins are holding their breath that Mario Draghi will batter the Bundesbank into agreeing to his plans to repurchase Spanish and Italian bonds and embark on further monetization adventures. The Federal Reserve will announce the results of its meeting on Wednesday, August 1 and the ECB will follow on Thursday, August 2, shortly after this is published.4 We would respectfully advise those anticipating any substantial announcements from these meetings to prepare for disappointment. To the extent they have further cards to play, these central banks are facing political and practical obstacles that will render it very difficult for them to deliver anything more than anodyne words and actions as summer moves into the always dangerous August holiday season. IPhones (we used to say Blackberries) should be kept on alert at the beach through Labor Day.
United States
The second quarter U.S. GDP print of 1.5% seemed too high, and we expect it to be revised downward in the coming months. Unfortunately, for those hoping for QE3, it may have been just high enough to keep the Federal Reserve from acting before the election. Coupled with the Dow Jones Industrial Average hitting 13,000 again and the S&P 500 approaching 1400, 1.5% growth probably doesn’t scream out for urgent Fed action. The stock market may have performed its own intervention, which could then cause it to sell off again in disappointment when the Fed fails to act. If it sells off, hopes for Fed intervention will then start up again. Such a dynamic describes just how nutty stock market psychology has become. In the meantime, the U.S. economy is barely growing, unemployment remains stubbornly high, the presidential candidates continue to talk about nothing, and the rest of us are left banging our heads against the wall wondering how this country is going to get back on a more productive and constructive track. This is how even the allegedly sane are rendered crazy.
I am seeing irrefutable evidence in the dozens of companies that I follow across a wide spectrum of industries that the U.S. economy is slowing. From the manufacturing to the retail and service sectors, corporations are seeing lower demand. They know consumers are worried. The University of Michigan consumer sentiment reading hit 72.3 in July, and the key “expectations” index dropped for the second month in a row to 65.6, the lowest reading of the year. In response, businesses are themselves contributing to slower demand. They are not hiring and are spending very cautiously. They are concerned about the future direction of tax, healthcare and regulatory policy. They do not know what their healthcare and other costs are going to be, although they have every reason to believe they are going to be higher in the future. They are worried about the fiscal cliff, on which they don’t expect to see any action until after the Presidential election, as well as about the outcome of the election itself. Until there is greater clarity on these and other issues, the economy is likely to be stuck in stall speed. In the long run, however, there is little that either Presidential candidate will be able to do to alter the nation’s inexorably negative budgetary, fiscal and monetary trends without radical policy reforms. And neither man has shown any sign of being capability of bringing forth any type of policy proposals that qualify as radical. That would require courage, and courage is in short supply in our political and business circles these days.
The problem is that the longer this slow growth goes on, the more difficult it will be for the economy to emerge from what has been a prolonged period of stasis. Another bout of quantitative easing is unlikely to have much of an effect in view of the fact that interest rates already are at microscopic levels. Economic activity is not being held up by the level of interest rates, it is being delayed by a profound lack of confidence in the future. Faced with the prospect of re-electing a president who believes that the government should be the primary driver of economic growth, or a private equity executive who appears to be too timid to shake anybody up (except the Brits apparently), the natural result is that economic actors lose their motivation to act first and wait for the government to lead. This may not be the intention of Mr. Obama and the Democrats, but it is the necessary consequence of their ideology. It is toxic for the country and for the economy.
The U.S. is in the midst of one of the most interesting earnings seasons in recent memory. More companies are beating on the earnings line than on the revenue line, something we saw in 2009 as the economy entered the balance sheet recession that it is still experiencing.5 But there have been a string of high profile earnings misses as well – MCD, AAPL, SBUX, DOW, AMZN, BSX, UPS. While individual companies are punished when they miss earnings, the overall market seems to shrug off the news. Third quarter earnings are unlikely to be as easy to ignore if economic growth stays on its current course.
Corporations will soon benefitting from a new gift from Congress and the Obama administration. The bill that the president signed on July 6 extending low interest rates on student loans also allows corporations to lower their pension contributions.
6 This is being done while S&P 500 companies have a collective pension deficit of $355 billion as of the end of June 2012. The rationale is that corporations need relief in tough times. But if corporate earnings are so great, why do corporations need relief? Corporations should be using their strong corporate profits to bolster their pension funds and protect their employees. This is another example of policy encouraging precisely the wrong behavior at the wrong time. Corporate earnings will soon look better than they should, but investors should not be fooled. Those pension shortfalls are going to have to be filled in the future.
1. Grant’s Interest Rate Observer, July 27, 2012, p. 1.
2. Neil Barofsky, Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street (New York: Free Press, 2012).
3. It is hard not to write satire.
4. The Bank of England also meets on Thursday. No disrespect intended for our British friends, but the impact of any BOE action is likely to be marginal at best.
5. In a balance sheet recession, consumers and businesses limit their spending in order to strengthen their balance sheets. While this is rational behavior for the individual economic actors, their collective behavior leads to slower economic growth. John Maynard Keynes called this the “paradox of thrift.”
6. This is accomplished by allowing corporations to assume that their pension assets are earning a return based on interest rates over the past 25 years rather than over just the last two years when interest rates have been so low. Since this calculation will pretend that they are earning more on these assets, corporations can then contribute less to their plans. Who says Congress can’t get creative when it wants to accomplish something?
Europe7
The European economy is deteriorating by the day. The UK is back in recession after experiencing 2Q12 GDP of -0.7%, the third consecutive quarter of negative growth. This was the biggest drop in GDP since early 2009. Industrial output was down -1.3% while construction plunged -5.2%. Hopefully the Olympics can cheer up our British friends.
Europe’s July flash manufacturing PMI was down to 44.1 from 45.1 in June. Germany’s flash manufacturing PMI came in at 43.3, down sharply from 45.0 in June, and France’s was down to 43.5 from 45.2 in June. France’s economy is beginning to be taken down the socialist path by its new president, who has proposed policies in its first budget such as imposing a new wealth tax on those with more than €800,000 of assets, lowering the retirement age to 60, raising the minimum wage, announcing plans to hire an additional 150,000 public sector workers, repealing a law that limited employer contributions to social security plans, and other anti-growth measures. The thing Hollande’s government has not proposed is any meaningful reduction in public spending. Look for French bond spreads to widen as M. Hollande dismantles Sarkozy-era pro-growth reforms which, while imperfect, were far more constructive than the retrograde policies being imposed today. France seems intent on joining its weaker southern cousins, whose rigid labor and spendthrift fiscal policies have delivered them to the brink of insolvency. Investors should be shorting French sovereign credit based on these retrograde policies.
Europe has hit many inflection points over the past two years, but its current situation is as close to a breaking point as we have seen since the 2008 financial crisis. Last week, Spanish 10-year bond yields definitively breached the 7% level that is generally considered to separate the solvent from the insolvent. Equally if not more troubling was the fact that 5-year yields and 10-year yields inverted, with investors demanding higher yields for the shorter maturity paper. Such an inversion generally implies that investors are expecting an imminent default. Rates only moved back down after ECB President Mario Monti muttered some brave words about doing whatever is necessary to rescue the euro without providing any roadmap for how he might accomplish that (more on this below).
Spain’s yield curve remains flat and elevated, and it won’t take much for it to return to unsustainable levels (if it is not already at such levels). Having already been abandoned by the interbank market, Spain has now been virtually deserted by the bond market. Regardless of the fact that Madrid has promised more austerity measures, time has run out. Moreover, Bridgewater Associates recently suggested that Spanish banks are running out of collateral that they could pledge to the ECB for further loans. According to Bridgewater, Spain’s banks may be down to their last €300 billion of collateral. Moreover, this collateral is not evenly spread among the banks but is likely concentrated in stronger institutions like Banco Santander and BBVA, leaving weaker institutions almost tapped out. This leaves Spain, its banks, and the ECB to manage a precarious balancing act to prevent a collapse of the banking system.
Italy is not far behind Spain. And it is no longer a question of Italy’s credit quality or economic reforms. It is a matter of market psychology, and market participants are going to be extremely reluctant to fund Italy at any reasonable rate if Spain is in default. Italy’s 10-year borrowing rates reached the 6.5% range last week and were heading steadily toward 7% before Mr. Monti began filibustering. Italy is considered by many to constitute the Maginot Line for the European Union beyond which the union is unlikely to survive. I would argue that Spain actually constitutes that line since a Spanish default in my mind will render an Italian default a near certainty.
There are now two possible scenarios that are likely to play out. The first – and most likely scenario – is that the European Central Bank (ECB) will step in with some type of massive bailout plan for Spain and Italy. The second is that Spain experiences a free-fall default that leads to Italy following and a global economic cataclysm. A third scenario – one that is no longer tenable - is one that global economic leaders have been hoping for but doing little to bring about – buying time for weak European economies to grow their economies to a point where they can generate sufficient income to service and ultimately repay their debts. That train has left that station. Spain is hopelessly insolvent and cannot hope to service its debt without restructuring it and inflicting massive losses on its creditors.
As noted above, on July 26, ECB President Mario Draghi started huffing and puffing and boasted that his central bank would do whatever is necessary to preserve the euro. Upon hearing this news, global equity markets rallied. Mr. Draghi provided no specifics concerning how the ECB would rescue the euro, but the markets were all too desperate to believe him. In the background, there was talk of the possibility of granting the European Stability Mechanism (ESM) (which won’t be in place until mid-September at the earliest) a banking license and other such dramatic measures, but these were merely conjectures. In truth, the only tools available to the ECB are various types of debt monetization or socialization schemes, none of which will remedy or even address the underlying causes of Europe’s economic malaise. The market rally places a great deal of confidence in the ability of central banks to come to the rescue of the global economy again. We do not share that optimism. In 2008, the balance sheets of the world’s largest central banks (the ECB, Federal Reserve, Bank of Japan and Bank of England) were approximately $3.5 trillion in size; today, they are about $9.0 trillion in size and growing (although the Federal Reserve’s balance sheet has actually shrunk slightly since the middle of last year). Some may believe that there are no limits to what central banks can do; history and common sense suggest otherwise.
Der Speigel, Germany’s leading weekly newsmagazine, said the following about Mr. Draghi’s outburst (thanks to Art Cashin for this):
“[E]xperts at the central banks of the euro zone’s 17 member states had no idea what to do with the news. Draghi’s remark was not the result of any resolutions, and even members of the ECB Governing Council admitted that they had heard nothing of such plans until then…
“Now Draghi is apparently prepared to lend a hand to the hapless politicians. Under his plan, which essentially creates a new form of cooperation between governments and monetary watchdogs, both of Europe’s bailout funds – the temporary European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM) – and the ECB will intervene jointly in the bond markets in the future to bring bond yields down.
“What sounds like a great success is actually a sign of weakness. If the ECB starts buying up the government bonds of highly indebted countries again, it won’t just be yielding to the pressure of European politicians. It will also be resorting to a tool that, in the most recent past, has primarily produced one outcome: discord within the ranks of the ECB. As Germany’s central bank, the Bundesbank, noted last week, Draghi’s proposal is a ‘problematic’ instrument.”
Despite Mr. Monti’s words, the ECB does not act with a free hand. It is ultimately answerable to Germany, and Germany is ultimately answerable to the German Constitutional Court (more than to the Bundesbank). I am attaching the English version of an article that appeared in the July 22 issue of El Mundo entitled “The Karlsruhe Ascendancy” that discusses the very real limits that exist on Chancellor Merkel’s and the entire German Parliament’s actions under the Maastricht Treaty. These limitations are set by Germany’s Constitutional Court, which is the most highly respected institution in Germany (even more respected than the Bundesbank). In a series of rulings dating back to the late 1990s, the Constitutional Court established the conditions that Germany must follow in order for its participation in the European Union to conform to Germany’s 1949 Constitution. 8 As explained in my El Mundo article, these conditions placed major roadblocks in the way of European fiscal integration. There are two broad principles that the Court requires to be followed. The first is that the very existence of the European Union must contribute to the stability of the euro currency. If actions taken to preserve the union do not contribute to such stability, the Constitutional Court can compel Germany to withdraw from the union. The second is that Germany may not cede control of its economy in any way. This ruling effectively nullifies the possibility of a true economic and political union unless other countries hand over their fiscal governance to Germany.
7. For readers interested in a detailed history of European Union since the financial crisis as well as excellent background history particularly on Germany’s relationship with the European Central Bank, I strongly recommend a new book Saving Europe: How National Politics Nearly Destroyed the Euro by Carlo Bastasin (Brookings Institution Press: Washington, D.C., 2012).
8. In one of these rulings, known as the Karlsruhe-Lissabon-Urteil (1999), the Constitutional Court had its Marbury v Madison moment and declared its right to be the final arbiter of Germany’s participation under the Maastricht Treaty.
In one of these rulings, known as the Karlsruhe-Lissabon-Urteil (1999), the Constitutional Court had its Marbury v Madison moment and declared its right to be the final arbiter of Germany’s participation under the Maastricht Treaty.
Both of these principles are going to be very difficult to fulfill. With respect to the stability of the currency, perhaps the most effective step Europe could take to make its economies more competitive would be to radically cheapen the Euro.9 While a managed depreciation of the currency might accord with the notion of stability, an unmanaged collapse of the currency arguably would not. Thus far the decline in the value of the euro has been orderly, but there is no assurance that the markets will continue to cooperate. With respect to the question of German control of its own economy, it is legitimate to question how Germany can truly retain such control when it is being asked to transfer an enormous percentage of its GDP to weaker European states. Germany has already transferred something on the order of 2/3s of its annual GDP to support its weaker European cousins. Many observers argue that Germany has received enormous economic benefits from the formation of the EU. But that argument prompts two responses. First, many of those benefits may in fact be illusory if one takes into account the hundreds of billions of euros of bad loans that the country’s banks are now holding (German banks’ total exposure to PIIGS totaled $537 billion at the end of March according to the Bank of International Settlements), plus the more than €700 bcillion of Target2 liabilities that are unlikely to be repaid in full.
Second, Germany is now faced with the choice of giving back many of those benefits through the transfer of hundreds of billions of Euros to the EU’s insolvent states or bailing its banks out of the losses that an outright Spanish or Italian default will trigger. In other words, the benefits that the euro delivered to Germany are now going to have to be repaid with a usurious rate of interest.10
Germany is truly on the horns of a dilemma, and both horns are jabbing it in the behind. Germany really can neither afford for the EU to stay intact nor for it to come apart. Either scenario is going to cost it hundreds of billions if not a trillion euros or more. What investors need to understand, however, is that the decision is not in the hands of the country’s politicians; it rests in the hands of eight red-robed judges in the tranquil town of Karlsruhe in Southwestern Germany, far away from politics in Berlin or business in Frankfort. And it is not these judges’ concern what happens to the EU, or to Spain, or Italy, or the rest of the world economy. Their job is to insure that the sanctity of Germany’s post-war Constitution is preserved. In the wake of the Second World War, Germany was a ruined and demoralized land. It had committed crimes against humanity and had to come to terms with its own guilt while trying to earn its way back into the community of nations. The Constitutional Court became the guardian of the country’s sense of justice and morality. It was the source of moral and legal authority then, and remains in that position to this day. The Court has set out the ground rules for Germany’s participation in the EU. The union was designed to limit German hegemony but remains tethered to German economic power.11 Investors need to understand that this power lies in Karlsruhe. There is only so much Germany can do, and it is not going to be enough.
Aurora
The Aurora shooting was the result of two modern policy regimes: gun control (or the lack thereof), and ecommerce. The murderer was able to purchase military weapons over the Internet without being subjected to any background check. It was harder for the killer to get a driver’s license than for him to assemble the arsenal that he used to murder 12 innocent people and wound another 58. New York Mayor Michael Bloomberg appropriately called for Barack Obama and Mitt Romney to disclose their positions on the rights of civilians to own assault weapons, and thus far only Mr. Obama has gingerly broached the possibility of limiting that right. In fact, no such right exists, as the former Constitutional law professor should know. The Second Amendment does not provide an absolute right to own any kind of weapon, as even Supreme Court Justice Antonin Scalia conceded in a recent interview. It was intended to protect the arming of militias, not to allow individuals to arm themselves with weapons that the Founding Fathers could not even imagine. There is an enormous difference between a handgun, which the Second Amendment may protect, and an automatic weapon with a 100-round clip. Such a weapon of war only serves one purpose – to kill as many people as possible in as short a time period as possible. There is no Second Amendment right for civilians to own such weapons and they must be outlawed immediately.
Of the many acts of moral cowardice that Congress has committed, allowing the ban on these weapons to lapse in 2004 is one of the most unforgiveable. Allowing such weapons to be sold over the Internet along with SWAT gear must rank among the most anti-human laws currently on the books in this country. It is time for politicians and those who elect them to stand up to the tyranny of the gun lobby. We may never be able to understand the madness of a man who walks into a movie theatre with intending to murder dozens of people, but the madness of a legal regime that arms him is so evidently a self-inflicted wound that one has to wonder why it needs to be explained at all. Consistency may the hobgoblin of little minds, as Emerson taught us, but the inconsistencies that lead far too often to mass murder in America are going to be the epitaphs of a dead civilization if we render them intellectually and morally coherent in a hurry. Americans should not have to worry that when they leave their homes to go to the mall or the movies that they will be murdered by home-grown gun-wielding madmen.
The presidential election
My political views are hardly a secret, but I do strain for some objectivity in writing about the election. As I wrote on Twitter several months ago, an election between a community organizer and a private equity guy was obviously designed to torment me, and it is certainly succeeding. I have not donated a dollar to any political candidate during this election cycle due to my profound disgust with the political process. I also want to be free to speak my mind without being compromised by any affiliation. Both parties have been equally corrupt, incompetent and devoid of ideas, and I want to be free to say so.
One would think that I would be enjoying the attacks on private equity in view of my well-known criticisms of that industry, but I take little pleasure in politically-motivated attacks that are based on ignorance and distort the facts. Private equity firms charge egregiously high fees and pay ridiculously low tax rate on his earnings. They should not be publicly held, and anybody who invests in their stocks does so at their own risk and is likely to lose money. In certain periods, such as the years leading up to the 2008 financial crisis, they invested recklessly in transactions that did not contribute to the productive capacity of the economy. But those are problems that could be largely remedied by sensible changes in tax policy. At some point, institutions and their consultants will figure out that the industry’s risk-adjusted returns are mediocre at best (with some rare exceptions) and do not merit the large asset allocations or undeserved fees that have been extracted over the years. But the industry is also doing some constructive things, such as investing in energy projects (and in some cases coming to the rescue of struggling energy companies and their local communities, as in the case of KKR’s capital injection in Petroplus Holding AG’s refinery in Coryton, England and Carlyle Group’s purchase of Sunoco Inc.’s Philadelphia refinery). Private equity has the potential to play a far more constructive role in the economy than it did in the 2000s. Productive investments can be as profitable as speculative ones.
A truly terrible book
While on the subject of private equity, I have to take a moment to pan a book written by Edward Conant the former head of Bain Capital, LLC’s New York office: Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong. In the book, which is largely incoherent, Mr. Conard attempts to rationalize virtually all of the wrong-headed policies that led to the precarious financial condition that the U.S. finds itself in today. His self-satisfaction drips off every page, and he clearly believes he is making intellectually clever arguments that challenge consensus thinking. Unfortunately, one need only to look at economic data and what has happened to the U.S. economy to realize that his arguments are unsupportable. And that would have been the case even had a decent editor shaped the prose into something readable.
If the substance of his book weren’t sufficiently deficient, Mr. Conrad makes certain assertions toward the end that are both unsupportable and offensive. He asserts – backed up by absolutely no factual evidence (because none exists) – that liberal arts majors are solipsistic and irresponsible, and are therefore responsible for what ails our economy. He writes: “Many liberal-arts [sic] majors choose selfish solipsism over the burdens of shouldering the risk and responsibility critical to increasing economic growth. They study literature and art history rather than computer programming and engineering.” He asserts that these students have “recognize[d] that working hard won’t make them happy.” (262) Continuing, he spouts: “Art history and Elizabethan poetry don’t employ workers; the arduous and tedious application of business sciences such as computer programming and accounting does.” (276). In view of the fact that it was ethically vacuous business majors who led the financial system to the abyss, Mr. Conard must have been inhabiting a parallel universe over the past decade. Moreover, his belief that computer programming and accounting are sciences speaks to a narrowness of thought and misunderstanding of these disciplines that explains all we need to know about Mr. Conrad’s qualifications to contribute to a meaningful discussion of the issues that deserve our attention. I strongly advise everyone to spend their time more wisely than I did and pass on reading this garbled and uninformed book.
Investment Recommendations
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Michael E. Lewitt
[email protected]
9. Harvard Professor (and former Reagan advisor) Martin Feldstein recommended just such a step in a recent Financial Times opinion piece. Of course, the ECB’s monetization policies have been going a long way to accomplishing this, just not quickly enough.
10. See “Investment Recommendations: Currencies” below for our recommendation to short German CDS resulting from this analysis.
11. Like many religious converts, who are even more punctilious about observance than non-converts, Germany has been far more conscientious about creating a pro-growth capitalist economy than the other countries in Europe on whom it inflicted so much death and destruction during the Second World War. It would be a grave error (one too often committed by market strategists) to ignore the psychological dimensions of this historical background and relationships among the EU members in trying to determine the likely course of events in this crisis. The Eurocrisis requires a much broader, more historically informed and psychologically subtle analysis than what Wall Street and the media has provided.
Disclaimer
All opinions and investment recommendations expressed by Michael E. Lewitt in The Credit Strategist as well as on Twitter under the Twitter name @credstrategist are solely the opinions of Mr. Lewitt and do not reflect the opinions of Cumberland Advisors or its affiliates or employees, managing directors, owners or principals.
Disclosure Appendix
This publication does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. This report contains general information only, does not take account of the specific circumstances of any recipient, and should not be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient. Each recipient should consider the appropriateness of any investment decision having regard to his or her own circumstances, the full range of information available and appropriate professional advice. The editor recommends that recipients independently evaluate particular investments and strategies, and encourages them to seek a financial adviser’s advice. Under no circumstances should this publication be construed as a solicitation to buy or sell any security or to participate in any trading or investment strategy, nor should this publication or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. The information and opinions in this report constitute judgment as of the date of this report, have been compiled and arrived at from sources believed to be reliable and in good faith (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness) and are subject to change without notice. The editor may have an interest in the companies or securities mentioned herein. The editor does not accept any liability whatsoever for any loss or damage arising from any use of this report or its contents. All data and information and opinions expressed herein are subject to change without notice.
The Credit Strategist
Michael E. Lewitt, Editor
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