We've warned for weeks that once the US elections were over, at least a few evil genies would be released and threaten risk asset markets, which are vulnerable given their being near decade highs despite deteriorating global fundamentals that are now hitting earnings.
We specifically mentioned both:
- The EU crisis: Washington had requested quiet in order to keep voters more upbeat about the current administration's handling of the economy.
- The Fiscal Cliff: the combination of tax increases and spending cuts, which would come back into focus now that the elections clarified the balance of power in Washington and the cast of characters tasked with solving the problem that Washington itself created when it raised the US debt ceiling in the summer of 2011 rather than make a serious attempt at responsibly cutting its budget deficit and national debt.
However the elections released a third evil spirit that we should have anticipated, but didn't. We'll deal with that topic below.
They key point is that in five ways, this past week was a taste of things to come for the remainder of the year and beyond, as these market movers are likely to be with us in the weeks ahead.
Prior Week's Market Movers
The top market 5 drivers last week were:
We've warned that with US elections over and Washington's imposed quiet in the EU now over, the EU crisis in general, and Greece in particular, would once again become a focus. Indeed it did, right on schedule, complete with media and market focus on
- Greece solvency concerns: EU officials continue to delay a decision on what to do about Greece, continuing the uncertainty about when and how Greece will default, and thus about the level of contagion risk. As we note in our weekly preview of the coming week and beyond, the big risk is not from a Greek default itself, but rather that it raises questions about the solvency of the creditors and sparks a banking and liquidity crisis, similar to what happened when Lehman Brothers bank died, only on an even larger scale. The biggest specific risk is that this crisis causes Spain's bond yields and borrowing costs to soar beyond its reach as we approach the New Year, just as Spain has well over €20 bln of bond sales scheduled (thanks to Kathleen Brooks of forex.com for kindly supplying those figures). See here for full details of this year end market crash scenario.
- Unrest including violent street protests and general strikes in Greece, Portugal, Spain
- EU Commissioner Ollie Rehn publicly warns Spain's deficit reduction plans for the coming years were inadequate, setting up exactly the kind of a coming confrontation that had been put on hold until after the US elections.
- Ongoing open policy disputes among the Troika members (ECB, EU, and IMF). The IMF views Greece from the perspective of reality, saying that because Greece cannot repay its debt it's time to allow a default and write down that debt to levels that allow Greece to recover. The EU and ECB however, oppose admitting their errors and facing voter anger. They instead favor continuing the policy of piling on more loans that cannot be repaid, to continue the pretense that another default can be avoided. The result will be bad for everyone.
- Greece will be pushed to accept more austerity measures, which will only further weaken its economy to the extent that Greece actually implements any of them(?), and lead to more loans, resulting yet more austerity measures and depression. As it was brilliantly put: The rest is pure catastrophe; not even tragedy (since tragedies end with catharsis).
- The eventual default, ultimately funded by EU taxpayers, will be that much bigger.
See here for a great summary of the situation by Yanis Varoufakis.
The elections removed any uncertainty over the balance of power in Washington and how that might influence what happens regarding the scheduled wave of tax increases and spending cuts. Short answer: no decisive victory for either side, essentially the same balance of power and cast of characters, and thus the same uncertainty about how the Fiscal Cliff will be resolved, if at all.
While specific forecasts vary about how this will be resolved, none of the likely outcomes are good. The basic choice of outcomes include:
- Political paralysis results in the full range of spending cuts and tax increases hits, slicing off an estimated 4% of US GDP and likely sending the US into recession. The good news is that it would actually mark the first serious steps to cut the US deficit that endangers America's longer term prosperity. But of course, long term benefits for the greater good have not been priority for Washington.
- Little or none of these will happen as Washington will once again defer any serious deficit cutting, as it did when faced with 2011's debt ceiling crisis (which set up the current fiscal cliff crisis). The pain is deferred, but at a cost of further increases in the US deficit that would likely bring another sovereign credit downgrade and increase the future pain.
- A compromise that mixes some minor progress on cutting the deficit with enough entitlements preserved so that both sides can claim victory. It's a lesser form of #3, and still leaves the US's debt issue to fester and grow.
All of them risk another US credit downgrade, because all show that Washington is unable to deal responsibly with its excessive debt. While the first option would actually cut the deficit, that result would only come by default and as a result of the same worrisome political paralysis that bodes ill for Washington's ability to deal further with its budget in the future. It's that same gridlock which caused it to lose its S&P AAA rating in 2011 when Washington raised the debt ceiling and deferred these budget decisions to the end of this year, hence creating the fiscal cliff. The others show a better functioning budget process, but one that fails to cut the deficit.
POOR DATA CONFIRMS ONGOING GLOBAL SLOWDOWN
Most of the top tier data releases missed expectations, particularly in the EU and US.
Of particular concern was data from the EU:
- Further evidence that the EU slowdown is hitting the few core funding nations on which the rest of the EU depends. Germany's ZEW business sentiment survey was far worse than expected, as was the Euro-zone's, and Holland's GDP.
- Even though flash GDP for the EU as a whole was slightly better than expected, it still was negative for the second straight quarter, marking the EU's official double dip back into recession. The significance of this news is that it undermines the credibility of the EU's overall approach to solving its debt issue via austerity. While all understand that austerity initially cuts growth before its benefits kick in, many have warned that the GIIPS nations are too weak to survive the direct approach to cutting debt/GDP ratios- austerity. Thus far, austerity measures have proved self-defeating, as they simply caused GDP to fall as fast, or faster, than debt levels.
The US also showed overall negative monthly data. Much of that was influenced by hurricane Sandy, so some of those reports might show exceptional improvement in coming months, while others will reflect ongoing damage as millions of consumers have less to spend as the US enters its prime holiday retail spending season.
Rising Mideast tensions were also, to a lesser degree, weighing on markets.
The one ramification of the elections that everyone missed was that Obama's re-election would embolden radical Islamic elements in the Middle East, due to a combination of two widespread perceptions (right or wrong) about him:
- He is weak and unlikely to confront terror states militarily, as demonstrated by his behavior towards both Gaza and Iran
- He is the most anti-Israel/pro-Arab (however you want to look at it) US president since Jimmy Carter.
In the days following the US elections, Israel saw a marked increase in rocket fire from Gaza (evacuated by Israel as a 'risk for peace,' now under control of the popularly elected Hamas party, which committed to Israel's destruction) and, for the first time in years, took repeated fire from Syria.
Correctly or not, these elements apparently assumed the re-elected Obama would feel free to keep Israel on a short leash. Sure, there's a risk of Israeli retaliation and casualties, but loss of human life, military or civilian, has never been a major concern for Hamas.
For Hamas, the decision to escalate may have been a serious miscalculation, because there were a number of reasons why circumstances that made the time right for Israel to behave like a normal country and defend its civilians from rocket attacks. These include:
- The recent destruction of a Sudanese arms factory owned by Iran and used to supply weapons to Gaza. That may complicate Gazan resistance.
- The US is occupied with both the Fiscal Cliff and damage control concerning the sex scandal and resignation of its CIA chief David Petraeus
- Hezbollah is focused on providing military support for their ally Syrian President Assad.
- Although the Egyptian PM shares Hamas's goals of wiping out Israel (he openly prays for Israel's destruction) this is not a good time for him to deal with the Israel Palestinian conflict.
ANTICIPATED NEW JAPAN STIMULUS
Both Asian markets and the USDJPY pair got a boost last week from hopes that coming elections in Japan will bring a more pro-stimulus leadership.
All of the above will continue to prominent market movers in the coming week and beyond. We'll discuss these in our weekly preview of the coming week.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.