In National Lampoon's European Vacation, Clark Griswold has tremendous difficulty negotiating a traffic circle in London, so much so that he gets stuck in one for hours. Ultimately, movie watchers see an exasperated and temporarily insane Griswold exclaim repeatedly, "I can't get left!"
We are reminded of Griswold's driving difficulties today as we ponder the eurozone, which is not afflicted by an inability to get left but rather by a seeming sense that it cannot get right.
What's happening in the eurozone is troubling on a number of levels, not the least of which is the recognition that it is an illustrative case for the U.S.
Fiscal austerity is necessary here as it was in the eurozone. That puts the U.S. at risk of getting stuck in the same traffic circle the eurozone is in.
Eurozone Turned Upside Down
Greece is a ward of the state; Italy is being led by a technocratic government; Spain's unemployment rate is over 25%; and Germany, the core of the eurozone, is starting to feel the economic effects of its troubled neighbors. Those are just a few of the problems.
Social protests are occurring more often; radical political parties are on the rise; demographics are unfavorable; and reaching a political consensus is a never-ending battle of brinkmanship.
The political and economic environment in the eurozone is polluted with unrest. Cleaning it up hasn't been - and won't be - easy.
Much like the Federal Reserve, the European Central Bank (ECB) has been a mainstay of support with its unconventional policy. Its pledge to defend the euro and to buy sovereign bonds of member countries seeking bailout assistance from the European Stability Mechanism has drawn the ire of many political critics.
At the same time, the ECB's stance has drawn approbation from financial markets, which have generally defied the reality of the troubled real economies. Sovereign spreads have typically narrowed in the last six months, most European bourses are showing gains for the year, and the euro itself is up slightly against the dollar since the end of 2011.
It is a fundamental divide to be sure, but investors there aren't fighting the ECB much like investors here aren't fighting the Fed.
Cautious about Being Carefree
Both central banks though are in the late rounds of their heavyweight fights and their punches aren't as forceful as they used to be. That is clear in the persistently low pace of economic growth.
The eurozone though is one up on the U.S. It is already bearing the brunt of fiscal austerity on top of the deleveraging that has occurred in the wake of the financial crisis of 2008-2009.
Government spending cutbacks have hurt some in the U.S., but it will get worse if political leaders find the gumption to do more to get our escalating debt under control.
Frankly, we are amazed by the market's carefree perspective when it comes to contemplating a fiscal cliff compromise. The market reportedly just wants a compromise - any compromise. That will presumably keep a worst-case recession scenario on ice and light a fire under the market.
The equity risk premium should come down with a worst-case scenario being avoided. However, there is a sobering reality that is escaping the punch-drunk market right now. A compromise involving higher taxes and/or lower spending of some kind is going to weigh on economic activity and earnings growth.
Mind the Gap
It has been widely reported that the Congressional Budget Office (CBO) is projecting a recession in the U.S. if we go over the fiscal cliff. What doesn't get mentioned as much is the CBO's alternative fiscal scenario.
The alternative scenario rests on an assumption that most tax cuts and other forms of tax relief set to expire get extended and that automatic spending cuts and other spending restraint are prevented from occurring. Under that scenario, GDP is projected to increase a whopping 1.7% in 2013.
If the Social Security payroll tax cut and emergency unemployment benefits are also extended, the CBO projects 2013 GDP growth to be 2.4%, which is still below potential.
The U.K. and eurozone countries know a thing or two about below-potential growth. They have existed in that languid state of economic affairs for the last four years (oh, and so has the U.S.).
What is noteworthy today, and what is relevant for the U.S. as it starts down its own path of fiscal austerity, is that unemployment rates went up and output gaps widened in the U.K. and the eurozone after fiscal austerity kicked in. The output gap is a measure that reflects the percentage of economic labor and capital not being used (i.e. the slack in the economy).
Three Unfavorable Scenarios
It is hopeful to think the U.S. will be spared a similar fate. It could, but we struggle to believe companies will increase spending and hiring as earnestly as they say they will if they just have clarity on fiscal policy.
Three scenarios could unfold in the next month:
- There is no compromise and we go over the fiscal cliff.
- A compromise is reached that includes higher taxes and/or lower spending.
- Every hard choice is deferred and the can gets kicked down the road.
Not one of those scenarios is favorable for increased business investment.
The first scenario would lead to a recession while the second scenario would lead to sub-par economic growth just like we have today.
It doesn't stand to reason that businesses will spend freely and hire more people if higher taxes and reduced government spending lower levels of disposable income and aggregate demand. Businesses didn't do it with sub-par growth in 2012. Why should anyone believe things will be so different in 2013 when taxes are higher and government spending is lower?
The third scenario buys some time, but companies said this year they held back on investment and hiring because of uncertainty about fiscal policy. Kicking the can down the road doesn't give businesses any more certainty about fiscal policy than they have today.
We should point out too that the CBO has warned that the economy would remain below potential and the unemployment rate would remain higher than usual for some time even if all of the fiscal tightening was eliminated. That's hardly the stuff increased business investment and hiring is made of.
Some Earnings Delusion
In turn, we struggle to see how analysts are forecasting double-digit earnings growth for the S&P 500 in 2013. We said as much last week.
Earnings growth estimates will be lowered in the coming months to reflect the low growth/no growth reality for many of the world's largest economies.
2012 GDP Estimate
2013 GDP Estimate
It would not be a surprise to see U.S. multinationals with heavy exposure to Europe lead the downward revision to earnings growth estimates.
What It All Means
Fiscal austerity is coming to the U.S. The question of when and how much remains unanswered. Fiscal change though is on the way. That change is going to slow economic and earnings growth in the near term, not accelerate it.
That may be irrelevant in the near term, however, to a stock market that feeds at the trough of the news cycle and monetary stimulus.
There will be a sense of relief in the capital markets if a compromise can be reached, but in due time the reality will be established that we're still stuck in a traffic circle of sub-par growth that is going to make it difficult for the labor market to get right.
The experience of the eurozone makes it clear that economic growth in the U.S. will get worse before it gets better. And it may be years yet before growth isn't just better, but is actually at or above potential.
The eurozone, which is further along with fiscal austerity, is back in recession. The U.S., which is just getting started, will be fortunate to avoid a similar fate.
We screened for S&P 500 companies that derived at least 30% of their revenue from Europe last year. Forty-five companies were returned in the screen (we included companies that report an EMEA segment, assuming most of the revenue is generated in Europe). McDonald's (MCD), Dow Chemical (DOW), and Priceline.com (PCLN) were among the companies making the list.
% of Rev
FY12 EPS Growth Est.
FY13 EPS Growth Est.
Illinois Tool Works
Marsh & McLennan
Foreign, primarily Europe
Sources: S&P Capital IQ; FactSet; Thomson Financial; Company Filings