I have written several articles regarding both the US and Europe. I wanted to give an update of my understanding of the present position in both continents and its implications.
I have previously written that Europe would stay contained as an open sore for the next 6 months and possibly longer. I estimated that there would be no definitive solution, just austerity for all countries with debt problems and a European recession.
I recently read this article by James Kostohryz, which I thoroughly recommend to all readers. It contains a link to an interview with the new Spanish finance minister. He is calling for a fiscal stimulus program for Spain, which will be paid for by a combination of monetization by the ECB and the issuance of eurobonds (read, paid for by Germany). Mario Monti has also spoken out, that more than has presently been proposed, is needed. He has not directly suggested further fiscal stimulus measures, but it is clear that he feels the present course is unsustainable.
So it would seem that austerity programs are loosing their political appeal. The new governments want the nice easy option of money printing for the foreseeable future. Internal valuations are clearly not easy but I did not expect governments to give up this quickly. It would seem that Spain wants a painless fix and if it gets it, so will every other nation. If (and this is a big if) these articles do reflect the policy decisions of the new governments there are 2 takeaways:
1. The European situation is much closer to an endgame position than I had previously thought.
If the Italian and Spanish governments stop austerity programs, the budget deficits are going to rise and will have to be financed. There will be no pretence of trying to become more competitive, just a pure money print to stimulate their economies. Germany is going to be forced into deciding if they will...
a) Pay for the stimulus measures for several Eurozone members combined with some money printing by the ECB to finish the financing.
b) Refuse to pay and not allow the ECB to print money to finance the fiscal stimulus.
If they refuse, the splits in Europe will become more divisive and difficult to manage. This will lead to failed summits and volatile markets once again. Yields on sovereign debt will go up and down as the latest news is digested.
If they relent and agree, the ECB comes into focus. Will they also relent and start buying large amounts of sovereign bonds? If The ECB says no, wash and repeat the consequences above. If they also relent, austerity is dead and most of Europe will be relying on monetization of their debt and budget deficits. In the short to medium term this will probably be calming for the markets and lead to a big rally in European stocks. In the long term this is likely a disaster, as the economic problems of fixed exchange rates and uncompetitive policies have not been addressed. Money printing on the scale envisioned by the Spanish finance minister would not be contained to Spain, it would be embraced by all of the Eurozone countries; every country would want a part of that handout. It would quickly become an enormous pot of printed money.
2. The German/ French position is being challenged.
Germany will have to decide if it still wants part of this problem. Up until now, the German coalition has been setting the rules. This is the first challenge to this equilibrium. It is quite possible that the German response is to decide that it is time to exit. I still maintain that this is the most likely outcome of the European crisis. I can not see the Germans agreeing to either part of the financing options of this new fiscal stimulus. However, I did not think that the ECB would have a balance sheet of €2.7 trillion either and this has happened under the noses of the Germans. As push comes to shove, Germany is slowly bending their line. I believe that some time soon that line will snap and the Germans will say 'enough'. The pusuit of fiscal stimulus by the periphery may just be the catalyst for that decision.
However, at this stage it is not clear if this is just the peripheral countries testing the waters for a response by the core nations. If it is and the response is negative, will Spain and Italy (and possibly others) actually push this further and insist on a change of policy, provoking a crisis? It would seem a high risk strategy and therefore unlikely. However, it seems that the cracks to Eurozone unity are starting to show. This will bring on a solution more quickly. Either Germany keeps insisting on austerity and the peripheral nations will no longer comply, leading to a breakup, or they relent on their hard money stance and European debts are monetized away and subsidized by Germany. There is a solution that is lasting in either case, we have monetization of debt or a breakup. These recent statements from the newly formed governments are certainly pushing a resolution much closer as they publicly air their discontent. These types of challenges and denials are what has led to past flare ups of the crisis. If Spain keeps repeating its policy option of fiscal stimulus and other nations jump on this bandwagon the situation will come to a head quickly as the divisions become obvious. How far Spain and Italy decide to push this policy is crucial.
One last point before I move to the US. All solutions other than monetization of debt are market negative. I wrote a post here on the many uncertainties in the investing environment at the moment. If Europe gets resolved, the biggest uncertainty is removed and investment decision become much easier. Unfortunately the market may go substantially lower if anything other than monetization is the chosen option.
The US economic picture is still not absolutely clear. Coincident and historic data are better than expected. However these data points only paint a picture of an economy that is growing sub 2%. We will undoubtedly get a first reading of 4th Quarter GDP of around 2.8% on Friday. However, first readings are presently all being revised down on later adjustments and if 2.8% turns out to be the correct first reading, the final version is again going to be close to 2%. An economy growing at this rate is very susceptible to any negative news. If housing data is being skewed by good weather and incorrect seasonal adjustments are effecting jobless claims, the data does not look so good.
I am not arguing that the economy is in recession, as it clearly isn't. What I am arguing is that the economic growth picture that has been in place for the last 9 months, of growth just below 2%, is still the most likely present position. This undoubtedly leaves the economy very vulnerable to any negative shocks, whether internal or external. It also takes out the bullish position taken by several present economists of an economy that is accelerating now and will show growth of over 3% for 2012. I feel this is very optimistic and highly unlikely to be achieved. It also leaves the ECRI recession call still very much on the table. If growth is presently around 2% the headwinds of reduced government spending and a slowing world economy may well be enough to push the US back into recession. I would not be surprised to see growth of 1.5-2% for 2012 or alternatively a recession brought about by events external to the US. I would be very surprised if growth were to hit 3% for 2012, regardless of any solutions adopted in Europe.
If this analysis is correct the present liquidity driven rally will need further QE to sustain it and it is possible that this may still not be enough. The risks of a reversal at some stage are much greater than is presently understood.
I remain cautious and largely in cash until the picture on both Europe and the US becomes clearer.
Disclaimer - This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.
Additional disclosure: Long RWM, short S&P500 futures