The market needs a new worry. The old reliable, Greece, is at risk. It looks as if Germany and its EU allies have decided that another package is the lesser of two evils - the bailout not being about saving Greece anymore, or they'd have shut the door long ago. It was the fear of what might happen to the rest of the EU and the euro, and we've no doubt that behind closed doors, many are bitterly lamenting louder than ever the decision to let Greece enter in the first place.
The latest version of the package, unfortunately, only went a little way towards resolving the problem. What Greece really needs is to write off the bulk of its debts and start over. The problem, though, is that there is no path for getting there that doesn't involve a great deal of sacrifice, and that is why we are being treated to this endless on-again, off-again spectacle.
A Greek exit from the euro would allow the country to write off most of its debt and start over with a more tradable currency. On the other hand, it would break the unbreakable vow, as it were. Not only would the sanctity of the union be forever in doubt afterwards, but the markets would immediately start to wonder who might be next. It would be quite unpleasant, despite the complaints that neither the Greek debt nor the Greek economy are all that large.
Writing off Greek debt within the euro is preferable, but the problem there is that the EU is not ready to confront the rest of the unrepayable debt. Portugal, Spain, Ireland, all are over-indebted and Italy's debt is large enough to be vulnerable under the right conditions. The northern axis is by no means ready to confront the amount of debt that needs to be written off. Thus we extend and pretend, while austerity crushes the wayward.
It isn't as if nobody in Europe has worked this out. Many have. The approach is still the same, though - try to contain the most visible parts of the problem, such as Greece, while hoping that the other parts will get better over time. In particular, hope that the banking system can repair itself (and to that end the so-far very successful LTRO program for the ECB to lend money to banks was put into place). Above all, keep trying to buy more time.
We're not aware of this approach ever working in the past - a debt bubble simply going away by itself - and are skeptical that it can work now. The debt has to be confronted in the end, and the days of drama are by no means past. The latest package didn't seem to change anyone's mind, so far as we can tell - the skeptics are still skeptical, while the "finmins" (ministers of finance) remain fingers crossed.
However, the markets are another story. The equity rally hasn't been about Greece or Europe for some time, not at bottom. It's been about the rally itself. After a long run such as the one we've hand, any trend starts to detach from fundamentals and the trend itself will become the trade. The horizon shortens and what may happen six months down the road vanishes from the radar. The trading is now about betting if a story tomorrow - not next week, not next month, but the next trading day - can be big enough to break the rally. This is what the so-called "climbing the wall of worry" is usually about.
In this regard, the Greek crisis has actually been fuel for the rally. The "high noon" worry was clearly identified - a disorderly exit - so every story that suggested that the final meltdown might not come was a trading reason to buy. Tuesday's reaction in the U.S. told you the story - much of the fix had been priced in, and with no fixable crisis to trade against, what can move the market higher?
A couple of things, actually. One is that the Greek situation is by no means a fait accompli. There are agreements in place, yes, but Greece is faced with a checklist that appears to be forbiddingly large. The Greeks not only have to promise to never tell another lie, do their homework every night and eat their broccoli, it looks as if they have to write it into their own skin, Harry Potter-style, and accept more pain first (minimum wage cuts, more government layoffs, more cuts, taxes, etc).
Many are voicing doubts that the Greek people will put up with this for much longer - however much you may think they earned it, they are entering the fifth year of recession and the latest bar of soap is quite a lot to swallow in one go. Some of those doubts are coming from the investment world, and others are coming from Greece itself: one of the left-wing parties has already started making threatening noises about what will happen after the April elections. Ergo, if the market can keep worrying about Greece without having the ultimate disaster befall it, it could keep heading up.
In the second place, Portugal is now making noises about renegotiating its debt. The worst-case scenario would be the same: default and Portugal leaves the euro. That is unlikely, making it a great worry target to trade against. Then there is Spain.
In such circumstances, the correction is quite often set off by something other than what the crowd is talking about. A year ago, the onset of the "Arab Spring" suddenly wracked the markets (though almost nothing can take away the April rally). Given the violence in Syria, the deteriorating Iran situation and spiraling oil prices, it may well again come from the Middle East. For the next few weeks, it doesn't appear set to come from Europe anymore, though social unrest and frayed tempers could quickly change that.
China relaxed its reserve ratio over the weekend, giving equities another boost. Foxconn workers were also given a big raise. Our guess is that exports are probably down by more than what the New Year could account for, and the authorities must be gravely worried if they are ready to push the inflation battle off to the side again. One might even say that it's a sign that the Chinese are starting to flail in their efforts to confront their bubble. In any case, our lesson from the school of hard knocks is that one must never trade against the first monetary easing, nor ever believe that it will do anything but cushion the fall.
Another worry: last week's domestic industrial news was not as good as we thought it would be, however warmly greeted by the market. We inferred a triple-play of unusually mild winter weather, normal seasonal ordering patterns and favorable adjustment factors casting a rosy glow over the data.
On the rosiness scale, it was a bit pale. Not so much for the market, which in its current state might rhapsodize over ragweed, but for what we thought might be stronger momentum. We also have to question the economic consensus estimates. Earnings estimates have long been carefully modulated to achieve a beat rate of about two-thirds; is this happening with the economic data?.
The consensus estimate for the Philadelphia Fed manufacturing survey released on Thursday, for example, was about 10, and the actual result was 10.2. An apparent winner, but why was consensus so low to begin with? The economy is widely portrayed growing as strongly, yet the February 2011 survey result was 29.8 (and originally released as 35). Ten almost looks as if it was designed to be beaten. On the other hand, January was only 7.3, so one could excuse a mild raise of the bar. But doesn't suggest a lower rate of acceleration that last year's first quarter - which turned out to be a dud, manufacturing notwithstanding?
Putting those issues aside, the headline number for both the New York and the Philadelphia Fed surveys, the general conditions index, were indeed misleading.New York finessed the issue by saying only that manufacturing activity "expanded for a third consecutive month," while its Philadelphia fellow opined that the data "suggest….activity continued to expand in February." What the market saw, of course, was that the NY general index went from 13.5 to 19.5, and Philadelphia went from 7.3 to 10.2, ergo buy the accelerating-economy story.
Diffusion numbers are tricky, though, and what the underlying data suggest - though as yet, it's still only a suggestion - is that manufacturing growth flattened out considerably in those regions in February. Most of the survey questions have three possible answers: was the activity in question higher, the same, or lower? When more respondents are saying "higher" and fewer are saying "lower," the higher diffusion number reflects a widening breadth of activity.
But that's not what happened with the February surveys. In both of them, the number of "higher" responses actually decreased sharply - but so did the number of "lower" responses, with the change flowing into a steeply rising "same" category. In other words, activity flattened out, despite the higher index value. The same happened with new orders.
The Industrial Production data was surprisingly light, showing no change, but that report at least was better than it looked. December got a big revision upwards, such that the final January value of 95.9 was about where consensus would have put it anyway (96.0). Manufacturing was indeed the center of strength, rising by 0.7%, with business equipment up a robust 1.8%. Apologists directed attention to the drops in mining and utilities, but we'd be more concerned with the drop in consumer goods (-0.1%).
We're sticking to our story: businesses are getting a lift from seasonal factors such as fresh budgets and an inventory replenishment period, but the consumer isn't up to much. Home Depot (HD), for example, reported that the warm weather added 2-2.5% to sales, but experience would suggest that most of the sales represent pull-forward business, rather than net additions. Similarly, the uncommonly mild winter meant fewer lost days and slowdowns, hence fewer layoffs and better hiring conditions. The flip side is that there will be no rebound effect either, not for Home Depot, not for the monthly jobs data.
As for the exhortations already in circulation that this time is different and rising oil prices will have no effect - all we will say is believe it at your own peril, for that would indeed be a first. The stock market could certainly rise higher; the last fifteen years have taught us that the markets can lose all sense of reality when it's on the momentum high. But the rally is quite overextended, and any decent excuse is going to lop a good five percent off prices, if not more. We still say it's day-to-day; watch out for the Middle East.