The Unbearable Lightness Of Eurozone Dreaming

Includes: EU
by: Kevin Flynn, CFA

Is it rally time? Have the EU debt issues have been solved? Do happy little bluebirds really fly beyond the rainbow?

Despite the tone taken in most of the business press, we don't think German Chancellor Merkel lost anything last week. She got what she has publicly wanted, namely an agreement to put a regulatory structure into place first. As Robert Reich pointed out, eurobonds are no longer in the discussion. Many seem to see last week's summit as a closer step towards banking union, and indeed it might be - if all 17 countries can agree on what the regulatory framework will be.

Nearly four years after the crash and President Obama's subsequent decision to adopt Paul Volcker as an adviser, we are still wrangling over Dodd-Frank and the Volcker rule. Republican candidate Mitt Romney has already pledged to repeal it. Getting 17 separate countries to agree on a banking framework - with DeutscheBank pitted against Societe General against ING against Credit Suisse (Switzerland may not be in the EU, but Credit Suisse and UBS have branches everywhere) - is hardly going to be a piece of cake. What Merkel is going to want is a Bundesbank-style regulator that will say nein a lot more than ja. Then, and only then, can the other lending start, and you can bet that Germany will want the hurdle for the green light to be set as high as possible.

Pimco's Mohammed El-Erian pointed out on Monday (and it appeared to us he was trying to restrain the depth of his concern), the second, really important step was for the ECB to step up Thursday the 5th. The EU didn't actually appropriate any more money; it established a framework for going forward, which is what the Germans wanted. First we talk regulations, then we talk money. Right now the regulations are a gleam in Merkel's eye and a mote in those of everyone else. Without the ECB, there is no more money, without more money what has changed in real terms? Nothing, nada, nichts, niente, rien!

Bernie Schaeffer observed in the this week's Barron's that open call interest on the VIX volatility index - in other words, contracts that would pay off if volatility rose - hit all-time records in June, after beating the records of the previous three months. The reason is that the VIX usually soars when stocks plunge, and everyone wanted some protection. There was even talk that pension funds had loaded up on the calls in an effort to manage "tail-risk," i.e. a crash. Everyone and his mother was hedged up against the Greek election going the wrong way, leading Schaeffer to muse whether the market was so hedged that it couldn't have crashed, as investors who are hedged tend not to sell. Indeed, fear of a crash may have been what swung the Greek voters.

Despite the approach of a feeble earnings season, the market was setting up to put on a 2007-style summer rally. The mighty June event-risk hedge is now in the rear-view mirror. Technical levels were being reclaimed. The American Association of Individual Investor's (AAII) bear index, notoriously contrarian, spiked to a lofty 44.4% last week (the long-term average is 30%). Investment newsletter tracker Mark Hulbert says that pundits are scrambling over to the bull side of the boat.

Had the ECB come up with more easing on Thursday like the Long-Term Refinancing Operation (LTRO) it did at the end of last year, stocks would have rallied because that is the playbook. Shorts would have covered in the face of a liquidity rush, adding more fuel to the fire. Trader columnist Vito J. Racanelli wondered in this week's Barron's if the upcoming earnings season could turn out to be a sideshow, and we had been asking ourselves the same question. Though you may rightly worry about upcoming negative corporate guidance, it could fan the "Fed-has-to-act" flames, especially if CEOs start showing up in droves on television in the usual effort to blame someone else.

The European recession is not about to improve because the EU has voted in favor of the idea of a banking regulator. The direction is okay, but the destination is still out of sight. We don't know what such a thing would look like, only that rather like Samuel Beckett's Waiting for Godot, the EU has agreed to sit and wait for its amorphous arrival. It's supposed to be next year, but like Monsieur Godot may promise to arrive without ever doing so.

But next year is far away. In the meantime, deadlines are rapidly falling off the event horizon. The financial ministers are to issue another implementation statement on Monday the 9th. It is likely to be filled with more vague hope. If the Friday jobs report is a lemon, the ministers will feel compelled to do more, but if it's okay, then whatever the ministers say may be received in a warmer light. After that, Europe is going to drift into the summer holidays and then back-to-school season. The next EU meeting isn't until October. The US fiscal cliff will most likely not be addressed before December. It all leaves more room to dance.

There is another catch, namely that the so-called troika (EU, IMF, ECB) arrived in Athens on Thursday for three days of talks (in turn reminding us of Gogol's Inspector General). Assuming that hurdle can be finessed, it will leave the jobs reports for July and August as the remaining swing factors this summer. Yes, earnings will be weak, but as traders like to say, "we already know that." The surprise factor could be second quarter GDP: the May PCE deflator fell (0.3%), and oil fell again in June. A weak deflator calculation will boost headline GDP.

That brings us to some bits of data that you may find rather odd, in view of the headlines: The jobs market has been doing better than everyone thinks. No, we haven't lost our minds. Actual non-farm payroll jobs - that is, not seasonally adjusted - have grown by 2.8% from the end of January through the end of May (we use the end of January because seasonal adjustments conceal the fact that the real workforce count actually contracts in the first month of every year, due to end-of-year turnover). According to Labor Department data, the average increase since 1980 is 2.4%, and the median increase is 2.6%. Excluding recession years, the mean rounds up to 2.7%, which still leaves 2012 (+2.8%) as above average.

We've seen the recent claims data, we've seen the recent survey data. The ISM manufacturing survey that showed contraction on Monday had a steady reading on employment. Weekly claims data crept up and caution has undoubtedly affected everyone's hiring and investment plans, but the creep has been quite modest - the year-on-year monthly comparison is still tracking around a 10% improvement over 2011. Jobs data does lag the rest of the economy, so we are not going to guess Friday's number, but given the recently published data, upward revisions should be coming unless the Labor Department has miscounted earlier in the year.

How much pressure will there really be on the Fed? Talk of the bank having no choice but to do more at its August meeting started minutes after the ISM posted its sub-50 reading Monday. The only thing we can say for sure is that if the stock market is higher at the August meeting than it is now, the Fed is unlikely to act without data so bad that any July rally would have been crushed. The S&P is up over 8% on the year now; if that creeps up to double-digits in August, how could the Fed possibly justify another major round of accommodation less than three months before the election?

But that is reality, and markets trade on perception. The next few days should give a very good indication of how much of a chance we have to float higher into August. First, we remind everyone that crashes come from a height. Before we can have a crash, we must first have a rally, and it looked as if the markets were trying to oblige - at least until the ECB failed to come up with additional accommodation. Now we must weather the troika visit and a market uncertain on whether to keep chasing the elusive promise of central bank easing.

Second, however much the masses may have been yearning for a study to discuss an EU banking regulator, it will have zero impact on this year's European recession. The global slowdown is going to build. The Fed will not act before September unless our budding rally has been crushed and the indices rolled back into the red. Had the ECB stepped up with broader quantitative action to go with its less-than-spectacular quarter-point cut, a dreary earnings season might have been ignored. Now the bank and the rest of the EU's maddeningly measured pace has left the door open to another summer slump - and a potential August headache for the Fed. Auf wiedersehen.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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