Interview With Liz Ann Sonders: Euro Implosion Would Be Much Costlier Than Several Country Defaults

by: Harlan Levy

Liz Ann Sonders is senior vice president and chief investment strategist at Charles Schwab & Co. Prior to joining Schwab in 2002 she was a managing director at U.S. Trust.

H.L.: U.S. stock markets are reacting strongly and negatively to the worsening situation in Europe with its sharp slowdown in economic activity, the need to cut large deficits, and an inability to solve the problems. What do you see happening?

L.S.: What is plaguing our stock markets more than anything else right now is what’s going on in Europe. Our view is that European leaders continue to take a “Whack-a-mole” approach, where you battle each problem as it crops up. Also what’s missing is an understanding of the role confidence plays in their system. Even in the U.S. our politicians are just coming to realize the role confidence plays. This is one giant confidence crisis.

There are certain basic things to do: Get passage of the expanded capabilities of the European Financial Stability Facility, which could lend to governments to inject capital into banks. Also, the European Central Bank. which fortunately did not raise rates at their last meeting, should consider cutting rates in light of rapidly slowing economic growth in the region.

H.L.: Is this going to persist for years?

L.S.: I would not attempt to speculate when they’re going to get their act together, but the ultimate finale – does the euro hang in there as a currency? We at this point tend to tilt at yes, because the cost of the euro as a currency imploding is significantly higher than several defaults on the part of peripheral countries. In fact, things appear to be coming to a head, with Germany saying they’re readying a plan to help the banks in the event of a Greek default.

H.L.: How much do Europe’s troubles affect the U.S. economy?

L.S.: At a fundamental level, not a tremendous amount, due to a low level of U.S. exports to Europe, relative to other parts of the world. But it’s certainly having a psychological impact on confidence and stock market volatility.

This confidence crisis is more than just an esoteric thing. Rather, it’s something that’s actually having a dampening effect on Gross Domestic Product growth and the market, too. You get the diminishing wealth effect, which doesn’t help our confidence in the economy and hits actual net-worth numbers. And companies now enjoying record-breaking profits and not seeing the slowdown as acutely as one might expect have great uncertainty about future tax policy, regulations, and ongoing deficit negotiations. Add to the mix the eurozone debt crisis and the lack of confidence in our political leaders, and you have a recipe for weak hiring in spite of strong profits.

We have a major healthcare reform pact, but we still don’t know the full extent of what the costs are going to be on the business level. We’ve had lots of changes in tax policy, but they’re all temporary. We know full-blown tax reform is on the table, but it’s not being done yet. We just got an extension of tax cuts, but what happens when they expire?

And this notion that businesses make hiring and investment decisions just based on short-term incentives and conditions is just not correct. They’re based on long-term conditions, and it’s very hard to plan when there’s still so much coming down the pike in terms of potential change.

Most businesses would be happy to accept things they don’t like on the tax or regulatory or healthcare front, and if at least we know the rules of the game and that they’re static, nor dynamic, businesses can get back to making decisions about hiring and investing.

H.L.: Will Congress pass at least some of President Obama’s $447-billion jobs package?

L.S.: Some of it will likely be easier to pass than other parts. I do believe there’s a greater willingness to be cooperative right now. They’re going to be forced to cooperate more due to the automatic across-the-board spending cuts that will kick in if the Supercommittee fails to agree on a deficit-reduction package that would now include the $447 billion jobs package. Automatic cuts and the process that would get us there would not please most of their constituents and voters, so that alone is a big incentive for them to be more cooperative.

Second, with record-low approval ratings down so dramatically, both parties’ voters are fed up with politicians. I think our political leaders realize they’ve hit the end of the road in the public’s tolerance for “My way or the highway” thinking.

H.L.: How do you rate the U.S. economy this year and next year?

L.S.: Slow growth at best. We’re not in another recession yet, but I’m not sure it matters that much, because part of the reason we may be able to avoid another official recession is that so many sectors of the economy never recovered in the first place. Whether it’s housing or small business, they’re unlikely to experience enough of a drop to trigger another full-blown technical recession. But that’s not doesn’t mean anything great in terms of growth or job creation.

It doesn’t mean a strong second half, but we’ll slog through without a recession. The biggest impediment to growth longer term, though, is debt and the deleveraging cycle. When government debt as a percentage of Gross Domestic Product is as high as it is right now, 96 percent, it is really really hard to get the economy to grow at anything resembling a normal pace. Even if we get a lift in the second half it will be a marginal lift, and we’re probably in an environment of slow growth for quite some time.

H.L.: Some stock market observers say the markets are rigged in favor of the hedge funds and other big players with their high-speed computers. Looking back to Sept. 11, 2001, are the markets fairer?

L.S: I think the definition of “fair” to some degree is in the eye of the beholder. High-frequency traders would tell you that they’re a positive force in the market. My personal view is that it’s really easy to debate that point.

What has changed in the last 10 years-plus is that we went from a market that had human beings and specialists making markets on the floor of the New York Stock Exchange in a traditional market, and we don’t really have that anymore. So we are in an environment where it’s machine versus man, and at least in the eyes of the average individual investor the machines are winning. So with high-frequency trading, which in the last couple of years has been as high as 80 percent of daily trading on many individual days, high frequency traders will claim that they’re adding liquidity.

The counter to that – and I agree with it -- is that they are playing on illiquidity and high volatility. They’re not coming in and taking big positions in any kind of long-term way to stabilize markets, as market-makers used to do. They’re trying to play on the instability of markets, and, as a result, are not only exacerbating the swings on a day-to-day basis but also making that all the more frustrating for individual investors, because the machines have time horizons measured in milliseconds, and we as individual investors have time horizons that are appreciably longer than that. So I think it has unleveled that playing field to a significant extent.

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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