‘Everybody Stay Calm! – A Slight Return’

Courtesy of Doug Short.

Interviewer: “What period does this remind you of?”

Economist: “Last year…the year before that…and the year before that.” – Bloomberg Radio

Recently, I found myself on a plane making an emergency landing, again. I have flown to and from a certain city four times in my life and had emergency landings on two of four occasions (2001 and 2012). I detailed my 2001 adventure in last year?s “Everybody Stay Calm!” The ritual: (i) get on for the ride, (ii) volatile mishap on the way up, (iii) rapid descent, (iv) get out quickly (via fun slide or boring jetway), and (v) wait for indications of what to do next. The violent “accordion-shaped” up and down moves in the commodities and equities markets the first halves of the last three years have left investors similarly “normalized” to the abnormal. This year, the Dow posted the best 1Q performance since 1998 (+8%), followed by the worst May since 1940 (-8%), followed by the best June since 1997, (+4%) – the gain for the first half of the year. Get on for the ride, volatile mishap, descent, and slightly propitious exit.

This year’s odyssey revealed a lack of leadership more awe-inspiring than my first dance with death eleven years ago. Instead of one leader “losing it” (i.e., the pilot), the entire leadership “lost it” (the airline), herding 150 or so passengers around the airport for 5 hours with no explanation, handing out useless taxi vouchers, delaying the replacement flight the next morning for another 5 hours with no explanation, and finally another 2 hours “due to an equipment malfunction” on the plane we hadn’t even boarded yet. Upon hearing this first direct communication from our “leaders” in over 24 hours, two would be passengers flipped out and had to be “escorted” to the “can” by security, ostensibly to be given some literature on how to behave when “Groundhog Day” meets “The Twilight Zone” and one must live through their progeny.

Similarly, in our global airport, not just one leader or leaders has “lost it” but an entire world of leaders is failing, repeatedly. The “Six Month Window”, discussed in Sleepwalking Toward a Precipice: Part I, where meaningful action in Washington happens in a brief time just once or twice every presidential term is proving more powerful than ever. U.S. leaders ignored their constituents (like so many passengers) in not addressing Bush and payroll tax cuts until the wee hours of 2010, and gridlocking over the debt ceiling and rejecting and ignoring the bi-partisan Simpson-Bowles and Domenici-Rivlin deficit reduction plans in 2011 and 2012 to the point of government shut down and sovereign downgrade. Ending 2012, politicians are ignoring the potential fiscal cliff -4% drag on GDP (~$567B), set to take effect in 2013, which would send the 2% U.S. economy into recession. Why? Elections of course, with politicking around “which rich” should be taxed higher (Democrats) and a ceremonial Affordable Care Act repeal vote in the House of Representatives (Republicans). It’s beyond absurd.

After 17 (count ’em) European summits on the debt crisis, Euro Zone leaders are playing dangerous games of political chess through the media and in person (Mario Monti of Italy threatening a potential end to the Euro Zone if bailouts and growth measures aren’t enhanced and Angela Merkel of Germany not “seeing” mutually guaranteed Eurobonds “in her lifetime”). The new “Latin League” of Spain, France, and Italy recently aligned to outflank German leadership at the June 28-29 summit (or did they? German King to e…exit?), but new aggression by Latin leaders is not in their constituents’ best interests any more than Germany’s hardline stance is for its constituents. If it were, they would write down sovereign debt across the “Whack-a Mole” countries, let the banks fail and, let the bondholders and equity holders take the hit, move good assets to good banks, bad assets to bad banks, and not leave the taxpayer on the hook for decades. The pain would be very harsh for a time, and politicians would be blamed and ousted, but letting the system clear, taking the strategic (i.e., long-term) view instead of the tactical would benefit country and citizen immensely (see: Iceland, Sweden, Argentina, Russia, Thailand, Korea, etc.). As Luxembourg’s Finance Minister put it in December, “We all know what to do, but we don’t know how to get reelected once we have done it.” At least he is honest. European leaders are as self-interested as American ones.

The Chinese Premier is talking up more fixed investment and the PBOC is cutting reserve requirements so banks can lend more into an economy desperately not in need of still more wasteful spending (and they say the West has a debt problem). China is in a “China-cession”, with official 2Q12 GDP growth down six quarters in a row to 7.6% with electricity usage and manufacturing output data indicate China may actually be in outright contraction, while also dealing with public furor over the excesses and corruption of monied political elites and the myriad structural problems of a misaligned state-capitalist growth model. So, what to do? Build more stuff. Bob would be proud. Jack Welch wouldn’t.

Japan, well, it’s Japan.

The point of all this is, we have been here before, 11 years ago for me, and last year, the year before that, and the year before that for politics, the global economy and markets, but, the leaderless world is worsening in trend and magnitude: (i) leadership is failing on a grander level (years of brinksmanship and gridlock is wearing down the gears of cooperation to the point of complete divide and rising social unrest and fringe parties), (ii) conditions are deteriorating faster and further with every “delay and pray” (bailout agreements and “new plans” have shorter and shorter positive half-lives), (iii) incredible uncertainty and mental fatigue is becoming the norm for businesses (delaying spending and hiring for years), consumers (stalling job growth, wages, consumption), and investors (years of net flows out of equities and into bonds for safety), and (iv) real breaking points are coming closer in economies and markets (Euro Zone-wide recession/depression, “China-cession”, and U.S. indicators pointing to recession currently or in the near future).

Apparently our “leaders” have no “literature” on how all this is actually bad.

In terms of markets, after the June 28th-29th Euro Zone summit agreement on a memorandum of understanding of a plan for a wish for a hope for a pixie dust of a solution, commodities and stocks rallied strongly for almost 5 full workdays, then it was over. Investors realized the summit was somewhat of a “breakthrough” in coordination, but sobered up to the realization that: (i) bailout funds (~650B, less $120B earmarked for Spanish banks) will have to be significantly enhanced to directly recapitalize additional Euro Zone banks and potentially directly purchase sovereign debt of distressed countries to keep country borrowing rates reasonable (the latter of which Germany opposes), (ii) establishment of a Euro Zone banking regulator overseeing bailout recapitalization and will probably not be in place until mid-2013, (iii) the German Constitutional Court has yet to rule on whether Germany could legally even fund its portion of the ~$650B ESM much less use it for the new proposed direct bank recapitalizations (the latest is that it will be 2-3 months until a decision) or sovereign bond purchases, (iv) ultimate progress towards a banking union will require relinquishing sovereignty which will be difficult to say the least for 17 proud countries, (v) debt mutualization (shared taxpayer burden of “Euro Bonds”) has not been agreed upon, and (vi) ultimately the European Central Bank (ECB) still remains the “Single Word Score” to intervene in markets to keep sovereign borrowing rates down until the 18th through however many more summits it takes to come to an ultimate resolution to the Euro Zone experiment.

Note: I am sure someone somewhere is tallying the number of 1920s-1930s European debt summits versus today. Those didn’t end well, although a debt jubilee (i.e., mutual forgiveness wiping slates clean) was almost at hand in the early 1930s (if not for extra French demands on Germany which aided in the rise of the, until then, fringe Nazi party to control of the German parliament). A jubilee would be impossible in today’s quadrillion (thousand trillion) dollar derivative-riddled markets (but I digress?).

As political leadership on debt and growth-related policy repeatedly fails to take root, central control has been ceded to the collective “Fourth Branches of Government” (i.e., central banks) around the world to reflate economies and markets. As such, it has become familiar to view reverse psychology repeatedly gripping and ripping stocks and commodities onward and upward on very bad economic data (if not just putting in a short-scaring bid under them as in April and June). That is, “what’s bad is good” for risk assets (minus the wise, grounded bond market) as prospects for central bank intervention increase with bad economic and market data including: (i) weekly jobless claims remaining stubbornly near 400,000, (ii) lackluster employment gains averaging just 75,000 in 2Q12 vs. 226,000 in 1Q12, with more people added to disability roles than the ranks of the hired since 2008 (3.1MM vs. 2.6MM), (iii) U.S. and global manufacturing data slumping, with 80% of global purchasing manager indices in contraction, (iv) Chinese GDP slowing for the 6th consecutive quarter to 7.6% (the lowest since the credit crisis), or (v) the stock market falling below where the Fed thinks it should be as Bernanke believes the Fed has the mandate to create a “wealth effect” by artificially boosting stock prices. Indeed, central bank intervention has been the lifeblood of the post-2008 stock market “recovery.” Therefore, the hope or reality of U.S. QE3, PBOC reserve requirement cuts, British QE expansion, and the ECB easing its historic inflation fighting “cut off nose to spite face” stance via bond purchases, 2 LTROs, and now multiple target rate cuts are pushing stock and commodity birds higher while economies founder.

The wise grounded bond “plane” is telling you something though, and what it is saying is everything is not clear for take off. Market pundits will say there is a bubble in Treasuries, and U.S. equities are the buy of the century because the U.S. consumer is delevering substantially, American companies’ balance sheets are the strongest they have ever been, and U.S. equities are trading at just 13x next year’s earnings when the long-term average is 15x-16x. Then they will be the first to turn around and tell you something else at the first signs of systemic problems,

The reality is U.S. consumers and businesses have been scared into better balance sheets, and it doesn’t mean they are willing or able to spend. These are not average times, so take that P/E multiple down to 10x and see what you get (clue: below where we are now), and we would already be there if not for Fed distortionary intervention. Lastly, how can there be a bubble in wisdom? How can there be a bubble in safety? With a global economic slowdown, a disinflationary to deflationary environment, and large swaths of European sovereign debt markets off limits, where does safe money have to go? Case in point is the the 30-year Treasury STRIP which outperformed all assets last year at +61%. There will be a time when American excess must be paid for and Treasuries are not attractive, but that time is not now.

In terms of our recommendations for these markets, we will detail it in part III of Sleepwalking Towards a Precipice in coming weeks, but in short, we may “rent” equities, commodities, corporate bonds and indeed Treasury bonds (for appreciation not yield), but we don’t “own” things for long in these leaderless “accordion”-shaped markets. We ignore the myriad signals from pundits, take a top-down, theme-oriented view for alternative investments to avoid the vagaries of public markets, and we may imbibe in free drinks on make-up flights for near death experiences. Who could blame us?

Cheers!

• Indian Quarter (April 7, 2012)
• Sleepwalking Toward a Precipice, Part I (February 26, 2012)
• Sleepwalking Toward a Precipice, Part II (June 12, 2012)
• The S&P 500 and the Yen Carry Trade (May 16, 2011)
• The S&P 500 and the Yen Carry Trade: Part II (August 15, 2011)
• The Age of De-Leveraging (January 21, 2011)
• Market Flash: “Everybody Stay Calm” (August 10, 2011)

(c) Cravens Brothers Wealth Advisors
www.cravensbrothers.com/
jleach@cravensbrothers.com
214-234-9464