Now That's European Unity For You
It seemingly dawned on investors today that something smells bad and it isn't clear whether it is something that is already in the trash (say, Greece) or something that should be put there (say, the U.S.). Faced with this dilemma, investors did the only reasonable thing: they took everything that smelled even slightly funky, threw it out, and took it to the curb.
Of the 27 countries in the EU, 23 of them saw their equity markets decline. In Germany, the UK, France, Spain, Italy, Portugal, Ireland, Finland, the Netherlands, Belgium, Sweden, Luxembourg, Denmark, Austria, Poland, the Czech Republic, Hungary, Romania, Cyprus, Malta, Slovakia, and Slovenia, every single equity index listed on Bloomberg declined; in Greece three out of four fell (Greek midcaps are clearly the place to be, baby! Well, maybe not.). The only ones that rallied? I hope you had your money in Bulgaria, Latvia, Lithuania, or Estonia. Being outside of the EU was no proof against an equity decline either; Russia, Switzerland, Turkey, and Norway sported falling bourses. European solidarity is at last a reality!
The weakness in Europe was fairly easy to trace. German Finance Minister Schäuble (spelled Schaeuble if you eschew umlauts in your daily life) wrote a letter to Bundestag colleagues clarifying some of the murkier elements of the grand plan that emerged last week. For example, he pointed out that the EFSF, which is the entity which is theoretically going to buy bonds to support the market, only can do so when the ECB does an analysis and recognizes "exceptional financial market circumstances," or if there is a "mutual agreement of the EFSF/ESM member states." (Be flexible on the precision of the quotation: this is obviously a translation from the German).
Schäuble also noted offhandedly that the IMF and the ECB expect a primary surplus from Greece in 2012, which is so outrageously implausible that some ministers must have thought they were at a comedy club. He described the €159bln (back to that number again!) bailout of Greece as a 'one off' thing, implying that the 'ring fence' attempt to prevent contagion wasn't really very serious. And he said the crisis is not over yet, which we kinda already knew but scares people when a politician admits it: "it would be a mistake to think that the crisis of trust in the euro area can be solved by a single summit."
Then, of course, we have the U.S. train wreck. The supposed engine of the global economic train may be slipping off the rails again, before we even get to the debt ceiling debate. Durable Goods Orders were weak, turning in a +0.1% ex-transportation versus +0.5% expected. Nondefense capital goods orders ex-aircraft, considered by some economists as a proxy for future business investment, fell -0.4% compared with an expectation for a +1.0% rise. Durable Goods is a volatile number, and one month does not a trend make, but the market needed a break and didn't get it. Later in the day, the Fed's Beige Book also showed that growth anecdotally "moderated" (that is, slowed) in two-thirds of the country.
The S&P ended the day -2%, and never really made any indication that it wanted to try and recover.
And now, the self-adulatory portion of our broadcast:
"It has now happened twice in the last few weeks that equities have blasted off, seemingly on nothing or next-to-nothing, before trading sideways for a couple of days in a moderately disinterested fashion. After the last episode, earlier this month, a final spike was followed by a series of somewhat-alarming slumps to erase most of the surge." - Me, "Readying the Next Bumper Crop of Money," July 20, 2011
I don't usually toot my own horn too loudly, because I don't like it blown in my face when I am wrong, but you have to admit: that was a prescient observation! Every now and then I get lucky.
The headline on Bloomberg throughout the day screamed "STOCKS, COMMODITIES SLIDE ON DEFAULT CONCERN AS DOLLAR GAINS, OIL DECLINES." Well...it is true that stocks slid, anyway. Commodity indices were only down 0.5% or so. I have some sympathy for the journalists; I know it seems like commodities should have slid. But as I keep pointing out, commodities aren't going up because of supply and demand of commodities - in which case, news of slow growth should kick the legs out of the commodity price rally - but because there is an extraordinary supply of money, which keeps rising, and that dynamic keeps the price of dollars (in commodity terms) on the defensive (or, conversely, keeps the price of commodities, in dollars, on the offensive). Actually, crude oil declined today because of large, surprising builds in the weekly inventory numbers that were released, and without the energy complex (-0.9%), commodities were basically flat overall.
As an aside, a number of "inflation protection" funds these days own equities of commodities producers, supposing these to provide protection in the event of inflation. I think these are acceptable investments if inflation stays low and stable, but if inflation rises then these equities will get marked to a lower multiple just like the rest of the market - moreover, since mining expenses will rise with a general increase in prices, it is not entirely clear that commodity producers will capture the lion's share of commodity market gains. With equities generally quite rich, I would be careful about my holdings of commodity producers or ETFs and funds which invest in them. These stocks and funds may well outperform the equity market in an inflationary debacle, but they will very likely underperform commodities and inflation generally, and not provide the protection they are expected to.
Bonds sold off modestly, and 10-year yields are back at 3% even. TIPS outperformed and were roughly unchanged (10y TIPS yield 0.55%). Bonds are perversely doing comparatively well because the chaos that would follow a U.S. default would supposedly lead to ...buying of Treasuries as a safe-haven. Now that is perverse, if even defaulting on your debt doesn't get investors to sell it! It isn't crazy, though, since investors understand (even if politicians and journalists don't) that a U.S. default would be merely technical in nature and a downgrade signifies less for the bonds than it does for the state of the economy (that is, a AAA country has a very rosy outlook while a BBB country faces only painful choices. Frankly, I think we're closer to the latter than the former, but it doesn't mean anything for the bonds, which can always be paid with paper).
Now, trading gets harder. The VIX ended today at the highest closing level since March, so options are no longer a cheap way to play what's going to happen (I still own my puts, though I'm now nervous about my vega exposure). But if equities are going to decline because the European situation isn't as resolved as it was and because there's a possibility of a technical default, then we can no longer necessarily sit and wait for the inevitable pop higher to sell into once the debt ceiling deal is reached. That could happen tomorrow, or it could happen 10% lower from here. When we were hoping and expecting a clean - if unimpressive - resolution to the standoff, we could just sit and wait for the pop. That is no longer an attractive strategy.
So what to do? If the equity pop happens today, I'll still sell it. And bonds are still expensive to virtually any likely medium-term outcome (deflation is just not happening, folks), so I'm more comfortable selling those or putting on curve steepeners even though I know I run the risk of getting stopped out on an equity market flush or a European headline that causes the same. Of course, I remain long commodity indices, and I hold a reasonable amount of cash. Actually, come to think of it I am not sure what would constitute an unreasonable amount of cash!