28 Oct 2011 The Road to Greece
Global equity markets popped yesterday, intensifying their October rally to 15% for the MSCI US Broad Market Index and 21% for the FTSE All World Index (ex-US). The enthusiasm was sparked by two events that equity investors broadly took as good news. European Union leaders agreed on a deal to theoretically end the two-year financial crisis with Greece at its center. And in the US, Gross Domestic Product grew in the third quarter 2.5%, more than was expected and following a 1.3% rate in the second quarter. But while conditions may be improving ever so slightly, the disease remains without serious work for cure.
The road to recovery mapped by Europe’s finance ministers comes in overdue, over-budget and strewn with potholes. Instead of cutting straight through the obstacles of massive debt, they’ve snaked around it, taking the short view by employing excessive financial engineering and leverage. After criticizing US remedies these past two years, European leaders are doing the same and worse.
Similar to the 2008 crisis, Greece will undergo a controlled default whereby banks who own their debt agree to shoulder a 50% write-off of their value. This arrangement is designed to prevent the triggering and payment of credit default swaps on Greek debt. At least two groups of speculators are bailed out by the new road to recovery; credit default writers and banks owning Greek debt. Now European taxpayers will get a taste of what happens when the natural selection process of markets are interrupted by socialist bureaucrats. If that sounds a bit strong, hear the arrogance of Nicolas Sarkozy’s boast of a year ago. “By ensuring that capitalism and the market economy do not become caricatures of themselves, we will save the market economy and capitalism.”
Francesco Guerrera of the Wall Street Journal warns of the longer range issues. He says that by undermining the value of Greek credit default swaps CDSs, “European leaders have created a precedent that will weigh heavily on the market in future crises. While CDSs attract speculators, a lot of banks and fund managers buy them as protection against catastrophe. Paradoxically, the second key element of the Greek plan is a CDS-like instrument for Italian and Spanish debt.”
Yesterday, we got good news at home that the US economy grew more than expected in the third quarter. We also learned that the value of goods and services produced in this country surpassed the pre-recession highs. But it took 15 quarters to do so, which is three times longer than the average for the 10 previous recoveries since World War II according to the Wall Street Journal. Neal Soss, chief economist of Credit Suisse said “the American economy finally has accomplished the recovery and has now entered the expansion, but the growth is clearly too slow to solve the most significant problems the economy faces: jobs and getting the public budgets under control.”
Companies increased purchases of equipment and software. The consumer also stepped up purchases significantly. Unfortunately spending came from savings and perhaps new debt as consumers suffered the biggest drop in incomes they have seen in two years. Declining incomes combined with weak confidence and high unemployment bring into question the sustainability of their part in economic growth.
Consumer confidence reported this week is at its lowest point since December, while expectations are at their lowest point since the recession. The consumer confidence index fell 6.6 points in October to 39.8 with the current conditions component down a sharp seven points to 26.3 and the expectations component down 6.4 points to 48.7.
The declining value of homes has not been constructive for consumer confidence. The best hope is that the declines are slowing. Case-Shiller data released earlier in the week show no change in the adjusted composite-20 index for August. The unadjusted reading, at a very weak 0.2% compared to 0.9% and 1.1% in the two prior months, indicates prices are still declining somewhat because the monthly readings are three-month averages.
Because of lower prices, new home sales jumped 5.7% in September. The median price of $204,400 fell 3.1% in the month for the third time. The annualized rate of 10.4% is the steepest since the recession in early 2009. The average price of $243,900 is down 3.9%, also for the third month. Annualized contraction is 9.9% and is also the steepest since the recession. The South and the West accounted for the bulk of the sales.
Don’t look to the special congressional deficit-reduction committee for any near-term good news either, specifically in the area of revamping the massively complicated and growth-inhibiting US tax code. According to the WSJ, as the Thanksgiving deadline approaches, some lawmakers from both sides of the aisle have started to view tackling a full rewrite of the country’s myriad tax laws as too challenging, especially coupled with the larger mandate of trimming at least $1.2 trillion from the federal budget deficit over 10 years.
On that front it appears the same tired divisions exist. According to the WSJ, Democrats offered a $3 trillion deficit-reduction proposal that included $1.3 trillion in increased taxes, which was dismissed by Republicans. The GOP’s plan to cut about $2 trillion from the deficit over 10 years was rejected by Democrats because it raises far less in revenue, taxes and fees.
If these guys don’t credibly deal with the outrageously large US debt and US deficit, another downgrade of Treasuries is not only possible, but likely. There is no way to prepare for that likelihood, just as there was no way in August. There are no alternatives to US debt at the present time. Perhaps that fact is what perpetuates the arrogance and stubbornness in Washington. Unless we address the core problems in this country of debt and entitlement, we will become more like Greece with every passing year, and the developing world led by China will eventually become our reluctant and demanding rescuers. If there is still a silent majority, it’s time to wake up and elect leaders who have the guts, statesmanship and complete lack of political ambition to deliver the cure.