Through most of the last decade, I answered an interminable number of investor questions about whether the weak dollar would destroy the very foundation of our world. (I exaggerate, if only slightly). Now that the dollar is showing some ballast, we get this: P&G to Apple Hurt by Strong Dollar Keep S&P 500 Profits in Check.
Look, I don’t care which way you fall but someone needs to cry foul when we perceive both a strong and weak dollar to be bad. In reality, we’ve had plenty of bull and bear markets in both strong and weak dollar environments, and in my view dollar direction doesn’t generally tell you much about what stocks are likely to do.
Currencies matter. A lot. But don’t get too far lost in this quagmire when it comes to judging the stock market.
For some years now this blog has argued the inclination to hold the pan European unity project together would be stronger than most believed. Despite ad infinitum and ad nauseum calls for increased nationalization, the Eurozone refuses to buckle just yet. If it will one day die, and it certainly could, it’ll die hard.
Now that it’s Q1 2013, this ought to be stunning to many pundits. Just as global equity markets’ resilience and lack of European meltdown has astounded many investors, too.
Graphic from the Wall Street Journal.
“Anna Schwartz was one of the greatest economists of the twentieth century… Anna had done path-breaking research since the 1930s in assembling the monetary statistics that were at the heart of her three monumental books written with Milton Friedman — “A Monetary History of the United States” ( 1963), “Monetary Statistics of the United States” ( 1970) and “Monetary Trends of the United States and United Kingdom“( 1982). I had the good fortune of collaborating with her on papers ever since; we just finished writing ( with Owen Humpage of the Cleveland Fed) “ U.S. Exchange Market Operations in the Twentieth Century.”
- Anna Schwartz, Pioneering Monetarist – Michael Bordo
Indeed. Her work will have a lasting impact for a long time to come.
So. The Bank of England is offering new liquidity to British banks. My sense is much of the market will interpret this as “this just shows how weak and fragile the system is right now.” But in my view this is an example of why the likelihood of a repeated Lehman-style panic is getting more remote. Ostensibly, the BOE’s plan is to help with things like household lending and consumption in the UK , but in reality this is probably about creating a ballast in case everything goes haywire on the continent and the euro breaks up.
One of the governing principles of this blog is: markets are pretty darn effective discounters of the widely known, believed, and feared. This isn’t just about pricing stocks into the future; it’s also how capital markets work. This event, rather than showing weakness, is instead another example of capital markets moving ahead of potential problems, ballasting them before they happen. This was not the case for Bear/Lehman/AIG, etc.—markets were not expecting those events and hadn’t braced for them. But they are bracing now. This is the nuts and bolts of the process of markets anticipating widely expected outcomes and therefore something else happening, in my view.
Note: equity markets rallied last week, with leadership in Europe.
A great rule of investing thumb is to look where others aren’t looking—what’s widely focused on is already largely contemplated and priced into capital markets. A similar lesson is also often applicable when thinking through public policy and geopolitics.
With everyone talking a potential Greek exit from the euro…
A Greek Euro Exit Could Be Worse Than Expected – Michael Sivy, TIME
…look the other direction: how might the European Union move toward greater federalization?
What Exactly Is a ‘Eurobond’ Anyway? – Catherine Boyle, CNBC
I don’t have any clear view on how all this plays out either way, but don’t get caught focusing on all the same things everyone else is—in politics and in markets, the path to many outcomes is seldom explicit, and often counterintuitive. It should not surprise in the least that a potential outcome of Eurozone break-up talk is the opposite—greater federalization and less direct democracy.
This blog has maintained Europe will be weak for the foreseeable future, but won’t catalyze a new global recession or bear market in stocks. (Though, in my view, it’s best to tread ballet-toe-lightly with sovereign bonds).
But there’s a big difference between saying Europe won’t cause a global meltdown and saying Europe will soon fix its ills. The very notion—treaty or otherwise—Eurozone countries will soon resolve all their deficit problems is laughable.
Italy puts back balanced budget goal by a year – Giuseppe Fonte, Reuters
Interest payments will cost the government 3.1 percent of gross domestic product this year, according to Office of Management and Budget and International Monetary Fund data compiled by Bloomberg. That’s down from 4.8 percent in 1991, the highest in the past 50 years, during George H.W. Bush’s presidency. Since 1980, the only incumbent with a lower ratio than Barack Obama was George W. Bush in 2004.
I’m as for fiscal restraint as anyone, but as this blog has maintained for awhile, the notion the US is headed for imminent ruin tied to the deficit/debt simply isn’t true. With interest payments heading down, and near lows, insolvency isn’t on the table—heck, it’s not even the campaign issue it once was.
I’m not a fully-fledged contrarian, and never have been. But smart investors must constantly ask themselves what’s already reflected in market prices. Because, if the thing you fear is already reflected in prices, that leaves a lot of room for upside surprise. A year ago, a euro breakup seemed impossible. Now it’s…inevitable? You be the judge:
Bogus Bailout: Why Europe Isn’t Off the Hook – Charlie Gasparino, NY Post
The Euro Zone Needs A Bigger Bazooka – Jason O’Mahony, MarketWatch
Survival Of The Euro Depends On France – Michael Sivy, Moneyland
Euro Crisis: Doubting ‘Domino’ Effect – Edward Lazear, Wall Street Journal
Achilles’ Heel of the Eurozone – Dimitri Papadimitriou, Los Angeles Times
Why We Can’t Escape the Eurocrisis – Gerald O’Driscoll, Wall Street Journal
Europe’s Doomed, Doomed I Say – Felix Salmon, Reuters
Is Greece Just Bluffing to Get a Better Deal? – Cyrus Sanati, Fortune
What Will China Demand to Save the Euro? – William Pesek, Bloomberg
The Mysterious, Gravity Defying Euro – Kenneth Rogoff, Project Syndicate
Alan Blinder’s recent Op Ed in the WSJ puts his views on the S&P downgrade of US debt about as bluntly and correctly as one can:
Yes, S&P is now telling investors that lending to the U.S. government today is riskier than (it said) lending to Enron was in August 2001, or than buying any one of thousands of soon-to-be-toxic mortgage-related securities was in 2007. If you listen to such advice, you deserve what you get….But many frightened investors moved their money straight into what they still know is the world’s safest asset: U.S. Treasurys. Treasury yields fell across the board—not exactly what you expect from a downgrade. In practice, S&P downgraded itself.
A Tale of Two Downgrades — Alan Blinder
But on his second point, the Fed’s “downgrade” of the US economy (it lowered its outlook last week), a few quibbles.
First, almost like every other widely published economic survey, the Fed’s economic models tend to blow in the wind. Note that, through most of the last couple years, as the economy beat expectations, the Fed’s expectations increased. And then when numbers started coming in weaker recently, they lowered expectations. This is what a behaviorist might call the “trend continuation bias”.
Just as importantly, though, is the Fed’s unique language that it would explicitly keep short rates very low through mid 2013. Blinder believes this is a bizarre attempt to give confidence to markets and the broader economy.
Bizarre, absolutely. (For one thing, keeping the risk-free rate for money at distortedly low levels for prolonged periods isn’t ideal, nor does it inspire confidence.) But I don’t think it’s just about the economy. There’s an ulterior motive: politics. Let’s see, what happens in the next couple years? Oh yes! Bernanke’s boss, the guy who can reappoint him, is up for reelection! By signaling publicly and in no uncertain terms that rates will be accommodative the next two years (theoretically propping up the economy), Bernanke is trying to hold on to his job.
In the modern era of the Fed (which in my view starts more or less with Volker), it’s an increasingly less independent and more political institution. This is more evidence.
The eurozone seems motivated—at least for now—to keep its monetary union together. Therefore, they probably will. Why? Because a sovereign power with enough clout can bend or even make up rules if they need to. Such as:
Now, I don’t know if this particular thing will work or not, but something of its ilk ultimately will.
I’m totally fascinated by how human minds so rigidly cling to society-made rules—be they by government decree or contract—as if manmade laws are some law of the cosmos. They aren’t. They’re just stuff other people made up that we all generally agree to adhere to, which is what allows the world to function. People don’t usually want to think this way because our minds are desperate for rules and patterns—anything we can grasp to make our worlds seem consistent, reliable, organized, predictable. We don’t want anarchy, we want stability. So we believe in the power of rules and norms. Our brains are so tightly wound into this notion it’s rare we stop to think or question them. But that doesn’t apply so much with hugely powerful sovereign entities.
This perspective is the key to understanding why it’s very likely the eurozone will find a way out of this thing.
I’ve by now read scores of in-depth, complex analyses from the best economists and analysts in the world about the PIIGS situation—what are the possible parameters and solutions to get out of this mess? All these scenarios get laid out about what the ECB, or eurozone extant, can do given the current rules. But the parameters as they exist today don’t necessarily absolutely have to apply.
My take on situations like these is that very big and powerful sovereign systems ultimately just make up solutions when motivated and have enough power to impose their will. The solution to the PIIGS situation won’t likely be had from rigid economic/accounting/mathematical analysis. Someone will come up with a creative solution (remember Brady Bonds?): a different way of shifting numbers around on ledgers, of interpreting an existing rule, or something else entirely, that will make things seem solvent, in a way participating members (and in this case ratings agencies) will accept or be coerced to accept (moral suasion).
The only constraint is whether those in power go so far that others lose faith in the system. That’s the tightrope: it’s the appearance faith and stability, not the rules themselves that matter. The rules are bendable, and can actually be bent pretty darn far before faith is fully lost. And a solution most folks can live with will likely be found for no other reason than the will to find a solution exists at this level of power.