The Euro-Turkey - Analyst Blog
While the U.S. was focused on feasting, football and shopping, the turmoil in Europe continued. The situation there continues to deteriorate. No longer are the problems confined to the small, relatively insignificant economies around the Mediterranean. This week, they even spread to Germany, where a bond auction failed disastrously.
Since November 9th, the yield on the 10-year Bund has climbed from 1.72% to the current 2.26%. Worse, that sharp rise in bund yields did not result in a significant closing of the spread between what Germany has to pay and what the rest of Europe has to pay to borrow. The only exception is Italy, but the absolute rate there is back above the critical "point of no return" level of 7.00%.
Belgium fared the worst over that time period, as it was hit with a bond rating downgrade. Geographically, Belgium is part of the core, but if one looks at its fiscal and political situation (it has been with out a real government for almost two years now) it seems to have more in common with the periphery.
That rise, however, has only stiffened the resolve of Germany's Chancellor Angela Merkel against taking any steps that would really address the problem, particularly in the short term. There was a summit between her, French President Nicolas Sarkozy, and the new Italian PM, Mario Monti. The outcome? Sarkozy agreed to shut up about any criticism he might have about the path that Merkel is intent on forcing Europe down.
That path? Severe punishment of any country that runs significant budget deficits. More austerity on top of the austerity that is already forcing the continent into another recession. "No" to any more involvement by the ECB or the development of Euro-bonds.
Her path would lead greater fiscal integration in Europe, but achieving that will take time. The treaty that created the Euro-zone and indeed the one that created the European Union would have to be substantially revised. To go into effect, those changes would have to be ratified by every single member of the Euro-zone, and in many or if not most of those countries, such a ratification would have to be done by referendum, not simply by a vote of Parliament. It would be amazing if that could happen in months, but the markets are not going to wait around for months.
In the best case, it seems like the continent has weeks, if not days. Given that the revisions Merkel seeks to the treaty would offer (at least in the short-to-medium term) nothing but pain and poverty to the members on the periphery, it is hard to see those populations rallying to the cause to ratify the new treaty, ever, let alone in just months.
Democracy can be a messy thing. For now, the Greeks and the Italians have tried to side-step that by installing new "technocratic" governments, headed by people who have no desire for extended runs leading their countries.
The Germans are terrified of inflation for historical reasons, and the ECB has proved to essentially be an extension of the old Bundesbank. However, a little bit of inflation would be useful at this point in facilitating the adjustments that are needed between the countries of Europe.
In real terms, countries like Greece have to become more competitive relative to countries like Germany. Prices have to go down in, say, Greece or Spain, and/or up in Germany. Brining prices down means deflation, and deflation means very slow -- or in most cases negative -- growth, very high employment and even more trouble servicing the debt.
Making the adjustment would be a lot easier if, say, inflation were 1% in Greece and 5% in Germany, than it would be to try to do so with 0% inflation in Germany and -4% in Greece. Inflation would also slowly erode the real value of the debt and make it more likely that it would actually get repaid in nominal terms.
What is clear is that the interest rates in the periphery right now are far higher than the growth of nominal GDP is likely to be. That means that the debt-to-GDP ratios are getting worse, not better, even if the country can manage to run a balanced budget before the effect of paying interest on the debt (run a zero or slightly positive primary surplus). This is particularly true if the existing level of debt is high relative to GDP as it is in most of the peripheral countries.
The yield curves in most of those countries are already inverted (short rates higher than long rates). Thus, the countries don't really even have the option of just trying to borrow short term. Also, keep in mind that an inverted yield curve is one of the most sure-fire predictors of a recession around the corner.
Meanwhile, at Home and Elsewhere...
Not all the action was on the far side of the Atlantic, though. We did have three days of full trading before the feast, and a half day after. Bulls did not have a lot to be thankful for as they sat down at the table. For the week, the S&P sank 4.7%, bringing the total decline since November 8th to 9.2%. Some of the reasons were domestic, but mostly it was international developments.
In addition to the problems in Europe, the Chinese PMI fell below the "magic 50" level, indicating an actual contraction there. While I doubt it means that the Chinese economy overall is shrinking, it could indicate that growth there is slowing more than most people expect.
Swami Dirk's Self-Analysis
It seems clear to me that my long standing target of 1325 on the S&P 500 at the end of the year is not going to be hit. I'm not going to play the game of changing it now and being able to claim that I was more accurate than I actually was.
After the drubbing of the last two weeks, we would need a rally of 14.4% to hit my target, and with just a month to go, it seems unlikely. From current levels we would need to rally 8.5% just to get into the black for the year. Not being positive for the year is extremely unusual for the third year of a Presidential cycle.
On the other hand, stocks are extremely cheap, and do seem to be pricing in a lot of the bad news. Thus, I simply consider my target to be pushed back, not wrong.