The Paucity Of Hope

By Monday there will have been a real shift in the political landscape in Europe

By Peter Tchir

In Greece, there is a real backlash against the alleged bailout.  The bailout was never about Greece.  In the end, with PSI, it wasn't even about the banks.  It is some convoluted concoction brought about by the arrogance of politicians to admit they were wrong, "legacy" preservation, hubris, a complete lack of understanding of credit markets, and an inexplicable aversion to contemplating and exploring all actual possibilities. This could become disruptive as stances taken by the ECB and IMF will likely be attacked, rightfully so.  The decision to accept so much debt in an effort to recapitalize four failed banks will also be questioned.  In the end, hopefully the people will win concessions and have a more optimistic future.  Hopefully the ECB will get off its high horse and accept losses on their decisions.  With a balance sheet as bloated as theirs, they have plenty of "carry" to pay for those losses.  Maybe the IMF will stop pretending Europe is different and treat European nations like other countries where they have actually helped - but that help almost always forced the nations to restructure rather than pretend somehow that all will get better with the existing debt burden. 
 

The direct consequences of Greece will have minimal impact on the markets.  It is small, and at this stage, such a mess, that disruption there will be largely isolated.  How the ECB reacts to demands that it take losses could flow into the broader markets.  If the Troika backs down on their "austerity" demands then we would likely see a reaction in the broad markets.  Most importantly will be the discussions surrounding Greece leaving the Euro.  If that becomes an open debate, then that has the potential to roil markets since so far the politicians have managed to deny it is a real option.  The impact won't be felt because of Greece leaving the Euro, it will be the speculation that other countries may follow.  The rhetoric and crazy sound bites that would come from this could provide weeks of entertainment and opportunities.
A Hollande victory is not just a shift in France, but a warning shot at Germany.  Merkel's direct support of Sarkozy seemed unusual and a loss for him has to impact her.  Whether she loses some power at home is debatable, but her ability to dominate the direction of the EU will have taken a severe blow.  That may turn out to be more important to the future of Europe than the change within France as significant as that is.

So, Europe is about to begin its "Audacity of Hope" moment.  I'm not sure how markets will react on Monday to the various results.  My best guess is that after an initial sell-off we see a rebound.  European politicians will start to say the "right" things about working with the new governments.  "Growth" will be the most commonly used word.  Equities “LOVE” growth. If there is one thing equity markets love, it is the talk of growth, stimulus, of more money being spent.  I think the equity markets will get sucked in.  Credit markets might get dragged along for the ride, but only reluctantly, as saying "growth" is far easier than achieving growth, especially if you actually account for the debt added to pay for that "growth".

That is the key.  Why is everyone so willing to believe Europe can achieve growth?  Let's assume that no one ever tried for growth before (though seriously, most policies implement in past 15 years had growth as at least part of the rationale).  What experience does Hollande have in creating growth?  If growth opportunities are so easy to spot and identity why do we pay 2 and 20 to hedge funds and private equity?  Why are venture funds so valuable if any group of people, with little business experience, can sit around parliament and just figure out how to create growth?  Why pay CEO's 10's of millions if not 100's of millions of dollars, if growth is so easy to create?

That is the harsh reality.  Identifying opportunities just isn't that easy.  Figuring out what projects will generate returns that pay for themselves is difficult.  A political body with many competing agendas is hardly likely to do better than companies whose whole goal is to find growth opportunities.  Corporations have no shortage of cash right now, they have a shortage of growth ideas.  If governments handed out €100 billion to its citizens or cronies, then we would get growth.  Without a doubt, GDP would go up.  But if GDP goes up by only €50 billion, what has been achieved?  NOTHING!  The country will just have more debt relative to its capacity to pay it back.  More time and energy wasted while capital is once again misallocated.

"Growth" which is really just code for spending, will be a failure.  The credit markets will see it sooner than equities, but equities will eventually see it too.  Saying you are going to become an actress is really easy.  Moving to L.A. in an effort to become an actress is a bit more difficult but still relatively easy.  Becoming an actress is really hard!  What is the percentage of people who move to California with dreams of becoming an actor/actress actually become one?  Judging by all the great looking waiters and waitresses who suck at their job but have huge attitude, I'm guessing the percentage is low.  The success rate of growth will be low too.  It's not easy.  But worse than that, once actual plans are announced, the markets will realize how feeble the attempts are.

Growth won't buy years.  It might not even buy months.  Like so much else through the entire crisis, the markets are willing to suspend their disbelief on the back of attractive headlines.  In the end, the actual plans disappoint.  Not because the politicians aren't good at making plans, but because the original announcements never had a chance of being implement and the suspension of disbelief (or critical thinking) was the market's real mistake.

The Paucity of Growth

If growth could be created by merely talking about it, we would be in great shape.  But it can’t and the data last week showed that conclusively.  The U.S. ISM Manufacturing report was about the only bit of economic news that hinted at any positive growth trends.  The equity markets decided to latch on to that report and ignore all the other evidence that growth was slowing.  

European data was disastrous, at best.  PMI data was awful across the board.  Rising unemployment is making it ever more difficult to extricate themselves from the mess as the ratio of tax payers versus tax receivers deteriorates.  Data in China wasn’t much better as much of the data showed the slowdown in growth was continuing (as I wrote earlier this week, I remain a bit confused how data can be showing contraction for 6 months running, while still achieving 8% growth).  The U.S. data missed almost across the board, but somehow, ISM and jobless claims were enough for the bulls to latch on to.  Friday’s NFP data was the straw that broke the camel’s back.  It was a big miss.  To me, it was a disturbing report across the board.

1. Upward revisions to prior month jobs means the slowdown is accelerating
2. If that many more people had been employed earlier this year, the bounce in housing and other parts of the economy was even more disappointing
3. People continue to leave the workforce, yet programs such as disability and food stamps continue to grow in size

I couldn’t understand the market’s initial reaction, though by the end of the day, the move seemed a bit overdone.
This week’s data calendar looks relatively “austere”, so the debate will largely revolve around analyzing and interpreting old data, rather than reacting to new data. 

Central Banks – Reduced to Managing Expectations?

For all the talk, for all the press conferences, for all the re-assuring words, it is starting to look like central banks are on hold.  The Fed seems on hold.  The data this week wasn’t that bad.  While it wasn’t good enough to support stocks with the S&P at 1,400, it wasn’t bad enough to warrant putting QE3 on the table.  Finally, after almost 5 years of free money (the Fed was aggressive and using alternative measures as early as 2007), there is real discussion about what the policy is achieving.  For awhile, the only argument that prevailed was “it would have been worse without these policies”.  But finally, people are starting to ask the right question.  “Would we be better had we adopted different policies?”  The squirrel and the grasshopper question is finally being raised away from just the “blogosphere”.  The Fed and government policy has been to ensure the least amount of pain in the near term.  Those decisions have consequences that affect the long term.  We still seem to get away with an immense debt load, but even here, prior spending decisions are limiting future ones.

This growing debate is making it more difficult for Ben to do what he wants, and in spite of a relatively unified front presented by the Fed, dissension within it seems to be growing, at least in their private conversations.

The Fed, definitely willing to print money if necessary, is largely on hold, and each passing day, the hurdle rate of how bad the data needs to be increases, because launching a new program too close to the election would make even more people question the independence of the Fed.

Meanwhile, in Europe, Draghi seemed to have more room to maneuver.  Banks and a large number of politicians are clamoring for more easing.  He didn’t deliver.  He was actually relatively hawkish.  This is really important.  To me, it is a strong signal that behind the scenes, the roll of the ECB is being questioned.  Their portfolio of Greek bonds complicated the Greek bailout.  For as much as people thought SMP was a good idea as the ECB was buying Greek bonds, it turned out to be a major problem at crunch time.

The ECB had encouraged banks to buy the debt of their own countries.  That is starting to backfire, and is forcing many banks to turn to the ECB for more money.  Private investors look at bank balance sheets over-exposed to certain countries and sectors, run by bankers under pressure from the ECB and politicians to take actions they wouldn’t otherwise take.  This is restricting private sector lending to banks.

I believe that just like with the Fed, there is growing disagreement, within the ECB and from outside, about what policies should be pursued.  For the first time Draghi did nothing, not because it wasn’t within his power, or because he didn’t want to, but because powerful people are telling him to do nothing since it isn’t so clear his policies have done much good in the long run.

The Joy of Victory and the Agony of Defeat

With so many moving parts, my guess is that we will experience some brief “Audacity of Hope” rally.  The change will be good.  Germany will say things to make people feel better.  Hollande will make growth so easy that the European crisis will seem like a distant memory.  Then the stark reality will hit.  Economic data will point to continued weakness.  The debt burden will still be a problem.  Then, finally, talk of growth will just not translate into actual plans for growth.  Any attempt to give real examples of how to grow will be weak and pathetic.  Will the big plan be lending money to the EIB so it can lend money to green energy projects owned by Hollande’s friends?  Will that be the growth we get?  Sadly, it probably will be what comes out.  Growth is not easy to get.  There aren’t 100’s of 1000’s of AAPL’s out there, because growth, net of the costs, is a difficult thing to achieve.

Will Friday’s weakness continue into next week? Will it take longer for the “growth” headlines and rumors to counteract the move?  Will that spark a real long term rally or just a couple of days of short covering and sucking in underperforming markets?

These are all questions that need to be watched closely.  I think the rally will occur sooner than people believe, that it will be far more isolated to stocks than bonds (even of Spain and Italy), that it won’t be as strong as bears fear, and the concept that growth pacts can save Europe won’t last until the end of the week.