The dog days of summer are upon us. We all have different ways of marking our seasonal calendars: my own “dog days” typically kick in after the July 4th holiday and the Wimbledon tennis finals, knowing that the next combination of a long weekend and Grand Slam tennis tournament will come in early September with Labor Day, the US Open and the new energy that anticipates autumn. Between now and then it’s all about the heat and humidity that define summers along the languid byways of the Chesapeake Watershed Region.
Investment markets seem to be feeling the heat as well – heading upwards for several days and then listlessly falling back like a Metro passenger dealing with a broken escalator in the midday sun. Even the renowned 3:30 Club has been somewhat muted of late – while we have had our fair share of 1%-plus days, we’ve seen fewer of those extreme lurches at the end of the trading day when the computer algorithms kick in with their hairtrigger buys and sells. Maybe the algorithms, too, are kicking back at Bethany Beach or casting their flies in the Savage River…
The major variable heading into the next couple weeks is the onset of corporate earnings season, kicking off as usual with Alcoa’s announcement after today’s market close. Investors will be interested to get more data points to help them sort out all the conflicting signals in the economy. Earnings surprises on the upside will add more weight to the default hypothesis that we are not headed towards the precipice of an imminent double-dip recession, and the consensus sentiment seems to anticipate this being the case. Of course, “surprises” in the earnings world are a double-edged sword, and early signs of stress by redoubtable market heavyweights like GE or Intel could set a negative tone for the season.
Over the course of this year to date we have characterized the global economic recovery as a series of “fits and starts”. Earlier in the second quarter there seemed to be more starts than fits and the US appeared to be gaining traction in shoring up global growth. The intensifying problems in second-tier European nations back in May raised the specter of more “fits” given the implications of solvency problems in the Eurozone for the US as well as the global growth engines of China, Brazil and India. Observers of macroeconomic policy are stuck between the rock of unsustainable deficits and the hard place of unbudging unemployment, underemployment and falling incomes. And thus the listlessness and indecision that bedevil the markets as moist droplets of hot air shimmer above the Potomac River.
Robust earnings could indeed stir the market out of its torpor and provide some direction, but we think there is an equally plausible case to make that the fits and starts may continue to contain any bull or bear tendencies from breaking out too decisively in either direction. Maybe it’s just the effect the dog days have on us, but we see the opportunity for sluggishness to continue being the market’s defining characteristic.
For the last month or so the market has exhibited two qualities: volatility and aimlessness. After another drop of more than 2.5% today the Dow and the S&P 500 were back to roughly their lows of May, when they first entered technical correction territory from the cyclical highs reached in April. Based on the trading patterns we’ve seen during this period it is clear that anything could happen tomorrow - daily gains or losses of more than 2% seem to be a fixed piece of the firmament. We always tell our clients to put little stock in the vagaries of the short-term and all the more so when the wild ways of the 3:30 Club hold sway. But there is also, we think, something of a deeper nature going on here - something, dare we sound so French? - philosophical. A philosophical dilemma, actually, with two diametrically opposed schools of thought about how we get out of our economic predicament.
Call these opposed schools of thought Team Krugman and Team Merkel. Reader’s of Princeton economist Paul Krugman’s New York Times columns know what he thinks needs to be done: increase spending via stimulus programs to ward off the dreaded Return of 1937. 1937 was the year when - in Krugman’s telling - a four year run of growth from the depths of the Depression was choked off by a premature return to austerity measures targeting deficit reduction. Because the austerity measures directly hit the incomes and jobs of working Americans they killed off the incipient seeds of organic growth and sent the country back into a deflationary spiral that only ended with the onset of wartime spending. Krugman’s point - and it is a compelling one supported by history - is that choking off a recovery is ultimately not going to help lower deficits - it will not only increase deficits but also increase the misery of unemployed, barely employed or hanging-on-by-a-thread employed Americans (or, for that matter, the good citizens of the battered Eurozone).
Despite the intellectual rigor of Team Krugman’s arguments it is the other side, Team Merkel, that is winning the war of words in the estuaries of public discourse. German Chancellor Angela Merkel has fast become the global face of the deficit hawks, whose main argument is that, figuratively, you don’t cure the drunkard by pumping more booze into his system. In this metaphor the bond market plays the role of the drunkard’s wife: for awhile she goes with the flow and supports him because there seems to be no better alternative (read: 10-year Treasury yields below 3% and the 2-year at historic lows below 0.6%). But eventually she’s going to reach her limit of tolerance, get up and slam the door on her way out - Treasury yields soar through the roof because nobody thinks of Uncle Sam as a risk-free investment any more. Catastrophically high interest rates in turn make a deficit crisis a deficit Armageddon, and so it goes.
The problem - and thus the “exquisite philosophical dilemma” of our title to this posting - is that there is a reasonable case to make that the road to meltdown could lead through either of these scenarios - the premature hijacking of a recovery or the toxic effects of adding flames to the fires of insolvency. Very few people in the world share the absolute certainty of conviction that both Paul Krugman and Angela Merkel display in the correctness of their respective positions. That makes all of us nervous and uncertain, which is the time-honored recipe for extreme market volatility.
Here at MVCM we generally think of ourselves as unbeholden to rigid ideology. After all the essence of our investment philosophy is the “chaos of wisdoms” - no one answer is right and we try to distill clarity from the complex ecosystem that is the global investment world. Much more is at stake here than who wins the battle of words and arguments - and we hope that prudent discourse will lead to prudent policy actions and calmer markets. But that calm is hard to discern today.
The week began on a sour note, adding to last Friday’s 324-point selloff on the Dow as the 3:30 Club knocked another 115 points off the index today. The return of volatility has been a generally negative story for global risk assets, most of which are considerably down from where they were at the beginning of spring. The world’s safe havens are playing their time-honored roles in the investor pantomime, with gold prices at 12-month highs and U.S. Treasury yields at 12-month lows. Both the dollar and the yen are sharply higher versus the euro - in roughly equivalent amounts, in fact, as the current dollar/yen rate of 91 is roughly what it was at the beginning of the year.
The yen’s relative strength is not helping Japan’s fragile economic recovery to gain traction: capital expenditures are coming in lower than expected as businesses contemplate the effects of lower exports to Europe (currency and demand weakness) and China (where financial tightening is having a broader effect on spending activity). As the annual rainy season gets underway in Tokyo investor moods were likewise gray and dour with the Nikkei 225 registering a 3.8% drop to close at 9520.
The overarching narrative in financial markets has not really been focused on Japan, as other stories of more immediacy have crowded out precious front-page media real estate. Subprime mortgages in 2007, Wall Street’s fallen masters of the universe in ‘08, the recovery of ‘09 and now the EU debt crisis have been the successive stories of the day. THat may change, and in my own opinion there is a better-than-average probability that the $5 trillion economy with a debt/GDP ratio of 197%, chronic deflation and the worst demographic outlook of the developed world is going to have its day on center stage.
If nothing else Japan offers a sobering case study for equities market analysis. On December 31 1989 the Nikkei index reached its all-time high of just under 40,000. That was 21 years ago. Today the same Nikkei is valued at less than 25% of that high-water mark. That is an astounding data point. In the wake of the Great Depression and Second World War it took the U.S. stock market about 25 years to recover its high-point value of 1929, but by 1937 it had recovered about 50% of that value and survived the most turbulent crises of the 20th century before resuming its long-term upward climb. There is simply no precedent in modern securities markets for an economically mature country’s stock market to sustain as bleak a long-term picture as Japan’s does. “Stocks for the long term” is the investor’s mantra, but that mantra has one large glaring elephant in the room that cannot be ignored.
The curious case of Japan’s stock market is going to be the subject of an upcoming in-depth research piece. As for the remainder of this week, keep an eye on the bond market data points in Europe. Belgium had a rather flaccid auction of 10-year bonds that generated some market chatter about the “Greece of the north” - an unwelcome moniker to be sure. We’ve been talking about Hungary for some time now in our commentaries, and this week has Budapest back in the news. No rest for the weary indeed.
“It is a question of survival” intoned German Chancellor Angela Merkel upon announcing a ban on naked short-selling in Germany and driving home her support for still-tougher regulatory measures to bring stability to financial markets. Merkel went on to denote the current crisis facing the Eurozone as the single largest economic challenge facing Europe since the Treaty of Rome in 1957 marked the Continent’s postwar journey towards economic and monetary union. Markets did not take kindly to the German leader’s words, continuing the negative tenor that has characterized the past several days and extending the roller-coaster volatility that has become the norm since Greece’s debt woes boiled over and sent markets into a tailspin on May 6. The move casts a spotlight on the relationship between the EU and its largest member with the most economic influence.
The Greek debt crisis has made clear what has long been at least tacitly acknowledged by observers: the EU is less a monolithic entity than it is a collection of sovereign nations with very different economic structures and prospects. These different structures are the result of decades-long traditions of domestic economic management with conservative, inflation-averse Germany on one end of the spectrum and the more inflation-prone, cyclically volatile economies of the likes of Italy and Greece on the other. The Bundesbank, Germany’s national central bank, is a byword for monetary prudence whose policies throughout the postwar period ensured the Deutsche mark’s unassailable position as the anchor of EU stability. The Bundesbank’s postwar mandate, after all, was established when memories of the disastrous hyperinflation of the Weimar Republic – and the even more disastrous descent into the Third Reich that followed – were fresh and raw in the minds of Germans. Although those days are now thankfully distant and far-removed from the present, German economic policymakers have never lost their intense abhorrence of the slightest hint of loose money and the specter of inflation.
Chancellor Merkel’s announcements today were unilateral – the ban on short selling and other measures addressed represent a singular German position and were not put on the table for consultation with its EU partners, many of whom voiced annoyance and concern in published comments today. Merkel, of course, has to heed the vox populi of her German constituents as well as coordinate policy with other national leaders to contain the ongoing crisis in the region. That’s proving to be a difficult balancing act. In announcing dramatic liquidity measures last week the EU provided temporary relief from the specter of outright debt defaults by weaker EU sovereigns. It did not, as we noted at the time (see our 5/11 commentary piece “Volatility: The Sequel”) ensure any measures for a return to solvency among these teetering economies nor a solution for saving the Euro itself. For the Germans, saving the Euro is exactly that “question of survival” referred to by Angela Merkel. For the Germans the Euro is what the Deutsche mark used to be, and history has shown that this nation takes its currency seriously. That may be good news in the end for the integrity of what is collectively the world’s second-largest economy, but for now the rough waters are not going away.
The news of this Monday morning could be seen as a brief vignette for the tenor of the year as a whole. In the US another set of data points supports a positive market case that seems to be getting better by the week - the “fits and starts” theme is starting to run the risk of lacking any “fits” at all. Consumer spending enjoyed another strong uptick, and given that income growth was more subdued it seems that our never-say-die consumers are dipping into their savings (which at 2.7% represents a low for the year). Another notch in the ISM manufacturing sector index takes this above 60 and marks the 9th straight month above the critical 50 level.On the other side of the Atlantic a different mood prevails. Although the €110 billion bailout agreement for Greece cobbled together over the weekend puts any day of reckoning off beyond the 19th of May, when Greece’s next debt payment is due, the package leaves little about which to be optimistic down the road. My advice: watch the spreads between bond indices of the European majors, in particular Germany and Italy. Any hint of a bloodbath among other second-tier Eurozone countries (like Portugal or Spain), or collateral damage in the non-Euro accession countries like Hungary that are teetering on the edge of the precipice, will likely create a widening rift between Germany, the Continent’s most solid credit by far, and Italy, which is at risk of being dragged into the vortex if containment gives way to contagion. So for now it’s all about apple pie and US equities, and this may be the tone of things for some time to come.