Risk markets are losing their patience. The Eurozone situation is approaching a major climax. This is by far the most important story to follow in the coming days and weeks. U.S. Economic data has been quite encouraging and the economy remains muddling along. If Europe took care of business quickly (a huge early Christmas gift for the bulls), global stock markets would rally sharply. The S&P 500 could possibly make a run at the bull market highs.
Unfortunately, there is a major ongoing political crisis in the region. There are 3 options.
The first option, which would entail a fiscal union and Eurobonds, seems to be out the window at this point. Merkel again rejected calls for Eurobonds and insisted on treaty changes as a first step. The probability that 17 parliaments could pass German requested amendments is quite low. As I have stated all along (section 2), I remain dubious on the hope that sovereign nations such as Greece, Spain, France, and Italy are willing and politically able to cede their sovereignty to what would clearly be a German-mandated supranational organization. It would be like WWII all over again, only this time perversely legal. There is little political appetite at this point. The second option entails the ECB monetizing the debt. My issue with the ECB printing, is that it would open a Pandora’s box over the long-term. In my eyes, if the central bank were to print, it would represent a stealth and dangerous commitment to fiscal union without the consent of the governed. Liabilities would be shared. German-mandated austerity programs would continue and the recession would grow deeper. This environment would begin to create significant animosity amongst these nations, possibly ending in armed-conflict. This post drives my point home. No doubt that if they printed we’d see a powerful rally in risk markets and the bears would get run over. I would significantly pair back bearish winners and initiate a few more bullish positions in commodities. But, the solution would prove only to be ephemeral in my view. The final option is a disorderly break-up and reorganization of the Eurozone. This option is becoming seriously probable and poor market performance suggests that investors are beginning to price-in what was seemingly impossible only a few months ago.
The other increasingly significant problem is China. Recent manufacturing PMI data showed that the sector is contracting at its broadest pace in more than 30 months. Signs of falling housing prices are more widespread and public protests have intensified. To make matters worse, the political leadership in China doesn’t seem to be loosening monetary policy as quickly as the bulls would like. They remain committed to tempering land prices. The chorus of “bank-crisis warnings” grows louder and export orders sank markedly in October. I’m paying keen attention to the charts at this point. Copper and the Shanghai Index have rolled over and are within striking distance of the their lows (the Shanghai Property Index is at its lows already). As I said here, if those markets break down, I think we’ll follow. Remember that the global recovery hinges on China, thereby I see the country’s stock market and copper as leading indicators.
Finally, it’s important to keep an eye on geopolitical risks. Tempers have flared as of late and the situation is very tenuous in the Middle East. I believe that oil markets have been pricing in a risk premium from these developments. I remain surprised at how little it has been covered in the mainstream media though.
Like I said before, the bullish case is appealing. Valuations are very tempting for stocks. If analysts earnings estimates were correct, the market would already be discounting a mild recession. Furthermore, you have a U.S. economy that continues to chug along despite weakness in the global economy. I will admit, I’m quite surprised at its continued resiliency. The clear dichotomy between consumer confidence surveys and actual retail numbers remains intact. Consumer sentiment surveys are in recessionary territory, yet consumers keep spending. They are learning to live with these conditions it seems. Transportation metrics such as the American Trucking Association’s Truck Tonnage Index and the American Association of Railroad’s Weekly Rail Traffic Report show a manufacturing sector that remains in growth mode. Looking at the GDP data, we may be setting up for a renewed wave of inventory building. Companies are lean as jobless claims are near 390,000 (correlations between equity markets and jobless claims is very strong). The data keeps telling us that the recovery continues and in fact may be accelerating according to the Conference Board’s U.S. Leading Indicator. China’s Leading Indicator is flagging a soft-landing in China.
Overall, the bullish case exists and it’s real. However, international macro headwinds are increasing in strength and are already proving to be too much for the recovery to bear. The S&P 500 just had its worst Thanksgiving week performance since the Great Depression. While the Bulls insist that exports to Europe comprise a relatively small portion of economic activity, I believe that increasing financial volatility, disruptions, and a major financial shock would affect the entire economy, not just the manufacturing sector. Banks would restrict lending and their balance sheet health would be questioned again (it’s already happening). A Eurozone blowup would undoubtably sink the U.S. recovery. The ball’s in Europe’s court and they need to take action. If they act now, it may still be on time to avert a Chinese hard-landing. The bulls would end up as winners and risk assets would make a comeback. It has really all come down to this binary variable in the short-term. Government officials wanted Globalization, well they’ve got it.