You know things are not normal when a 4%-5% movement in equity markets looks routine.
I’ve been a bit surprised that it has taken investors this long to get the memo that the prospects for the economy (both domestically and internationally) are lousy. The stunning US GDP revisions of last month should have been a wake-up call, but they seemed to be swamped by the deficit ceiling/S&P downgrade theatrics.
In case anyone managed to miss it, advanced economies have decided to put on the austerity hairshirt, which assures near or actual deflation. The concern re the uptick in consumer inflation figures excludes the biggest input into goods costs, namely wages. Commodities inflation seems to be driven by a combination of speculative inflows (which is believed to include hoarding of storable materials, such as metals in China) and emerging economies, particularly China, running at over potential and being too slow to increase interest rates to cool off demand.
The US program of using monetary stimulus as a fix for a failure to reform the banking system, write down bad debts, and apply generous stimulus as an offset isn’t working out very well. The notion was to have the wealth effect of higher stock prices and hopefully stabilizing and improving housing prices restart consumer spending. But consumers were in retrenchment mode as a result of being overlevered, and the lousy job market is keeping them correctly very cautious. So QE-induced optimism goosed asset prices, like stocks and subprime debt, without doing much for the real economy.
But even though investors got ahead of themselves in the US, the real trouble spot is Europe. The latest EU attempt at confidence building by Sarkozky and Merkel on Tuesday wasn’t even kick the can down the road, it was pure smoke and mirrors. With a lack of any political consensus on moving to a fiscal union, the job of holding the Euromess at bay falls to the ECB. And as we’ve indicated, its Bundesbank mentality guarantees it won’t do a Bernanke and balloon its balance sheet to the €2-3 trillion level needed to do the job. It has already done roughly €96 billion of bond purchases to support periphery debt. Italy has €68 billion of debt maturing by the end of September, and market participants estimate the ECB would need to buy €100 billion of Italian debt to keep its borrowing rate at 5%. That would push the ECB’s purchases above the level than many think the bank is comfortable with. This is not a trivial issue. The ECB is already divided on further interventions; we are told by colleagues who speak to staffers that board meetings have devolved into screaming fights.
The assumption has been that if we have a Eurocrisis, the authorities will do what the markets think is the right thing and bail out the banks and provide generous liquidity. But any TARP-type facilities will have to be on a national level, and with austerity the order of the day, that would seem to be a non-starter. It also seems unlikely that the ECB would change stripes and create a raft of Bernanke-style emergency lending and asset-purchase facilities, or at least not quickly enough to halt an unraveling.
The other wild card is that the policy paralysis in the Eurozone means an eventual breakup, with some countries exiting and the rest remaining as a rump Euro area, seems more and more likely. Europe otherwise needs a vastly lower euro (Wolfgang Munchau has estimated .60 or .80 to the dollar) to alleviate the internal imbalances and give periphery countries a boost via increased exports. That does not seem likely, plus that magnitude of a currency move would have its own knock-on effects. A dissolution could take the form of a German bloc exiting, but given the denial among politicians, it would probably happen as a result of banking-related stresses becoming more acute, rather than as part of a program to remedy them.
I’d rather be proven wrong on this one, but days like today are likely to look tame relative to what is in store.