Why the Markets have not Bottomed

 

All experienced investors can recite a number of valid market "rules":

1. The market will rally when there is "blood in the streets" and all optimism is wrung out.  (courtesy Warren Buffett). 

2. The market discounts the future; when the market has discounted the recession (priced the impact into stock prices), the market will rally.

3. The market will rally when investors least expect it.  (Bearish sentiment is a contrary indicator)

[Feel free to add your own to my list]

As i write this on May 26, 2022, for YTD, the NASDAQ  Composite is down 28.9% and SPX is down -16.3% (Bloomberg), many analysts are tempted to say that the markets are close to the bottom.  

The problem facing investors is that there is too much uncertainty to make any useful prediction of future market dynamics.  

Inflation is the major financial/economic issue facing both the financial markets and the Federal Reserve.  At this point, we know one thing for certain.  The Fed is focused on crushing inflation and bringing it back to within range of its 2% target.  To do that, the Fed MUST slow US economic growth.  At the neutral rate, somewhere around 2.5%, by definition, rates will NOT slow economic growth.  The Fed will have to raise interest rates above the neutral point, to some higher rate AND convince the market that rates will move even higher until inflationary expectations are wrung out of the consumer's psyche.  The "market" consensus, that 3% would be an appropriate end point is much too optimistic.  It is easily possible that the Fed will have to raise rates well past 3%, possibly to 5% to both reduce demand and really change inflationary perceptions. 

As Chairman Powell has repeatedly pointed out, the Fed can only deal with the demand side of the inflation equation.  Demand will not slow until there is a slowdown in the general US economy, including job growth (and the resulting wage growth).  Of course, the Fed has a dual mandate, but job growth is much too hot, and as a result wage growth is too hot.  The Fed aspires to bring down the job vacancy ratio from 2:1 to a more normal 1:1 and asserts that by doing so, it will temper inflationary pressures.  This would be the "soft landing" that would temper inflationary pressures without increasing unemployment.  Regrettably, that is not consistent with human behavior.  Wage pressures will not abate until there is some fear of losing a job and possible unemployment (i.e., some equilibrium is restored between labor and capital).  In today's environment, employees can demand higher wages, without any penalty for pushing too hard.  Another job is around the corner, AND savings accounts are high so some time off does not seem so bad.  The hallmark of the US labor market is that employees are able to transition between jobs relatively easily (very different from he Euro markets), but this feature has gotten out of balance in the current environment. 

Interest rates are not the only story; external inflationary pressures also have to be considered, although these are more supply side driven.  The war in Ukraine will  have its own inflationary pressures due to the impact on Ukraine (food prices) and the sanctions on Russia (gas and Nat Gas prices).  These are long term impacts.  Over the course of time, the markets and the global economy will adjust to these factors, but the point of equilibrium is likely to be well beyond 2022. We must also add the impact of other inflationary forces to this tasty stew.  Supply chain disruptions are clearly resulting in inflationary pressures due to the fitful and incomplete restart of the global economy after the pandemic.  As of today, China is clearly not in restart mode, and clearing the bottleneck will take some even after it reaches full restart.  It seems fanciful to think that this aspect of "return to normal" will occur in 2022. 

Some other factors for investors to consider independent of the above analysis.  (1) the impact of the War in the Ukraine, (2) the impact of the shift to QT from QE, and (3) the impact of the end of TINA. I could write a separate column on each of these factors.  For the moment, I will only point out that all of these will tend to lead to higher interest rates across the yield curve, and lower stock prices. 

If my analysis is correct, what are the implications? 

The market has exhibited an inability to discount the impact of inflation (rising input costs; rising inventory costs) combined with the initial indications of a slowdown in spending, at least is some sectors.  Good example (of many) is the reaction to Target's earnings release.  This a premier company with excellent management and a long track record of success.  Nevertheless, Target was unable to simply pass through higher labor and inventory costs.  It also implies that consumer demand was not sufficient to allow the firm to raise prices.  The result was that its stock price declined nearly 25% in one day. 

My conclusion from this analysis, despite being a true believer in market's efficiency, is that there is simply too much uncertainty for the moment to reach any conclusions about the future course of market movements.  We will not be able to rationally forecast a market bottom until the market has a much better idea of (1) the end point in the interest rate cycle; (2) the long term impact of QT; (3) the depth of the economic slowdown necessary to tame inflation, and finally and most importantly, the impact of this end state on individual companies and the demand for their products and services.

Market Efficiency

The theory of Market Efficiency is that all available information that might affect stock prices, whether company-specific, macroeconomic or other, are incorporated into stock prices immediately and accurately.  Behavioral Finance is a conflicting theory that asserts that market prices are driven in great respect by emotional factors (such as FOMO), biases, and cognitive errors.  This conflict has been contested for many decades. Both theories are confirmed by the award of Nobel Prizes to their adherents.  

What do we make of market dynamics today (April 2022)?  I am an advocate that the market is mostly efficient.  My evidence is that few professional investment managers beat the market in any year, much less over a period of years.   Nevertheless there are instances of clear mispricing that can be detected ex ante.  In 2021, profitless growth was priced on the basis of historically high P/S ratios ranging up to 100x.  Many of us argued at the time that these were unsustainable over even the medium term.  This is the best evidence supporting Behavioral Finance.  These valuations were clearly affected, in very large part by the ZIRP interest rate policy of the Federal Reserve, and stimulus of all the major governments in the world.  This resulted in a historically low discount rate.  Since these companies were not projecting earnings for many years, the discount rate applied to distant cash flows and earnings was a critical factor in valuation. However even at the time, it was clear that these factors were coming to an end.   Nevertheless, high valuation persisted for a long time.  

Another factor in stock prices over the last two years has been the impact of the Covid Pandemic.  Since its onset in March 2020, consumer behavior shifted dramatically to WFH, Play at Home and Shop at Home as consumers endured government mandated lockdowns in many jurisdictions. The Covid Pandemic is not over, but clearly in the US, it is on the wane and return to normal is taking hold not just in work, but also in Entertainment (full sports stadia) and Travel.  Until recently, little attention was paid to the Pandemic Darlings; those companies that benefited from Covid.  The poster children for this phenomenon are Peloton and Zoom Video. But there were many others including Apple, Microsoft, Facebook, NFLX, Amazon, and Roku.  .  

Here is where market efficiency should have kicked in.  By January 2022, it was clear that the largest pandemic impacts were dissipating in the US.  Mask mandates were being phased out: vaccine cards were no longer being required in indoor places and testing sites were empty.  Also, by this time, the Federal Reserve's intention to being to increase interest rates to more "normal" levels was well understood although the path was uncertain.  The market should have been able to incorporate the loss of the pandemic benefit into stock prices.  This is not complex.  Take earnings from 2019, pre-pandemic, add a little for permanent growth, and you have a reasonable forecast for post pandemic.  Yet in the past two weeks, the market has been surprised by the loss of pandemic benefit in two high profile stocks:  NFLX and AMZN.  Yesterday, AMZN reported earnings, and the stock price is -9% today despite continued high growth in its AWS business.  NFLX reported last week, and was down over 30%.  Yes, there are company-specific issues and macroeconomic issues (supply chain, energy  and Ukraine War) that affect many stocks but clearly the market did not correctly anticipate the Pandemic benefit.  

In the age of the Internet, Market Efficiency should apply regardless of  the size of the company involved. However there is an argument that small companies with limited analyst following are more prone to inefficient prices due to lack of information and the inability of arbitrage to correct mispricing.   I mention NFLX and AMZN because they are widely followed by Wall Street Analysts.  There is no argument that the stock dynamics are a function of lack of information or arbitrage.  I acknowledge that we can see larger evidence of inefficiency in smaller stocks in which there is less information available (fewer analysts) and arbitrage is more difficult.  The poster child for this argument might be TDOC which reported its earnings this week and sank more than 30% from an already near 52-week low.  Similarly, after reporting declining active users, HOOD suffered a decline of 10% as its users begin to leave their comfortable couch and return to work. 

We are living through a market period that is not only volatile but also topsy-turvy.  Profitless Growth is no longer being rewarded with huge valuations.  (Plus for Efficiency).  However, yesterday's price action reminds us that the market has still not adjusted for the pandemic benefit received by many companies. This is negative for the market efficiency advocates. 

Powell votes for more inflation

Yesterday, April 22, Chairman Powell reiterated his increasing concern with rising inflation, but again his actions belie his words.  He allowed that the FOMC "could consider an increase of 50 bps at the May meeting (May 2-3), but that decisions are made at the meeting, and meeting by meeting."  Once again, Powell failed to deliver a clear roadmap to the market of the Fed's interest rate policy.   

As an economic fact, the Fed remains in a stimulating posture until the short term rate reaches the "neutral" rate, assumed to be over 2%.  At the moment, the rate stands at 0.5% and even with a 50 bps increase will still be only 1%.  The result is further simulation of inflation perhaps through the summer.  Even after reaching neutral, presumably, the Fed will have to at least gently restrain the economic in order to restrain inflation (the "soft landing").  If this is to be achieved, the Fed Funds rate would have to reach closer to the neighborhood of 3%.  Again, when will the Fed get to that point?  If it is not until late 2023, as indicated in the last Fed minutes, inflation can be expected to gain force through all of 2022 and most of 2023.  I am not an economist but this seems unwise. 

Further, the FOMC and Powell have not made any definitive statement about Quantitative Tightening.  The minutes suggest 90B per month will be allowed to roll off the Fed's balance sheet.  While one could debate the apprpriate size of the Fed's balance sheet, clearly $9T is too high.  At the rate of $90B per month or a little over $1T per year, it would take 7 years to reduce the Fed's balance sheet to the pre-pandemic level.  

Another economic fact: the markets will do some/all  of the work of the Fed and increase rates through the yield curve IF (note the capital letters) the path, and ideally, the destination, is communicated clearly.  However, we have had a complete absence of clarity.  As a result, the market remains highly volatile surging in one direction or the other based on threads of perceived information. 

 Netflix has reached maturity

Neflix reported Q1 financial results last night (April 19); the company reported a loss of 200,000 subs for the quarter but guided to a future loss of 2 m subs in Q2.  The market's verdict was swift and harsh, with the stock down by 36% to $222 late in the day on April 20.  The one-year decline is worse, down nearly 60%.  Despite the sharp declines, it is probably not the time to buy the stock.  Compare the stock performance of Meta (FB) since its "adjustment" in Feb 2022 when it reported its Q4 results.  The stock cratered a massive 31%, but since that date has dropped a further 10%. 

During its conference call after the release, the Company flagged 2 interesting issues.  First, its shutdown in Russia cost 700,000 subscribers.  Excluding these subscribers, the Company would have gained 500,000 subs, but still far below the 2.5m that it had guided to.  The second point was that password sharing might account for 100m additional shadow subs.  Of course, it would be great for the Company to find a way to curtail this, but it does not change the fundamental narrative of low future growth.  

These results signal that NFLX has reached maturity.  The days of large subscriber growth are over.  Perhaps this is a result of saturation of its TAM, or perhaps influenced by increasing competition.  One response from the Company was to suggest that it might add an ad-supported subscription to its offerings.  However, this would also come with competition from other streaming services such as DIS and HBO Max.  

As a mature company, the Company needs to change the narrative and focus investors on another metric: either Revenue growth or a profit metric.  The Company has more flexibility with profits since its content spending in 2021 amounted to $17B.  Apple had the same transition when it stopped releasing data about unit sales and focused on Revenues.  NFLX has reached the same point.   

Elon's Next Move

Confidence is the key to takeover battles.  Any Raider needs to project confidence to the "market" in order to muster investor support.  Generally, tender offers are about dollars and cents, but proxy fights, which generally accompany the tender offer and give it more teeth in the face of a poison pill, are about creating a sense of confidence.   

Apparently, Mr. Musk plans to obtain financing commitments and use these to support his bid, either in the tender offer or in negotiations with management.  But to succeed, he must become the "serious" Musk not the flaky "Musk".  This is as much about PR as it is about Finance.  Musk struggles to raise funds

What Will Elon Do Next: a case study in Current Takeover tactics

 

In early April, Elon Musk announced by filing a 13G that he owned 9.2% of Twitter inc (Ticker: TWTR).  On the same day, he accepted a seat on the Board of of Twitter and entered into an Standstill Agreements. Shortly thereafter, on April 9, he terminated the agreement and announced that he would not be joining the Board.

On April 14, Musk announced a proposal to buy the remaining shares of TWTR for $54.20 per share or $43B, a premium of 18% over the closing price of the stock on the day before, but 45% over the unaffected price prior to the announcement of his share stake.

On April 15^th, the Board announced that it would consider Muck’s offer but also announced that it had adopted a poison pill that would, among other things, prevent Musk from acquiring more than 15% of the firm without the Board’s approval. 

Twitter is a Delaware Corporation with a staggered Board of Directors divided into 3 classes with only 2 Directors standing for election in 2022.  Twitter has distributed Notice of its Annual Meeting of shareholders for May 25^th.  Nominations to the Board of Directors are closed (as of Feb 2022)

What will/can Musk do next?

Musk faces some significant obstacles but ultimately should be able to prevail if he is determined to own the company. 

Twitter is a Delaware Corporation.  Delaware is the most popular state for corporate charters in part due to the Delaware Chancery Court which is experienced in resolving issues of corporate law and has a well-developed law governing corporate takeover battles. 

Nominally the two major obstacles facing Musk are the Poison Pill and the fact that Twitter has already filed notice of its annual meeting to elect directors for May 25^th, and other nominations for Director are now closed.

Musk’s options include the following, which could be taken simultaneously or separately:

1.       File suit in Delaware Chancery Court asking that the Pill be redeemed by the Board or be declared invalid. Under Delaware law, the court will apply the standard of “enhanced judicial review” from Unocal.  Unless the Board is prepared to announce an acceptable price as required under the Airgas case, it is likely that Musk will eventually prevail. 

2.       Make a Tender Offer for any or all shares with a 51% minimum condition, although this would have to be subject to redemption of the pill.  To do so, Musk would not have to have procured financing but only a “highly confident” letter from a credible investment bank.

3.       Launch a proxy fight in the election of the two directors standing for election and ask shareholders to cast a NO vote on those directors.  This is unusual since Musk could not nominate his own Directors, but by obtaining a majority of the votes, he would force the Nominees to resign, which is required under Twitter’s Bylaws and market practice.  This would not directly gain control of the firm but would send a strong message to the Board and would most likely decide the battle.

Musk’s best option is #3.  To give his proxy fight more credibility, Musk should take actions designed to reinforce the view that he is fully prepared and able to buy the company either alone or in conjunction with a financing partner.  Given Musk’s personal wealth, management credibility and obvious connections in the financial community, this should be achievable. 

Jerome Powell never fails to disrupt the markets

 

Jerome Powell never fails to disrupt the markets

The Federal Open Market Committee quarterly update on Weds afternoon was supposed to be "baked in the cake".  The FOMC previously announced that its zero rate policy would be continued for the foreseeable future ("several years" according to a prior Powell statement)--until the economy was fully recovered.  This had been modified to say that even in the event that the economy ran "hot" (defined as inflation over 2%), the Fed Reserve was prepared to withhold rate increases.  Easy money is magic elixir to the financial markets. 

The FMOC meeting was held in the context of continuing high levels of COVID infections in the US and Globally, and slow return to work in the US during the summer months.  Nevertheless, economic data had indicated a slow but steady improvement in the most recent quarter, with unemployment modestly declining but remaining at a high level relative to historic trends.  Most investors, in my opinion, expect a continuation of those trends: modest economic improvement, but with the economy remaining well below normalized output levels pending distribution of an effective vaccine.  I believe investors know that there is a risk of a "second wave" in the winter flu season which would entail some new economic disruption. 

When the Fed Reserve announced its policy statement at 2pm, simply re-iterating the prior policy statements, the Dow immediately rallied about 70 points (presumably, there must be someone that is not paying attention). 

The Statement indicated that:

           "With inflation running persistently below this longer-run goal [of 2%], the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer term inflation expectations remain well anchored at 2 percent."

The real action began when the Chairman started speaking at 2:30p.  As his usual practice, Chairman Powell was unable to simply articulate a coherent regurgitation of what everybody knew and expected. Rather he spooked the markets by implying that conditions had worsened  and the economic outlook had become riskier.  Furthermore, when pressed on the specifics of the general policy statement for added definition to words like "moderately" and "some time", he was unable to add anything of value.  At one point, he insisted that the word "modestly" meant...well, "modestly" and "everyone knows what that means".  The result, the market, measured by the DJIA, sank from up 270 to down by the time the presser ended. 

Regrettably, Chairman Powell, a lawyer by training, is unable to perform a basic lawyering skill--forcefully advocating his own position. The next step is also well rehearsed at this point.  Fed Reserve Presidents will walk back his remarks over the coming weeks.  If past is prologue, even Chairman Powell himself will attempt to repair the damage he has done in his Congressional testimony next week. 

Rumor is that Chairman Powell has regained the confidence of President Trump and is likely to be reappointed if there were a second Trump term.  All I can say, is Please NO!!

Huge Pile of cash has missed the market rally

I noticed the following tweet earlier today:

Investors Are Sitting on the Biggest Pile of Cash Ever – Grappling with the most economic uncertainty in decades and a head-spinning stretch of volatility in the U.S. stock market, many investors have rushed into money-market funds. Assets in the funds recently swelled to about $4.6 trillion, the highest level on record, according to data from Refinitiv Lipper going back to 1992. WSJ 

While the cash is sitting in MMFs earning 0% interest, the SPX has rallied 30% off the March 23 low and the NASDAQ 100 has breached its all time high several times.  NDX100 currently is at 10,015.23.  SPX is at 3,126.84.  (12:29p)

This is a good reminder that nobody can time the market.  Some of the smartest financial minds have missed this market rally, including Warren Buffett.  The rally was initially led by the WFM stocks, such as ZM, NFLX, ZS, CRWD, AMZN, but rotated swiftly into the 'recovery' plays such as airlines, hotels, and cruise lines.  

With little corporate guidance, it is entirely possible that this move into cyclical recovery stocks is too soon too fast.  Personally, I don't try to pick tops or bottoms, but simply look to allocate assets to good companies at good prices.  I DO try to notice if the tide is moving in or out.  While the recovery stocks might be priced on a too-rosy scenario, it is likely that there will be a recovery over the next 18 months and all of these stocks and the underlying operating businesses will approach 2019 levels.  

On the other hand, the Pandemic-enforced WFM movement probably has changed or accelerated changes in our lifestyles on a permanent basis.  Video conferencing will grow; delivery/take out dining will grow, and of course, streaming will grow.  I am not opining on the current price levels, just pointing out that major secular shifts are evident to any careful observer and these shifts will be reflected in stock prices over a long period of time.  

Finally, being fully invested does not mean solely in equities.  If you are saving for retirement, a 50/50 split between high quality long term bonds and stocks is still a sensible path.  As a side note, at the market low, at the time that the SPX was down 40% from its high, a 50/50 portfolio would have been down only about 5% (measured as of March 23).  

Why the Stock Market is not overpriced

As of 10:30 am today, May 18, all of the major indices are in rally mode, with the SPX 2941.36 (+2.71%), NDX 100 9318.90 (+1.82%) and the DJIA 24,403 (+3.04%).

Early this morning, the three major indices were moving nicely higher, on the basis of improving virus news and Chairman Powell's interview on 60 Minutes on Sunday night, until news was released later in the pre-market period that Moderna (Ticker: MRNA) had positive early stage test results for its coronavirus vaccine.  Since that point in the time, the three major indexes have roughly doubled their gains for the day.

Recent Economic news can only be described as terrible:
      1. Industrial production -- lowest since 1919
      2. Retail Sales: April -16%,  far worse than the reduced expectations
      3. Continuing jobless claims: over 22 million
      4. First-Time unemployment claims: over 36 million in just eight weeks.

Within the last week, various stock market "experts", including Warren Buffett, David Tepper, Stanley Druckenmiller, and Ray Dalio, have said that the "market is overvalued".  You have to respect these opinions since all of the aforementioned are real investors.  In addition, many of the TV "experts" (not investing their own money) including the widely respected Mohamed El-Erian, have chimed in.  As a lowly finance professor, also investing my own money, I must say that I disagree with this conventional theme that the markets are overvalued.   I am not saying that the "market is cheap" but that generally stocks are fairly valued given the environment and expectations.

 Many are asking how can the stock market be going up (although it is still below the pre-virus levels) given the terrible economic news?

I assert that all of these things make sense.

It is a market of stocks, not a stock market.  Lets take a deeper look at market price dynamics.

Lets go back to fundamental principles as taught by every major business school in the world. 
First, the market is a discounting mechanism that looks to the future--specifically future estimated cash flows.  These cash flows can be in the form of dividends + stock repurchases, or implied dividends (using a variety of financial models, but the residual income model is the basic version).  Second, the indexes are constructed by either market cap weighted (SPX, NDX) or price-weighted (DJIA).  Index construction has an important impact on the movement of the index. 

Looking at the performance YTD of the indices, we see 3 very different pictures of the "market".  The NDX is up 1.02%, the SPX is -9.3%, and the DJIA lags down -15.1% (all YTD, without dividends).  These levels are well above the lows of mid March. For instance, the SPX dropped about 33% in the Mid-March decline and has recovered about two-thirds of that decline. Our first conclusion is that nobody should be talking about the "market" without specifying an index.  How do we explain this rather shocking divergence among the indices? 

It comes back to the impact of the virus on future cash flows.  The market is differentiating among three categories of firms: (1) those firms not affected by the Pandemic induced Lockdowns, or even positively affected by the "shelter in place" orders (examples: ZM & NFLX), (2) those that are currently impacted but perceived as recovering early after the Lockdown is ended (eg. DIS, SBUX); and (3) those that will not recover for some time (airlines, hotels, cruise ships, movie theaters etc).  Take this matrix and apply it to the indices.  The NDX is a market cap weighted index and the largest five firms account for over 40% of the index: MSFT (+15%), AAPL (+4.6%), AMZN (+31%), FB (4.4%) & GOOG (3.6%).  What do these firms have in common?  They are all less affected by the virus (MSFT & AMZN)  or perceived as recovering sooner (AAPL).  Lets take MSFT as an example:  its sources of revenue are its legacy businesses of windows, and Office, and its newer business of data centers.  None of these are very affected by the virus, and its cash flows are growing.  When we look at the SPX, the same firms account for about 20% of the index. In other words, 495 other stocks account for 80% of the index but this group includes airlines, cruise lines and hotels, all of which are 30-50% below their pre-virus highs.  The DJIA is down more because it is price weighted and affected by the sharp declines in BA (63%), RTX (40%) JPM (38%)  Dow (34%), AXP (34%) XOM (32%), WAG (34%) CVX (25%), GS (25%) and 3M (21%). 

As an investor, it is time to place your bets:  Which firms are going to recover faster post Lockdown? Which firms will lag?  Is the market too optimistic about the laggards?  The thesis of the "experts" is that the "market" is too optimistic.  But the laggards are well below their pre-virus levels.  Examples:  DAL (-63%), LUV (-50%) , MAR (-39.5%), HLT (-33.1%), are all far below their pre-virus levels. 

If we look at the leaders for the year, including SHOP, ZM, NFLX, NVDA, PDD, SRNE, BTAI, NVAX, MRNA, and DOCU, it is easy to complain that their prices are too high and that too much credit is already incorporated into the prices for future growth.  This is the group that is probably legitimately susceptible of the "1997" critique: good ideas, and even good firms, but much too expensive.  A good portion of these firms are engaged in the development of revolutionary pharmaceutical products.  These tend to be binary bets with a lot of downside risk.  Fair enough to say that the stock of these firms are overvalued.

My point is that there is a tier of stocks that are growing fast, and have very attractive prospects, but are priced at levels that seem much too high.  But many other stocks seem appropriately priced for the current environment, and the inherent risk to their future cash flows, and these are the largest stocks that drive the indices.  Can we have a correction?  Of course, and at any time for any reason, or for no reason.  Nevertheless, my conclusion is that the "market" is fairly priced--not cheap, but not expensive. 

March Jobs Report

The equity markets are placing great reliance on the improvement, i.e., the decline,  in the unemployment rate as confirmation that the US economy is slowly recovering from the impact of the Great Recession.  Nevertheless, the Federal Reserve, particularly its chairman, is warning explicitly that the trend in the unemployment rate is unsustainable.  For this reason, various Fed governors have asserted that QE 3 is still under consideration, and the Chairman has announced that interest rates will remain on hold until at least 2014. 

What is causing the Fed to be so cautious about employment trends?  Table 1 below shows the trend in month-to-month change since the onset of the Great Recession. 

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec
2007	236	93	190	72	139	75	-40	-18	73	79	112	89
2008	41	-84	-95	-208	-190	-198	-210	-274	-432	-489	-803	-661
2009	-818	-724	-799	-692	-361	-482	-339	-231	-199	-202	-42	-171
2010	-40	-35	189	239	516	-167	-58	-51	-27	220	121	120
2011	110	220	246	251	54	84	96	85	202	112	157	223
2012	284	227	120

As shown in the table above, job growth has shown a degree of acceleration only at the end of 2011.  Nevertheless, this rate of growth is below that which occurred after the 1990s recession which was not as severe.

Year	Jan	Feb	Mar	Apr	May	Jun	July	Aug	Sep	Oct	Nov	Dec
1991	-122	-302	-161	-212	-127	88	-48	17	32	12	-58	23
1992	50	-66	52	157	126	60	70	141	35	178	139	212
1993	310	242	-51	308	265	174	295	160	239	278	261	307
1994	270	201	462	353	333	313	364	298	355	208	422	272

As Table 2 shows, the monthly increase in employment post-1991 was over 300,000 jobs per month.  (all data is seasonally adjusted).

The first conclusion is that the rate of job growth has been slow compared to the post recession periods of prior recessions.  Notwithstanding the low rate of job growth, the unemployment rate has declined 1.5% since Dec 2010.  The Fed's conclusion is that that decline has not been fueled by job growth, but, in significant part, by the decline in the participation rate, which is down 2.5% since 2007.  In short, workers are getting discouraged and dropping out of the labor force and therefore do not fall into the unemployment rate.  This is particularly striking among workers with a high school education or less.  While the overall labor force is roughly equally divided between men and women, this category has a larger component of men.  As manufacturing and construction employment was severely affected by the Great Recession, this is not surprising. The March employment report continues these trends.  The number of new jobs added was only 120,000, a level that would not normally cause any change in the unemployment rate.  But the unemployment rate declined slightly to 8.2% as the participation rate also declined by 0.1%. 

Another reason for caution about the trend in unemployment is the large number of part-time workers.   The number of people working part-time for economic reasons is nearly 8m.  As the economy recovers, workers will shift from undesired part-time jobs to full time.  These workers are likely to be the "first hired" since they are the most motivated, and have current skills.   Again, the March report is a good example,  The number of workers in part-time jobs for economic reasons declined by over 400,000 significantly greater than the decline in the number of unemployed, 133,000.  In addition, discouraged workers are likely to be drawn back into the job market as the economy begins to generate, no matter how slowly, more low skilled jobs. 

This data is what underlies the Fed's cautiousness about further improvement in the unemployment rate.  Job growth would have to accelerate from its current level.  There is no evidence of that this is occurring.  Even at this low rate, it is likely that workers will be drawn back into the work force which will reverse the impact of the decline in the participation rate and cause the unemployment rate to stagnate if not rise. 

The can gets kicked in Europe

Today, the ECB announced that 523 Euro banks borrowed €489 Billion (source: Bloomberg) of 3-year loans under its emergency lending program.

There have been a number of media comments that have misunderstood the purposes and effect of this program.  In sum, this is a liquidity facility which removes one risk but leaves solvency and capital issues unaffected.

All large banks finance a substantial portion of their assets through open market borrowings, as short as overnight.  In ordinary times, this is a very liquid market and funds are readily available at low rates.  The lenders are other banks, including US, Chinese, other Asian banks as well as US mutual funds, and other institutions that have short term funds to invest.  In the last quarter, the liquidity in this market had been "drying up" as US banks (among others) began to worry obsessively about "counterparty" risk.  One consequence of this can be seen in the negative yield on 1-month US Treasury bills.  There is simply a strong risk aversion in the global debt markets.   The cost of the overnight funds and other short term funds, the equivalent of auction CDs, for Euro banks has been increasing as availability has tightened.  Last month the Fed Reserve and other central banks announced facilities to provide virtually unlimited funds to European banks.  This IS important.  Without this reassurance, there could have been a modern day version of a "run on the bank".  As we all saw with MF Global, confidence is essential to funding large financial organizations.  On this issues, let me congratulate the ECB and the Fed for making an astute move.  This reassures all investors that no Euro bank is going to collapse because it could not roll-over short term debt. 

The balance sheets of the European banks are somewhat opaque, so we don't know if most of these funds are simply replacing other short term, but higher cost, debt; but this is my suspicion.  Because it was a requirement that all of these loans had to be collateralized, it does not seem like there will be excess funds to purchase additional sovereign debt or other assets.  Nevertheless, this program should create a substantial positive carry for participating banks, which will increase profitability.  This similar to the Fed's actions in 2009-10 in the US which allowed the major banks to earn their way out of the crisis.  But this program eliminates counterparty risk for the major money-center banks such as JPM, C, GS and MS.  The business model of the US money center banks (JPM, C, BAC) could be questionned in light of Dodd Frank and other regulatory initiatives, but the risk of European contagion from counterparties has been removed.  In fact, lending money to European banks will again be a very profitable niche business. 

BUT.....

The Euro banks still need additional capital for 3 primary reasons: (1) a special one time "buffer" against sovereign debt which is designed to reassure the financial markets. (2) additional capital to meet the Basel 3 requirements; and (3) additional capital to reach the 9% capital bench mark for risk weighted assets.    This is going to have to be resolved in the first half of 2012.  Historically, the Euro banks did not need to allocate capital to support sovereign debt because default was thought to be impossible. For purposes of calculating capital, sovereign bonds have not been marked to market.  (in some cases, they are marked-to-market for accounting purposes).   Today, part of the need for  additional capital is to allow sovereign debt to be marked to market, ahead of the Basel 3 requirement.  The remainder of the additional capital is for the purposes outlined in number 2 and 3 above. 

European banks are required to present plans in January 2012.  The European Banking Authority estimated the capital shortfall to be €114B.  The largest shortfalls are in Greece (€30 Billion), Spain (€26Billion), Italy (€15B), and Germany (€13B).  But the total amounts only tell half of the story.  The other part is the size of the shortfall in relation to the size of any specific institution.  In this regard, a few small-ish banks are facing large capital shortfalls when expressed as a percentage of their market capitalization. For instance, Commerzbank (PINK: CRZBY) is thought to need a capital injection of €5.8B according to the EBA, but this compares to a market capitalization of €6.8B.  This is a stock to avoid due to the risk of an "AIG-like" solution or massive equity dilution. This will be doubly challenging due to that institution's history of erratic operations and profitability.  On the other hand, Deutsche Bank (NYSE: DB) is thought to need capital of €3.2B according to the EBA, but this compares to a market cap of €27B.  Given the size of the entity, this is likely to be raised without major dilution to shareholders. 

The EBA has explicitly stated that these capital requirements are to be met by:

1. Retained earnings, including reduced bonus payments;
2. New common equity or other approved forms of capital; and
3. Sales of selected assets that do not impair lending capacity.

The EBA discouraged shrinkage of balance sheets, which would lead to contractionary pressures.  Although unstated, the national governments are the investors of last resort. 

A Definitive Solution is not in the cards

Most economists recognize that the "Geithner" solution would be the best way to proceed.  This would require a combination of the liquidity program (which is now in place) and a massive equity capital injection similar to TARP.  The mere availability of this equity capital would end the speculation about the solvency of the European banks and would free the banks to purchase government debt at something close to normal yields.  However, this would require a massive sum of money; at least €2T and perhaps double that amount.  Ultimately, it would be repaid, as TARP was largely repaid.  Banks would raise replacement capital over a period of time, and calm, with a good share coming from retained earnings.  But there is simply no political will for this program in the EU.  It is seen as the strong subsidizing the profligate and accordingly is simply DOA (dead on arrival).  So what is left????

Kick the can down the road, continue in small incremental steps, and hope that an economic recovery within the next decade will eventually bail out the sovereigns.  In the long term, this is workable; but the path is likely to be rocky and painful at times.



 

Reality sucks

Happy talk of Euro summit tested at today's Italian bond auction.  Reality takes hold as yields rise for 3 year notes to 6.47% from 6.29% of Nov auction.  Indicates lack of market confidence since the new money is going to 3-year notes not 10-year bonds and even these shorter maturities are at the magic 6.5% limit.  

The European Crisis Continues

The European Crisis Continues

American Equity markets are anxious for a definitive resolution to the European Debt/Fiscal crisis.  Despite the rhetoric surrounding the latest “solution”, they will be disappointed. 

First, lets cover some basics.

1.     The EU is not going to break up because it is in the individual interests of the all of the main players for it to continue.  It IS a political union (or Confederation) and for all of its shortcomings it has created the foundation for over a half-century of peace. 

2.     The Eurozone will survive in its present form.  I wouldn’t say it is impossible for Greece to leave but highly unlikely.  I am also NOT saying that there won't be a default.

3.     The European leaders will not accept a “real” solution, but will resort to smoke and mirrors accompanied by high-minded rhetoric.  The pseudo-solution will not solve anything but WILL kick the can down the road.  Eventually, over the next decade, higher economic growth will solve the current problem. 

It is commonly understood how to definitively solve the current fiscal crisis.  As Secretary Geithner points out repeatedly the EU must create a “shock and awe” wall of money that will assuage the worries of the global credit markets.  The problem is that this will require at least €2 Trillion, and the principal funding source, Germany, is simply politically unable to make the required commitment.  The latest “solution” suffers from the same problems as the previous attempts.  It is simply too little and too undefined.  

The Structural Agreements

The European Summit agreed on basic budgetary principles that would limit “structural deficits” to 0.5% of GDP with “automatic correction measures” when national deficits violate the target..   This is in addition to a tightening of the disciplinary procedures for countries that violate the limit of deficits over 3% of GDP.  These principles would apply to the 17 Eurozone countries. On its face, this solution is implausible and unworkable. 

This first prong of the framework is a Treaty amendment to attempt to establish greater fiscal discipline.  The new plank is a requirement for the member states to adopt a sort of balanced budget amendment that will be deemed satisfied if “structural deficits” are limited to 0.5% of GDP.  Each nation is expected to adopt constitutional “automatic correction mechanisms” pursuant to principles to be established by the European Commission.  In addition, the existing limit on deficits to 3% of GDP will be strengthened by additional (undefined) “automatic consequences” for failure to adhere to this limit.  Why the reference to structural deficits?  This relieves countries that might suffer temporary deficits due to recessions—such as occurred in France and Germany (!!!) in 2008-09, and continues in France today.  The “automatic corrections” or the increased “disciplinary” actions have yet to be defined or implemented.  Even if they were legitimate, they would be highly contractionary. 

Little of this debate is new. 

The issue of acceptable budget deficits was anticipated and debated in the early 1990s in connection with the adoption of the convergence standards in the Maastricht Treaty in 1992.  The German position has not changed.  Germany worried about the profligate Italians at that time and they accepted two “solutions”.  One was an independent central bank, the ECB, that would adopt the strong German-oriented anti-inflationary fiscal policy.  The powers of the ECB were carefully negotiated.  The powers reflect a compromise of the divergent views of monetary policy within the EU and are unlikely to be radically changed. 

In addition, fiscal deficits of the participants in the Eurozone were restricted to 3% of prior year GDP, except for temporary exigencies, in the Maastricht Treaty in 1992. The problem is that ALL of the Eurozone countries, including Germany, violated the limit during 2008-10.  France is still in violation of the limit and is hoping to get back to it in 2012.  (However, the question is whether the French public will support the changes necessary to bring expenses back into line. )

During the last decade the European Commission abandoned its cherished dream of fiscal harmonization, which is a necessary predicate to fiscal or political union, due to an inability to harmonize the BIG issues.  This is nearly a decade-old process and it is not going to be reversed.  The BIG issues are the places in which there is BIG money: pensions, medical care, labor regulation, and other social benefits.  Americans see all of continental Europe as a bunch of aging socialist countries.  There is a large dose of truth in this, but it masks very significant differences, both in terms of social benefit structure, savings rate and demographic makeup.  Harmonization, and, therefore fiscal union, has not occurred because it is simply intractable. 

American investors find Chancellor Merkel to be a difficult myopic personality. Actually, she merely reflects German culture and her life experience.  There is no “equity market” culture in Germany. Investment in publicly traded equities is confined to a tiny portion of the populace.  Ms. Merkel grew up in East Germany, and is educated as a physicist.  She has no intuitive feel for the relevance of the capital markets.  In Germany, capital is the responsibility of banks, supplemented by a small coterie of wealthy private family businesses.  Germany is simply not a dynamic market based economy, and frankly, rejects every suggestion that it become one.  American hand wringing about dithering misses the point. Providing certainty to the equity markets to encourage investment and innovation is simply not a goal of policy makers because their equity markets don’t provide that function in their societies.  There is greater concern for the Bond market, but primarily insofar as it relates to local Banks. 

The German goal is for each nation in the Eurozone to fix its own problems with only limited support from the other member states, i.e., the Italians must fix Italian problems.  The Germans really don’t care how they do it: higher taxes, higher poverty etc.  They are willing to provide a limited amount of backstop support but as little as possible.  In this regard, Ms. Merkel is reflecting German public sentiment.  Frankly we are watching a multi-dimensional game of “chicken”.  Ms. Merkel wants to provide the smallest commitment possible that will achieve economic stability (Germans love stability).  This is a TRIAL AND ERROR process.  It will continue inching along until they find equilibrium.  No German leader is going to be hurried. 

There is one certainty.  The solution will not be “real”.  It will not really address the fundamental drivers of government spending: the large welfare state that is financed by a decreasing number of workers.  Sarkozy is proposing to extend the retirement age for some workers, but this is still tinkering around the edges.  And he is encountering fierce resistance.  But over the next 30 years, as the baby boom ages, the problem will simply fester for another generation of leaders to deal with.  Second, the solution will be highly contractionary.  Europe is headed for a recession in 2012 in any event and the actions taken will exacerbate.

The Money game

While much attention has been focused on the purported benefits of the greater coordination of fiscal discipline, this will not solve the current short term funding issues in Europe.

The Summit took two actions, but the math is fuzzy.  When math is fuzzy there is a reason.  First, there was agreement to make €200 Billion of additional funding available from the European central banks to the IMF with a plea for more money from non-EU nations.  Apparently, the understanding is that this would be lent back to the European nations in some form.  This commitment apparently involves “real” money. 

Secondly, the new European Stability Mechanism was accelerated by a year to mid 2012 and would operate side by side with the existing EFSF until its expiration in  mid-2013.  However, the total amount allowed to the combined EFSF/ESM was limited to €500 Billion. However, this limit would be reconsidered in March.  In this case, the actual cash contributions were limited to 15% of the Funds with the rest to be obtained through “leverage”.

It seems that in the current best case, there is €700 Billion possibly available to solve short term funding issues in Europe. Apparently, the IMF is being used to avoid some of the constitutional restrictions on actions of the ECB.

Nevertheless, €700 Billion is not close to adequate to refinance the sovereign debt due in 2012 which Bloomberg estimates to be over €1 Trillion with an additional €500 Billion of European bank debt also needing to be refinanced and at least €100 Billion of bank capital to be raised in the first half of 2012.  In effect, the EU is leaving Italy, Spain, and the other heavily indebted countries to live with the market reality of their position.  The onus is on them, as the Germans desire, to create budgets that restore the confidence of the bond markets and reduce borrowing rates to a sustainable level.  The ESM/EFSF and IMF will stand as a kind of last resort to plug any small gaps but will not to be the supra-financing vehicle that the Fed Reserve is in the US.  The simple fact is that Germany is not willing to increase its assistance to the other nations of the Eurozone

The summit was long on rhetoric and short on funding.  It is a continuation of the Euro leadership’s response to the crisis: an elaborate fudge.  Initially the global equity markets seem content while global bond and currency markets are more wary.  But the reality of the situation will set in during the first quarter of 2012 when European bond auctions occur. 

The net result of the latest machinations is that the “can is simply being kicked down to road” to the next summit in March 2012.

Don't be misled by the drop in the Unemployment Rate

November Labor report

The November labor report indicated that employers added 120,000 jobs in the month of November.  The unemployment rate, measured by the household survey, dropped to 8.6% from 9%.    Superficially, this seems like evidence of an economic expansion, or at the least the beginning of one.  However, the leading indicators within the labor report indicate continued stability in the US labor force with no indications of either a meaningful improvement or a recession.   

The “break even” number for maintaining the unemployment rate is generally accepted to be 150,000 new jobs.  How could a mere 120,000 new jobs cause a four-tenths of one percent decline in the unemployment rate?  The easy answer is “technical factors” which are discussed below.  The key leading indicators within the report do not show signs of an improving labor market.

For reasons discussed below the best that can be said about this report is that it indicates stability in the labor force.  It is NOT indicative of a “double dip” recession, but it is also NOT indicative of an incipient expansion.  Within the report the “leading indicators” were all flat, not up.  All of these indicators show a labor market that has improved since the end of the recession but is now largely stable with perhaps a tiny bias toward improvement.  A focus on the improvement in the unemployment rate, to 8.6%, would be misleading.

Some key elements of the report.

1.     Hours worked for production workers declined slightly to 33.6 from 33.7.  This is a leading indicator of an improving economy and labor market.   In an expanding economy, employers respond to increased demand by lengthening the hours worked in the initial phase since uncertainty is high and the cost in overtime is justified by flexibility.  Normally, production work is the most variable part of the work force and is very sensitive to changes in demand.  I wouldn’t attribute any significance to the small decline but merely point out that this is NOT indicating further expansion.

2.     The average hours worked for all employees remained flat at 34.3 hours, the same as in September and October.  Generally this is a leading indicator of a labor market improvement.  Similarly Overtime hours remained flat compared to October at 4.1.  Overtime is also an immediate source of flexibility for employers in responding to increases in demand. 

3.     The number of Temporary workers (seasonally adjusted) increased 1% in November compared to October and 7.8% compared to prior year.  In October, the increase over prior year was 8.1%.  Year over year gains have moderated throughout 2011. 

4.     The penetration rate of Temporary workers increased slightly to 1.77% of the workforce from 1.76% in October.  The penetration rate is highly influenced by production workers.  The rate has been improving since the bottom of the recession.  This small improvement is consistent with the trend of a stable labor market. 

5.      Unemployment among college graduates remained flat at 4.4% compared to October, although a significant improvement from the 5.1% of prior year.  This is a key statistic.  It is partly a leading indicator since these are the most employable people in the labor force and partly because purchasing power is highest in this group. 

These are important signals in the November Labor report that there is little risk of a double dip recession, which was greatly feared as recently as October.  In previous recessions, these indicators turned down for many months before a recession was evident.  On the other hand there is little evidence, in this data, of the economy entering into an expansionary phase strong enough to reduce the record unemployment rate. 

The most encouraging data, the decline in the unemployment rate, is misleading as an indication of future activity.  In fact, the unemployment rate is likely to increase in coming months.  The decline in the unemployment rate was a function of two factors in the household survey that is used to measure it.  First, the reduction in the total labor force in the household survey accounted for about half of the change in the unemployment rate or 0.2%.  This reduction is due to discouraged workers dropping out of the workforce.  Hardly a good sign; and perhaps influenced by seasonal factors.   Second, the household survey contained a larger increase in the number of people employed compared to the establishment survey; this accounted for about half of the improvement or 0.2%.  For many reasons the Household survey and the Establishment survey frequently differ; in this environment, the Household survey is probably a better view of new job formation, so let assume the 0.2% is real.  Nevertheless, the nominal 0.4% improvement in the unemployment rate is unlikely to be sustainable.  As the labor market recovers, more individuals will be drawn back into the work force, which will, paradoxically, cause the unemployment rate to increase. 

The lingering Housing Crisis--Changing perceptions of Home Ownership

The Housing crisis has lingered and is clearly contributing factor to the slow growth recovery.  The crisis has defied all of the government’s attempts to fix it. For the reasons discussed below, I think housing is going to continue to be a drag on the economy for several years—far longer than most forecasts.  In addition to the problems of collapsing housing prices—which are showing signs of stabilizing, there is a secular shift that is occurring in terms of the perception of the attractiveness of home ownership.  This perception has been largely overlooked but ultimately will be the source of a continuing drag on the recovery of the housing market even in the medium term. 

Housing used to be a “slam dunk” for most middle class Americans.  The formula was simple:

Shelter+ROI+Tax breaks+30 year mtge+easy credit=JUST DO IT (apologies to NKE)

--Shelter means the provision of the proverbial “roof over your head”

--ROI means the return on your investment since over any 10 year period since WWII housing prices have risen; conventional financial advice found in any money oriented magazine of talk show discussed housing as the "largest asset" of most families.

--Tax breaks means the mortgage interest deduction

--30 year fixed rate mortgage:  unreal, especially with only 10% downpayment

--Easy credit means the proclivity of banks to lend BEFORE the sub prime mess

Really, what was there to think about? 

Contrast today’s situation:

Shelter:  Same—you gotta live somewhere

ROI:  can’t count on it; equity may be at risk!!

Tax breaks:  under threat

30 year mortgage: still the best deal going, but need 20% down payment now

easy credit:  Hold the phone

Objectively, home ownership is just not the no-brainer it used to be.  You can make a good case that renting is better; or at least it is a simple economic decision in a particular geographic market, comparing monthly rent to a monthly mortgage payment plus the implied opportunity cost of the (larger) down payment.  In fact, risk adjusting the ROI on an investment in property, renting would have to be much more expensive to force a rational dispassionate investor to buy a home--even at today's low interest rates. 

 In 1940, home ownership reached a century low of 43.6% (source: Census Bureau & Wikipedia) before growing strongly after the end of WWII to reach over 60% in 1960, only a 20 period. Home ownership peaked at 69% in 2004, and has now declined to 66.9%. (source: US Census Bureau)  This is the largest drop in home ownership in any decade (sic) since 1930s. Home ownership is probably going to decline further before stabilizing, but the question is at what level.

 If the cyclical decline were to equal the depression era decline of 4%, we would be roughly half way through the cycle.  This feels optimistic given the structural challenges of the economy including high unemployment (16% counting under-employment and those no longer seeking work), and low income growth.    If we extrapolate the impact of the changed perception of home ownership to the broader economy, we are facing several years of sub-par  economic growth. 

Sources: Wikipedia and US Census Bureau

EU rescue: Fact or Fiction

With great drama, the EU announced a package of measures designed to end the current fiscal crisis sweeping Europe.  Most economists polled in the last 24 hours are cautious as to whether the plan will work.  As with everything with the EU, it is one step forward and......simply hard to say whether it is also a step back.

The package contains: (1) a "voluntary haircut" on Greek debt held by banks (but not the debt held by the ECB) of 50%.  This seems rational, but the irrational part is that it was accompanied by a statement that the Greek debt is to reach a level of 120% of GDP by 2020!!!.  Of course, 2020 is a long time, which implies that the Greek debt load is way out of balance today and benchmarks long in the future have a tendency to get diluted over time when the spotlight moves away.  This latter term is highly speculative for reasons I have discussed previously.  Simply restated: the cut in Greek spending is so large as to imply a massive cultural change, not just a tinkering with the Budget.  This cultural change  must be unprecedented in the annals of economic history; at least since the hyper-inflation of the 1930s.  Finally, there is no real discussion of how much money Greece, Italy, or Spain, will need in the short term or how it will be financed.  But see below.  Finally, this deal is "voluntary" only as it relates to large Euro banks (who will be forced to accept the deal) and will not be considered a default under the terms of standard CDS instruments.  What about the other holders: hedge funds and non-Euro investors?  They might not be so accommodating. 
(2) The EFSF fund is going to be leveraged "4 to 5x" and will reach $1.4T.  First, we don't actually know how big the Fund is today, but assuming the math is right, it implies that the fund is down to something around $300B from €440B .  Second, it is a bit of a mystery how  this leveraging is going to take place.  If outside lenders/investors don't join, isn't this just going to lead back to France and Germany who effectively guaranty the bonds of the EFSF today?   On what terms will outsiders lend or invest?  Will the Chinese or IMF make an investment with any risk of loss, or will they, particularly the Chinese, require concessions or other quid pro quo?  Doesn't this lead right back to France and Germany being the funders of last resort?  (Italy and Spain don't have the cash, and the others are too small to matter).  The EFSF will have two roles apparently: (a) to provide funds to bailout EU governments; and (b) to purchase Sovereign bonds in the market.  But even $1.4T doesn't go very far.  Apparently, the bond purchases are designed to hold bond rates down, and provide financing of a last resort to the beleaguered  sovereigns (e.g., Greece);  but this reminds me of currency intervention and we all know how well that has worked.  Also, is the ESEF willing to take a loss on the bonds that it purchases? Apparently not;  which makes it is a sort of Ponzi scheme in which the EFSF buys bonds and then lends money to the sovereigns to pay the interest on the bonds just purchased.  If outside investors in the EFSF are going to be guaranteed against loss to some extent, isn't this leveraging merely creating a contingent liability of France and Germany--as the largest countries in the Eurozone?  Whew. 
(3) Banks will be forced to raise capital by June 2012 to bring capital ratios to 9%.  Apparently, in addition to discounting Greek debt by 50%, the banks must discount Spanish Debt by 3%.  I haven't seen anything on Italian debt.  This equity will be raised through all sources including cuts in dividends and bonuses, sales of assets, contraction of assets and sales of equity with the sovereigns, not the ESEF, being the investors of last resort.  Since the French banks are rumored to have the largest problems, doesn't this lead back to France and their vulnerable AAA rating.  Or will this become basically the "mother of all sales" on French bank equity?  Economists have been critical of the capital requirement because they see it as highly contractionary--at a time of Euro recession. 

You have to ask the question: Why all the machinations?  Why not just the obvious simple solution?  Well, of course, the Germans are trying to limit their exposure and save Merkel's government, and the French are trying to save their AAA rating and Sarkozy's career.  At the same time, EU leaders know that they have to provide a "shock and awe" blast to the markets to cool the fear of contagion.  Again, we are short on the "details".  Probably, this plan will work, with periodic agony, over a period of time; but we have just lived through one Black Swan event, and now we remain vulnerable to another.   "Kicking the can down the road" has become the fiscal strategy of choice outside of the UK.

As the (Old) World Turns: Is the European fiscal crisis drawing to an endgame?

On Oct 9,  Ch. Merkel and M. Sarkozy announced that they “will reach an agreement regarding the recapitalization of Europe’s banks”.  Since then news reports have indicated that the European Central Bank is considering a requirement that European banks increase Tier I common equity capital from a minimum of 7% to 9% within 9 months.  If they cannot raise private capital, they will be required to accept some form of government aid.  In the meantime, the “troika” of international auditors are supposed to approve Greece’s next distribution of funds from the EU.  There is great risk in both of these steps which are fundamental to solving the European fiscal crisis. 

The Merkel-Sarkozy agreement is only a statement of principle and not in any sense a real agreement.  It fudges the main issue dividing the two countries.  There are two schools of thought.  The Germans want to see recapitalizations handled on a country-by-country basis.  Lets call this the “Irish Solution”.  The French want to handle it on a consolidated European-wide basis.  Lets call this the “French Solution”.

The issue with the Irish Solution is that the sovereign debt of the home countries would escalate dramatically, which (1) could lead to a down grade by the rating agencies and certainly would lead to an increase in spreads in the financial markets; and (2) it would highlight the political fallout of a bailout for ‘bankers'.   The French solution would involve the use of the European Stability Fund but augmented in some way.  The French feel that they have already contributed to this fund by their guaranty of payment and it should be used first. 

The plan is supposed to be announced no later than early November at a meeting of the G-20 but the October 23 meeting of EU leaders will be an early test of the resolution. 

In the meantime, Greece has announced a new round of budget austerity measures designed to both cut expenses and raise revenues.  Again, there are many unanswered questions and the plan looks fudged.  The plan relies on property tax since Greeks are notorious cheaters on income tax.  But property tax is also problematic since there is no systematic record of property ownership in Greece.  Moreover, what is reported is often based on unrealistically low appraisals relating back many years.  So tax collection has an element of “volunteerism” that is likely to be ignored by  many Greeks.  There is also a plan to reduce government employment and a further reduction in government salaries (40% in total reductions).  The latter are good ideas in a country in which civil servants obtain salaries that are said to be 2-3x of the private sector with generous pensions and yet corruption is still rampant.  The only problem is that the real reductions in employment are still to come.  The Greek “austerity” plan is really a dramatic cultural change with a smaller and more efficient civil service that will be paid closer to levels of the private market.  This seems ambitious for a plan that is to be implemented in just 2-3 years.  There is plenty of room for disappointment—meaning default.  Assigning compliance to the “troika” seems to set the stage for a default at some point; if not in November, then early in 2012.  

The history of this saga has been filled with half-measures that are taken only when the EU has been forced to act by external factors.  The world’s equity markets seem now to believe that this cat is going to change its stripes and now act decisively and definitively.  There is plenty of room for disappointment.