A Tale of Two Continents
The ancient Greek philosopher Plato once wrote: “never discourage anyone who continually makes progress, no matter how slow.”
The EU and Plato’s descendants in Athens have certainly put that sentiment to the test–progress toward a reasonable and durable solution to the European sovereign-debt crisis has been a painful affair of three steps forward and two steps back.
Greek Prime Minister George Papandreou hurled global markets into chaos this week when he announced a surprise decision to call for a referendum on Greece’s euro membership and the mandated austerity measures. Just two days later, under intense political pressure from both other EU leaders and within his own party in Greece, the PM reversed that decision, prompting yet another run back into stocks and other risky assets.
The bad news: The European sovereign-credit crisis is far from over. As I have written for more than a year, Greece, Ireland, Portugal and even Spain are just a distraction–the country that needs to be monitored most closely is Italy. All of the other PIIGS nations (Portugal, Italy, Ireland, Greece and Spain) are relatively small economies. But Italy is the third-largest country in the eurozone and its government debt-to-gross domestic product (GDP) ratio stands at close to 120 percent. Italian 10-year bond yields spiked to well north of 6 percent this week, a key level to watch; yields much higher than that will make it exceedingly difficult for the Italians to bring down their debt burden to sustainable levels, regardless of the austerity measures passed.
The good news: There are signs that EU leaders are finally recognizing the gravity of the situation and, in characteristically gradualist fashion, making progress toward stabilizing their economy.
Although the European Central Bank’s (ECB) new president, Mario Draghi, delivered a surprise 0.25 percent cut to Europe’s benchmark interest rates earlier this week, he also sounded a cautious note on the central bank’s program of purchasing Italian and Spanish government bonds in an effort to reduce yields.
He reiterated his predecessor’s mantra that bond purchases are “temporary” and aimed at “the functioning of monetary policy transmission channels.” Of course, Mr. Draghi, dubbed “Super Mario,” is an Italian, which puts him in a difficult position. There are already elements in Europe who are suspicious of an Italian at the helm of the ECB; one can only imagine the reaction if his first act as president of the central bank were to announce a massive expansion of the ECB’s bond-buying program targeting his home nation. However, that doesn’t mean his rhetoric won’t soften if conditions deteriorate.
Moreover, Mr. Draghi’s admission that the euro-area is headed for at least a mild recession was a welcome change. Europe appeared to be in denial about the impact of the sovereign-debt crisis on the region’s financial system and real economy. Recent data from Europe, including the region’s Purchasing Manager’s Index (PMI), suggest that the EU may already be in recession. And with growth clearly slowing, the Continent facing an inherently deflationary deleveraging process and commodity prices pulling back from their highs, it was becoming increasingly untenable to argue that inflation was a major concern. This reality check should also pave the way for a more aggressive monetary easing into early 2012–I expect another 0.25 percent cut to rates by year-end, with more to come in 2012.
Ultimately, the Europeans will be forced to step up their efforts to reduce yields on Italian government bonds by purchasing debt in far larger quantities than has been the case since the ECB’s program began in early August. It’s also likely the market would react positively if Italian Prime Minister Silvio Berlusconi steps down. One possible solution would be for the Italians to elect a “technical” government charged solely with implementing a credible package of austerity measures.
Although Italy’s government debt situation is tenuous, it’s important to recognize that the nation isn’t in the same dire straits as Greece–Italy’s deficit is currently among the smallest in the EU and the amount of austerity and reform required to balance the budget is comparatively modest. The country also benefits from low levels of household debt, particularly compared to nations such as the US and UK. Although Italy’s government has been profligate with debt over the years, her citizens haven’t been.
Another bit of good news is that contagion to other global credit markets has been limited. In fact, US high-yield debt markets have experienced a significant rally in recent weeks, prompting a resurgence in new issues. In October, US high-yield issuers sold $9.31 billion in debt compared to $6.1 billion in September and just $1.12 billion in August. And just four days into the month of November, US junk bond issuers have raised about $1.8 billion.
Europe has been the main driver of global markets for the past three months and the market will continue to be sensitive to headlines out of the Continent. But continued signs of progress in the EU will be enough to calm fears. This week’s modest bout of profit-taking in the US stock markets after a near-record October rally won’t change the basic equation–stocks are likely to head higher into year-end.
The US Economy is Strengthening
Across the pond, the US economic picture continues to brighten. The first week of the month is always a big week for economic data, with the release of the Manufacturing and non-Manufacturing PMI and the widely watched monthly employment report.
Although the headline numbers looked slightly worse than consensus expectations, the details of the reports were actually robust. They’ve boosted my confidence in predicting fourth-quarter US economic growth of about 3 percent.
I avidly follow the PMI data released each month by the Institute of Supply Management (ISM). The interpretation of this data is simple: Readings over 50 indicate expansion for the manufacturing sector while readings of under 50 indicate contraction. Typically readings under 45 are consistent with an economy in recession; so far this year, the Manufacturing PMI has never dipped below 50.
The October reading for the Manufacturing PMI was 50.8, down slightly from 51.6 in September and below expectations for 52.0. The first point to note is that there’s not a great significance to 1-point-move in the PMI numbers; the fact that the headline PMI was a bit below expectations isn’t particularly relevant.
More importantly, however, is the sub-indexes within PMI. In particular, the PMI for Manufacturing Inventories slumped from 52.0 in September to 46.7 in October and the PMI for Customer’s Inventories dropped all the way to 43.5 from 49.0. This suggests that in October, manufacturing inventories were still contracting and customers’ inventories were reported as “too low.” A drop-off in inventories tends to depress growth and the overall PMI number because falling inventories means less production. But as I noted in last week’s issue, when inventories are cut too much, businesses must ultimately rebuild. Falling inventories dragged US third-quarter economic growth by about 1.1 percent, and I suspect they’ll add to fourth-quarter and, likely, first-quarter 2012 output.
Another crucial index to watch is the New Orders PMI–readings above 50 mean that companies are seeing a pick-up in orders for new goods. The New Orders subcomponent is considered the most forward-looking of the PMI indexes because orders ultimately translate into production and output growth. What’s absolutely crucial to recognize is that new orders grew to 52.4 in October from 49.6–the number of new orders went from contraction to expansion, which suggests future growth.
Lean inventories combined with a pick-up in demand is the recipe for faster economic growth and that’s exactly what I forecast for this quarter. Certainly, none of this is not consistent with a recession.
As for the October employment report, the headline number of 80,000 non-farm payrolls created was less than the 95,000 to 100,000 the consensus expected. In addition, private payrolls grew 104,000 compared to expectations for about 125,000. I read one headline on a news service today stating that the jobs number missed expectations by a “huge margin.” This is an idiotic statement–a miss of 15,000 to 20,000 jobs isn’t even statistically significant.
In addition, the actual jobs growth was far, far above expectations. The Bureau of Labor Statistics (BLS) revised their estimate of payrolls growth in September from +103,000 all the way to +158,000 and their estimate of August jobs growth from +57,000 to +103,000. That means that while October jobs growth was 15,000 less than expected, the BLS added more than 100,000 jobs simply by revising the prior two months’ reports sharply higher. A gain of 100,000 jobs is actually statistically significant.
Some investors may remember all the headlines about zero jobs growth in the month of August; the market bears seized upon that release as proof the US is headed for recession. In the first release of the August data, the BLS reported zero total jobs created because the decline in government jobs offset all private sector gains. In the Sept. 2, 2011, issue of Mind over Markets I wrote:
Trends in initial jobless claims and last week’s report from ADP Employer Services also raise questions about the accuracy of the latest BLS data. In the past, divergences between the ADP and BLS data have been followed by subsequent revisions to the BLS estimate. Many economists also contend that ADP’s employment statistics are less-sensitive to weather-related events than the BLS data.
My suspicions proved correct. The August data was revised higher to +57,000 jobs last month and up to +104,000 this month. Consider that before the August Employment Report was released, economists were looking for about 75,000 jobs to be created–subsequent revisions have taken a report considered well below consensus and turned it into a report that was significantly above expectations. This should be a warning to anyone attempting to divine the economy’s trend based on 10,000 or 15,000 jobs in a single month’s data.
I also suspect October jobs data will be revised higher. In the most recent week, initial jobless claims dropped to 397,000, the lowest in weeks, suggesting a pick up in the jobs market. In addition, the ADP Employment Report released earlier this week showed 110,000 private-sector gains compared to expectations for about 100,000. Because the ADP has historically underestimated BLS, I would expect upside revisions in coming months.
With the US economy accelerating again from a summertime slump and Europe stabilizing, albeit gradually, the market still has room to the upside. My biggest fear remains for the second half of 2012, when the combination of a contentious US Presidential election cycle, a massive, looming increase in taxes and continued weak growth in Europe may raise uncertainty once again.