Have We Seen The Future: The European Solution/ China Slowing?

Being bearish is so exhausting.  I felt so lonely; every day reading analyst research reports increasing estimates, strategists targeting S&P 1300 – it was getting to me. And then the endless articles about the negative feedback loop, castigating those who dared voice a jaded view on the economy.  Much like those kindergarten girls who I coached in soccer many years ago, I thought every broad based comment was directed at me.  I needed a break.  I decided it wouldn’t be that difficult to change my outlook since I tend to be more optimistic than pessimistic. I find life much easier that way and with my golf game if I focused on the negative, if I only looked at the blemishes, I would be a really bad tennis player instead of a decent golfer (caution: literary license at work). I looked for an opening, a sign of what could go right.  Europe was the biggest near term issue and I decided to put myself in the Germans’ shoes. I took off my Tod’s, after all, they are a sign of profligate Italian spending, and figuratively put on a pair of Jackboots. I channeled Merkel and decided that the German motivation for holding the Euro together was stronger than the Greek’s desire to derail it.  After all, given that Germany is one of the strongest economies in the world with trade surpluses only recently surpassed by China, if they were to have their own currency it would decimate their export economy.  Germany needs weak partners in the Euro so that their machine tools and cars look cheap to the rest of the world. 

 

I took off all my short exposure, primarily index shorts, beginning of last week, which of course, took my long exposure higher. I added to this by increasing my holdings in some core holdings including KO, QCOM and WLP, and picked up a bargain in NIHD. I started to pare back exposure yesterday, first at a leisurely pace, only to see the news about the potential framework of the European bank recapitalization erase about a third of yesterday’s gains. The news wasn’t a surprise to me; I had written that I had expected bumps in the road to EU resolution from “leaks” and dissension to occur before we reached the moment of resolution. Slovakia didn’t scare me; their decision was an easy one – either return to using live cattle and goats as a currency or approve the ESFS.  For the Slovakian politicians, with 50% of their trade into the EU, it is only a question of how many new Mercedes and Volkswagens they could wring out of the Germans.  My reason for cutting back exposure was fairly simple which is that the market move higher was, in my view, entirely due to Sarkozy and Merkel guaranteeing a “deal” by November 3^rd.  For bulls, the European debt crisis had been the governor on the market, holding it back from much higher levels, believing that corporate earnings remain robust and that China is not slowing.  But has the market been too generous in taking Merkozy at their word when they have arguably done little to earn it.  And, by the by, the EU isn’t only about France and Germany.   

 

So what is the market assuming?  My best guess is that equity investors assume a shock and awe plan which would entail:  massive liquidity injections into the economy whether in the form of a TARP like plan or some other mechanism: continued buying of sovereign bonds; capital injections into banks and backstopping future equity holders accompanied by massive dilution to existing shareholders; and either Greece defaults in a controlled manner, with a one time alimony payment, or a write-down of its debt to believable levels.  SIGN ME UP.  Actually I did sign up as I noted above.  Instead what we got yesterday was the hint that the banks may be given a period of time to raise their Tier 1 capital ratio to 9%.  They are a number of ways to do this: sell equity which they have said they don’t need thus limiting the appeal of doing so at 50% of book (I choose not to believe those numbers); convert debt to equity; or cut credit lines which, of course, has the impact of improving the balance sheet. If this were to be the plan, we saw the future yesterday in terms of US equity market reaction and today, in the sell-off of the European markets.  It wasn’t good.  But even assuming the markets go for this plan either because optimists win the day or because the market retreats thus lowering the hurdle rate what is acceptable, and the banks succeed in raising capital, there will be marked uncertainty during the period of capital raising and the eventual effect will be a slowing of growth as credit availability declines.  And this, of course, assumes that investors are as gullible in believing that Tier 1 capital is 9% as they were in believing the stress tests were accurate.  Bottom line, to quote that noted philosopher Michelle Bachmann “the devil is in the details.” 

 

The other issues of course are what a Greek default would do to the markets and the potential for a downgrade of French debt.  The best news for France is just like in WWII, they were on the sidelines while we fought the battle.  As the US came through virtually unscathed so will the French.  As to a Greek default, the result is more up in the air. Most equity investors I believe assume that any default would be accompanied by ring fencing the debt of Spain and Italy and this would be positive.  Who needs ouzo when we have grappa? Of course, any significant haircut only worsens the bank’s balance sheets but that is assumed to be taken into account as well. What about a big haircut: well, the banks responded to that potential today much like Hercules did when faced with the same scenario. 

 

But wait! Here comes Mario Draghi to the rescue.  That’s like putting Bernie Madoff in charge of compliance.  Draghi knows how to spend it so he knows austerity from the other side.  He will undoubtedly cut rates at either his first, or more likely, second meeting.  By that time, European numbers will show recession and commodities will have declined to a level low enough to provide cover for a 50 BP cut. 

 

Unless the Troika comes forth with a plan of shock and awe that removes all doubt about further contagion, I see the market fading.  Even if the shock and awe doesn’t dazzle, the surrounding issues are becoming too prevalent to ignore. In my view, as evidenced by the trade numbers form China, the European economies are slowing significantly.  US earnings season has a decidedly different tone out of the gate then those of the past 6 or so quarters. And Washington is still a mess. Actually the bright spot from Washington is that I expect a partial ray of sunshine as the Republicans and Democrats come to common ground on some mechanism to create jobs. I would expect infrastructure spending and military put to work in some fashion but keep in mind that there is a decent lag to the passing of the bill and the actual spend.  I also believe that if Romney is able to break to the front of the pack convincingly, it might actually help matters in D.C. and bring Obama more to the center while also giving business leaders hope if Romney can take a strong lead in the polls over Obama.  However, with no votes being cast in any primaries just yet, this is way too soon to call.

 Is China’s export economy slowing or are they trying to fend off a trade war and pressure to let their currency rise by showing such poor numbers?  Depends if you believe their numbers or not.  I do in this case but only because it supports my investment thesis on China slowing. I’ll take what they give me.  Jawboning down economic activity further pressures commodity prices allowing them to stockpile inventories. 

 JPM:  if JPM can’t put up decent numbers with the strength of their franchise, then what does that say about the rest of the financials?  The regional brokers are in for a world of hurt. JPM is picking up share in IB and still down 31%.

 Although I disagree with what appears to be the overriding premise of the OWS movement which is the distribution of earned wealth to those who haven’t earned it such as community organizers (sorry that slipped.  After all, community organizers are the farm team for the Presidency), I do admire their ability to mount a globally coordinated effort.  In fact, I would like to see them share their insights with the EU and Washington in terms of how to accomplish a purpose, any purpose at this point. 

 I think RIMM’s moment of silence for the passing of Steve Job’s lasted a bit too long.