I have been very cautious on US equities since April 2011, warning that good apparent valuation would be overwhelmed by the significant macro risks. Recently, the US economy has distanced itself from recessionary risks, at least for the shorter term, and US inflation has started to recede, providing relief to consumers and a more solid background for valuation. (Note: see my complete record on equities)

The Euro risk remains significant, especially since all measures agreed upon in the ”comprehensive package” have yet to be realized, if they ever are. However, now that Greece, Italy and Spain have taken the necessary political and fiscal steps to begin the long healing process, the bond market is allying itself with other countries to force the hands of the Germans.

Here’s how I see things.

1. THE EUROZONE ECONOMY IS SINKING FAST. The latest example comes from Italy where industrial orders fell 8.3% MoM in September. Orders were down 3.6% YoY. The September decline was led by domestic demand, as orders from within Italy sank 10.1% MoM, but also reflects weakening demand abroad as orders from abroad fell 5.5%.(Italy Industrial Orders Slump).

The economic weakness will accelerate as banks are forced to retrench and liquidity dries up. The cost of funds is rising rapidly as European banks, increasingly concerned about their ability to access funding, are devising complex and potentially risky new deals that enable them to continue borrowing from the European Central Bank. This is substantially increasing banks’ funding cost.

Some banks are exhausting their supplies of assets—such as European government bonds and certain types of asset-backed securities—that the ECB accepts as collateral and that the banks haven’t already committed to other uses, according to bankers and analysts. Others are scrambling to stockpile such assets to comfort analysts and investors worried about the banks’ abilities to weather a long-term freeze in bank-funding markets.(…)

In the increasingly popular liquidity swap, banks transfer illiquid assets such as non-investment-grade loans to corporations or to finance public-infrastructure projects—and which aren’t eligible to serve as collateral for ECB loans—to investment banks or insurance companies.

In return, the investment banks or insurers provide government bonds or other liquid assets that the original bank can use as collateral to secure loans from the ECB. The investment banks apply a discount to the assets they are receiving—shielding them from some potential losses—and receive commissions on the trades. (Banks Face Funding Stress)

Banks’ liquidity problems get aggravated by the spreading lack of confidence, not only among themselves but also with their own major clients.

Siemens has reportedly taken 6B euros out of SocGen and deposited it directly at the ECB. Not at another Euro bank, not even at a German bank, but directly at the ECB! And today’s WSJ reveals that

Norfolk Southern Corp. has decided not to use any European banks to refinance a credit line out of concern about the banks’ future health, according to people familiar with the matter.

2. CONTAGION RISKS REMAIN HIGH as investors were reminded Wednesday afternoon. (Fitch’s Warning Spooks Investors)

“Unless the euro zone debt crisis is resolved in a timely and orderly manner, the broad credit outlook for the U.S. banking industry could worsen,” the New York-based rating company said yesterday in a statement. Even as U.S. banks have “manageable” exposure to stressed European markets, “further contagion poses a serious risk,” Fitch said, without explaining what it meant by contagion. (U.S. Banks Face Contagion Risk From Europe-BB)

Fitch said the five biggest U.S. banks had $188 billion of gross exposure to France at midyear, including $114 billion of exposure to French banks. That figure represents a quarter of the five top U.S. financial firms’ Tier 1 capital, a measure of a bank’s ability to absorb losses.

The gross exposure shows “the susceptibility of banks to contagion risk and the interconnectivity of large global banks,” Fitch said. (…)

Fitch put out the report, managing director for financial institutions Christopher Wolfe said, because it wanted “to go on record” with the view that the health of Europe’s economies is more important for investors than the direct exposure of U.S. banks. Another Fitch analyst, Joseph Scott, acknowledged that “some of these concerns are very difficult to quantify, especially the macro concerns.”

3. GERMANY IS GETTING MORE ISOLATED ON ECB BACKSTOP   More countries, including France, are openly asking for an ECB backstop.

French Finance Minister Francois Baroin risked renewing a clash with Germany over using the European Central Bank as a backstop, saying that ECB support for Europe’s recue fund is the best way to counter the debt crisis.

“The only remaining show in town is the ECB,” Willem Buiter, Citigroup Chief Economist, said yesterday on Bloomberg Television’s “Surveillance Midday” with Tom Keene. “They may have to hold their noses, but they will have to do it,” he said. “The notion that they can’t do this because of their price mandate is nonsense.” (France Clashes With Germany Over ECB’s Rescue Role)

French Budget Minister Valérie Pécresse added the same day:

“The ECB’s institutional role is the stability of the euro, but also the financial stability of the euro zone,” Pecresse said. “We trust the ECB to take all appropriate measures to maintain financial stability in the euro zone. It did so in 2008 when the situation demanded it, we have all confidence that the ECB will take all necessary measures today.”

Ambrose Evans-Pritchard, the UK Telegraph International business editor confirms: (my emphasis)

On Wednesday, France began to deploy its political leverage in earnest, leading an open revolt against Germany over the fire-fighting role of the European Central Bank.(…)

In what is clearly a co-ordinated move by top EU players, European Commission chief Jose Manuel Barroso said Europe is “facing a truly systemic crisis” that requires a condign response from all players in the unfolding drama. “Should the central bank be responsible for financial stability as well as price stability? My reply is yes, definitely.”

IS ANGELA MERKEL OPENING THE DOOR?  So far, Germans have claimed that the ECB has absolutely no legal ground to act as a backstop. Wednesday, Merkel indirectly asked for other interpretations of the legalities.

According to our interpretation of the treaties, the ECB does not have the means to resolve these problems.”


EU law is complex. While Article 123 of the Lisbon Treaty enshrines price stability as the bank’s chief task, the ECB also has a duty under Article 3 to promote “economic cohesion” and the general objectives of the Union.

“EU treaties do not explicitly give the ECB the role of lender of last resort, but they do not forbid it either. The treaties are silent,” said professor Andre Sapir from the Breughel Institute in Brussels.

THE DEBATE HAS MOVED FROM PHILOSOPHICAL TO EXISTENTIAL. Der Spiegel provides ammo to the hardliners:

Wolfgang Franz, head of the influential German Council of Economic Experts — which advises the government on economic issues — expressed vehement opposition to unlimited ECB bond purchases.

“History has shown us, and not just in Germany, that the monetization of state debt is a deadly sin for central banks,” Franz told the Frankfurter Allgemeine Zeitung in an interview published on Thursday. “Doing so not only results in a loss of independence, but it also raises the risk of inflation. Finally, it also represents the undemocratic collectivization of debt under the auspices of the ECB.”

Mario Draghi felt he had to weigh in, reminding politicians that they have yet to act on their “comprehensive package” (ECB’s Draghi urges action on rescue fund). The problem, as Draghi very well knows, is that there is no money coming forward to load the bazooka. In effect, there is no bazooka!

4. THE BALL IS IN MOTION in an obvious binary situation: Euro blowout or ECB backstop. As more Eurozone countries get attacked by the bond markets, as banks find it increasingly difficult to fund themselves at a reasonable cost and as contagion threatens US banks, the call on the ECB will come in many more languages. Even though “Europe speaks German now!”, Germans will also need not only to hear, but also to listen to and, ultimately, to understand their neighbors’ call.

The “keys” to the EFSB funding problems have eventually been found, though unused for lack of funders. In the same fashion, keys to unlock the legalities with which the Germans have wrapped themselves will also be found in the not too distant future. All that is needed is to put a few investment bankers on the problem, tack on huge finders fees, and solutions, however incongruous, will magically appear.

5. PRESSURES GROWING. An isolated Germany will find it increasingly hard to keep defending the ECB virginity. Bloomberg this morning (Merkel Risks the European Union to Save ECB Credibility):

She argues that it would be wrong to guarantee sovereign debt — with printed money, no less — and would wreck the bank’s credibility. It would also be illegal, she insists: The relevant EU treaty forbids it.

She’s wrong. The ECB can and must play the decisive role in stabilizing Europe’s unraveling economies. The central bank has the resources to stand behind the debts of euro-area governments precisely because it’s the only institution in the unique position of being able to create its own.

(…) the current emergency simply wasn’t foreseen in those discussions. If these aren’t “unusual and exigent” circumstances (in U.S. Federal Reserve parlance) calling for extraordinary measures, it’s hard to know what would qualify.(…)

In the immediate term, honoring the spirit of the treaty as originally conceived risks tearing down the very thing the treaty was intended to build: Europe’s single currency. If the price of preserving the ECB’s credibility is to destroy the monetary union over which the ECB presides, what’s the point? Merkel may be ready to burn the village to save it. Europe’s other leaders should tell her firmly, no thanks.


(…)  a growing chorus of economists within Germany itself is calling for a strategic change. Wurzburg professor Peter Bofinger wants the ECB to cap Italian and Spanish yields.

“We are in an emergency situation; this isn’t plastic surgery. If worst comes to worst, the ECB has to act before the financial system falls. And if it acts, it should act properly and set an upper limit for sovereign yields. It’s naive to believe that Italy can solve its problems on its own. Structural reforms can’t be implemented overnight.”

Dennis Snower, head of the Kiel Institute, said the ECB must act to stem the crisis, even if this means straying into fiscal policy. Thomas Mayer from Deutsche Bank said Italy’s new government will fail unless the ECB buys time by holding down yields, perhaps as low as 5pc. (Ambrose-Pritchard)


“Bunds are no longer reacting the same way,” said Hans Redeker, currency chief at Morgan Stanley. “Until recently, if investors were selling Italian bonds, they would tend to rebalance within the eurozone by buying Bunds. But now they seem to be taking their money out of EMU altogether. US Treasury (TICS) data shows that the money is going into US Treasury bonds as the ultimate safe-haven.”

Critics say Germany is falling between two stools. It has backed EMU rescues on a sufficient scale to endanger its own credit-worthiness, without committing the nuclear firepower needed to restore confidence and eliminate default risk in Spain and Italy. It would be hard to devise a more destructive policy.

There is no change in sight yet. Chancellor Angela Merkel repeated on Thursday that Germany would not accept joint EU debt issuance or a bond-buying blitz by the ECB. “If politicians think the ECB can solve the euro’s problems, they’re trying to convince themselves of something that won’t happen,” she said.


Yet she offered no other way out of the logjam, and each day Germany is sinking a little deeper into the morass. (Ambrose Evans-Pritchard)

This is a binary situation and Angela Merkel will not want to go down in history as the euro sinker. The writing is on the wall and that German wall will also fall.


The Aruoba-Diebold-Scotti business conditions index is designed to track real business conditions at high frequency. Its underlying (seasonally adjusted) economic indicators (weekly initial jobless claims; monthly payroll employment, industrial production, personal income less transfer payments, manufacturing and trade sales; and quarterly real GDP) blend high- and low-frequency information and stock and flow data.


Plot of ADS Business Conditions Index in the Most Recent Two Years

The big surprise comes from the consumer who has kept spending in spite of tough employment and income conditions. ISI’s claim that the stock market is having a strong influence on holiday sales is gaining traction.

If the S&P holds at yesterday’s 1258 close, it will be +7.2% above its Sep average of 1174, an increase that suggests nominal retail sales in 4Q increase +6.6% q/q a.r. Over the last 16 years, there’s been an 89% correlation between Holiday Sales and stock market performance from Sep to Dec.

Economic forecasts are more upbeat (Economy Growing at Fastest Pace of ’11 in U.S. Quarter Forecasts) while inflation is tapering off. Core CPI rose only 0.1% in each of the last 2 months, 1.6% annual rate in the last 3months.


US employment is slowly recovering  (Claims Report Shows Layoffs Slowing)

The U.S. labor market is edging forward, with fresh data suggesting October’s modest job gains are continuing into November.

The US LEI keeps rising, gaining 0.9% in October after 0.1%in September and 0.3% in August. The October advance reflected gains in many areas that have been lagging in the recovery so far.

The October rebound of the LEI — largely due to the sharp pick-up in housing permits — suggests that the risk of an economic downturn has receded. Improving consumer expectations, stock markets, and labor market indicators also contributed to this month’s gain in the LEI as did the continuing positive contributions from the interest rate spread. The CEI also rose somewhat, led by higher industrial production and employment.




At 1221, the S&P 500 Index is selling at 12.9x trailing EPS. The last time the trailing PE fell below 13 was in March 2009. Prior to that, one has to go back to 1989 to find PEs below 13, a period when US inflation was in the 6% range.

The Rule of 20 takes inflation into account when assessing equity valuation. October CPI was +3.5% YoY (+2.4% annualized over the last 3 months). Under the Rule of 20, the appropriate PE should be 16.5 (20 – 3.5) which, using $94.75 trailing EPS gives a fair value of 1563 for the S&P 500 Index.

As the chart shows, the current 22% undervaluation is very rare and has been a strong buying signal.


Now that US recession risks have significantly diminished and that inflation seems to be receding, both earnings and valuation risks have decreased meaningfully (see EARNINGS UPDATE for a discussion of current earnings).

Of course, risks remain, particularly from the political side. This is why valuation is so attractive. However, the Euro risk has entered its “terminal” phase and while US politicians continue to act … as mere politicians, the resiliency of the economy and the easing of inflation, coupled with extraordinarily low interest rates promised for “an extended period” and ample liquidity, provide a good background for US equities.


Leave a Reply

Your email address will not be published. Required fields are marked *