After the Fall A Race Against Time

 

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Europe continues to be a problem for the global economy. In addition, we also have problems in the U.S. like the expiration of the Bush Era tax cuts, the deficit, the election, cities going bankrupt and the municipal and state budget deficits to name a few. The Chinese and Indian economies are slowing. Is it me, or are there more problems economically today than ever before?

After the Fall

In a 2010 article by Carmen M. Reinhart of the University of Maryland, and her husband, Vincent R. Reinhart of The American Enterprise Institute, they explain the behavior of GDP, unemployment, inflation, bank credit and real estate prices in a twenty-one year window surrounding selected adverse global and country-specific shocks or events. The episodes include the 1929 stock market crash, the 1973 oil shock, the 2007 U.S. subprime collapse and the fifteen severe post-World War II financial crises. They found that GDP growth and housing prices are significantly lower and unemployment higher in the ten-year window following the crises when compared to the decade that preceded it. They present evidence that the decade of relative prosperity prior to the fall was importantly fueled by an expansion in credit and rising leverage that spans about ten years; it is followed by a lengthy period of retrenchment that most often only begins after the crisis and lasts almost as long as the credit surge. If this trend holds true we have six more years of this economic mess.

Their main results can be summarized as follows:

  1. Real per capita GDP growth rates are significantly lower during the decade following severe financial crisis. The median post-financial crisis GDP growth decline in advanced economies is about 1 percent.

  2. In the ten-year window following severe financial crisis, unemployment rates are significantly higher than the decade that preceded the crisis. The median unemployment rate is about 5 percent higher than prior to the crisis.

  3. After the crisis median housing prices are 15 to 20 percent lower in the eleven-year window with cumulative declines as large as 55 percent.

  4. In the decade prior to a crisis, domestic credit/GDP climbs about 38 percent and external indebtedness soars. Credit/GDP declines by an amount comparable to the surge (38 percent) after the crisis. However, deleveraging is often delayed and is a lengthy process lasting about seven years.

The decade that preceded the onset of the 2007 credit crisis fits the historic pattern. If deleveraging of private debt follows the track of previous crises, credit restraint will damp employment and growth for some time to come. Deleveraging could take a decade.

Race Against Time

The European Union (EU) is in a “race against time” to do something about its economic crisis. Paul De Grauwe, Professor at the London School of Economics, says that the European Central Bank (ECB) must be the lender of last resort. He says that countries must give up sovereignty over fiscal decisions and their banks. The problem is that European countries do not trust each other. A senior EU official with direct knowledge of the situation recently said, “I need to make it clear what the ESM (European Stability Mechanism), the bloc’s permanent bailout fund that comes into operation this year, can do: the ESM is able…to take an equity stake in a bank but only against full guarantee by the sovereign concerned.” This is still the problem: insolvent governments guaranteeing insolvent banks. This doesn’t solve the problem that is getting worse each day. At some point there has to be a true monetary and fiscal union like the U.S. or a breakup of the EU. In both cases the European economy and the global economy weaken. A breakup of the single currency would precipitate a horrific result says Der Spiegel, Germany’s oldest news magazine. “All Europe would plunge into a deep recession. Governments, which would be forced to borrow additional billions to meet their needs, would force the choice between two unattractive options: either to drastically increase taxes or impose significant financial burdens on their citizens in the form of higher inflation."

If the EU decides to create a United States of Europe headquartered in Brussels and gives power over the banking system and government budgets to Brussels, what will happen? Will this all of a sudden solve the problem? The bad loans in the banks and the huge sovereign debt burden will still be there. Brussels will have to stabilize the banks by injecting capital to cover write-offs, creating a huge debt burden at the ECB. Then Brussels will tell the overleveraged countries that they must put severe austerity programs in place and must default on a portion of their debt or take at least a decade, and in some cases more than a decade, to slowly pay down their debt. What will this do to the European economy? It will create a very severe recession/depression for many years. Do you think that these sovereign nations will be willing to hand over their sovereignty to Brussels? Either way a global recession takes hold with a depression in Europe.

There is a third option. Some believe that the cure for deficits is growth and the quickest way to spur growth is via monetary reflation. A still-cheaper euro – at parity with the U.S. dollar – could restore Europe’s competitiveness, end its debt crisis, and save its currency. It worked before in the last decade. After two years of haircuts and half-measures, the only way left to save the euro may be to debase the euro.

The idea of printing money is dangerous heresy to European authorities. Instead, European Union officials have pushed spending cuts and tax hikes as conditions for bailouts of Greece, Portugal and Ireland, along with reforms of regulation that constrict job growth even in the best of times. Europe’s political leadership, led by German Chancellor Angela Merkel, contends that structural and fiscal changes are needed first, and that excess money and credit were the causes of the current problems. Simply revving up the printing press would only let Greece, Spain and Italy off the hook. European leaders want to use the current crisis to force reforms that wouldn’t be possible in normal times.

Some think an easier ECB policy would likely induce higher inflation in Germany, but in the periphery “excess capacity is abundant” so stronger demand would translate into greater economic activity rather than upward pressure on wages and prices. Others disagree and say that if the ECB prints money, which violates its current structure, it could send European credits into a tailspin.

The conundrum is the cost of the single currency and its different effects on each country. Fixed exchange rates force an “internal devaluation”, in which belts are tightened literally and figuratively – prices are lowered, wages and payrolls are reduced, and government budgets are cut – in order to maintain the currency’s value. These are painful steps that don’t go down well in a democracy.

United States

You get the feeling, and the data is starting to back it up, that the U.S. economy has stalled and there are clouds on the horizon. There is uncertainty for sure. We don’t know who will be in the White House or Congress next year. We don’t know what taxes will be next year. We don’t know if or how the government can lower the deficit. We are watching cities in California and other states file for bankruptcy. We are facing a “fiscal cliff” as the budget deficit gets out of control.

The stock market does not like uncertainty. The fate of the EU is uncertain. China’s growth is uncertain. U.S. economic growth is uncertain. S&P 500 earnings growth for the second quarter is projected to drop relative to the first quarter for the first time since 2009. Unemployment is stuck at 8.2% but really is at 15.9%. Everyone is waiting for the results of the election before making plans for next year.

Conclusion

What has happened in the current financial crisis is not different from prior crises. We will get through this but it will take time, probably another six to ten years. As Europe continues to teeter on the edge of collapse, the Chinese economy slows, the U.S. economy slows and money flows from the stock market and countries that are in financial trouble into the U.S. bond market. We don’t see this changing anytime soon. The stock market has and will bounce around based on the news of the day. With earnings growth slowing and the global economy slowing, we could see another correction in the stock market. An increase in the severity of the European crisis can be the catalyst for a Lehman Moment in Europe.

For all these reasons we believe it is prudent to have a balanced asset allocation with a slightly higher allocation to fixed income. As in 2008 preservation of capital is more important than risking capital in the current environment. Interest rates are low but they can go lower, and if they do the fixed income portfolio will look pretty good compared to the stock market as a result of capital appreciation. Once the European event happens, one way or the other, we believe there will be an opportunity to increase equity exposure at very attractive prices not only in the U.S. but in Europe as well.

Jamison Monroe, CIMA®
Chairman & CEO