Good Evening: U.S. stocks finished mixed again today, but the journey to unchanged was the mirror opposite of Tuesday’s action. Equities tried to extend the rally that began yesterday afternoon, only to succumb to a wave of selling in the final hour. While it was tough to tell if the sudden return of risk aversion portends more weakness ahead, the next two sessions should be telling. If yesterday’s lows give way, then the cat will once more be among the pigeons. If those lows hold, then today’s action may have been the type of head fake that could soon see the S&P 500 back above 1100. The underlying debt problems both here and in Europe continue to receive a lot of attention, most of it of the gloom and doom variety. I’ve been as guilty as anyone on this count, so perhaps we should examine some views that give our current debt issues some historical context.
Global equities were mostly higher overnight and the news flow was on the quiet side. When U.S. stocks opened in New York, most of the averages were quickly 1% higher and the VIX was probing toward 30. By 11am Eastern, the gains ranged from just under 1.5% for the Dow to almost 3% for the Russell 2000. The credit termites in Europe were oblivious to the rally on Wall Street, however, and different news items began gnawing away at those equity gains. A report by the FT that China was reviewing its holdings of European debt was one of the chief culprits, but a portfolio review is hardly the same thing as the type of wholesale liquidation some apparently fear. China just doesn’t operate that way. Renewed weakness in the euro currency didn’t help calm any nerves, though.
While liquidation is too strong a term, what happened to Microsoft today is an indication of just how fragile the market environment has become of late. WhenMicrosoft’s CEO opined that any economic weakness caused by the debt mess in Europe might not be limited to economies on the Continent, the knee-jerk reaction by investors was to treat Mr. Balmer’s econometric guess as a de facto lowering of forward earnings guidance. MSFT shares were sacked for a 6% loss before finishing 4% lower. If negative psychology could so easily overwhelm a cheap behemoth like Microsoft, investors must have started wondering what might happen to smaller and more speculative names when the forces of momentum take over.
They soon found out. After trading mostly sideways during the middle of the day, the indexes fell sharply during today’s final hour of trading. The Dow, S&P, andNASDAQ all finished down by more than 0.5%, but both the Russell 2000 (+0,41%) and Dow Transports (+1.15%) managed to hold on to decent gains. What happens next is anyone’s guess, but the disparate action in the major averages indicates the noise to signal ratio is pretty high right now. Treasurys once again pulled aCostanza and did the opposite of equities. Early losses were pared as the day wore on and yields climbed between 3 and 6 bps. The dollar benefited from the sick euro, with the USD index up more than 1% at day’s end. Commodities, which were mostly closed before stocks began falling this afternoon, finished with solid gains. It will be interesting to see whether these gains hold up tomorrow, but the CRB index rose 1.6% on Wednesday.
The late author, Michael Crichton, wrote many fine novels that later became entertaining movies. More than a few of his stories explored Man’s penchant for letting the pace of scientific discovery far exceed the development of ethical standards and risk management systems for safely harnessing these discoveries. “Disclosure” was different. Accused of sexually harassing his female boss, the protagonist in Disclosure thinks all his troubles are behind him when the harassment arbitration is settled in his favor. Tom Sanders’ sense of vindication doesn’t last long, though, and only when he heeds a series of warnings imploring him to “solve the problem” does he finally emerge triumphant.
If you happen to watch the movie version of “Disclosure” any time in the near future, perhaps you, too, will come away with the feeling that the warnings issued to Tom Sanders (Michael Douglas) could just as easily apply to today’s sovereign debt mess. For almost three years, governments have been treating the upheavals in our financial markets as a liquidity problem. It’s not; illiquidity is just a symptom of the underlying problem that too many developed nations have taken on more debt than they readily can afford. Even the U.S. is not immune from the financial version of the swine flu infecting Europe’s PIGS. Only yesterday did Moody’s warn the U.S. to curb its profligate ways or it will risk losing its AAA status (see below).
Also below please find three different viewpoints about the potential for a rising tide of sovereign debt to drown the nations now issuing so much of it. Aside from a thumbnail sketch of each, I will let each author speak for themselves. These articles are a lot to chew on, but please consider trying to get through them all over the upcoming holiday weekend. Each offers some interesting historical context, and first up is Harvard’s Niall Ferguson:
Fiscal Crises and Imperial Collapses: Historical Perspective on Current Predicaments
Mr. Ferguson offers perhaps the gloomiest perspective among the three. He sees unsustainable debt levels in almost every Western nation (Canada is an exception), and while he thinks defaults by countries like the U.K. and U.S. are unlikely, he also thinks it’s highly unlikely any modern nation will have the will to rein in spending and grow their way out from under the debt loads. He offers some interesting historical context that is too often ignored, saying, for instance, that the only nation throughout history to combine austerity and growth to defeat a debt burden was Great Britain in the early 19th century. Some nations will have to default, says Mr. Ferguson, but the most likely outcome for many of them will be the silent default of currency debasement and inflation.
Investment Outlook, by PIMCO’s Bill Gross
PIMCO’s Bill Gross holds the middle ground among these three authors. Also citing history, he sees some nations (e.g. Greece) eventually defaulting on or “restructuring” their excessive debts because they’ve already reached the point where austerity can’t save them. Middling debtors will likely suffer a long period of stagnation in Mr. Gross’s view, while reserve currency nations like the U.S. may be able to avoid the worst outcomes. The recent rhetoric about fiscal responsibility is nice, says Mr. Gross, but he thinks it will be difficult for any nation to escape debt deflation by creating more debt. PIMCO’s “New Normal” will not be painless.
Credit Suisse Market Focus: Sovereign Risk — Beyond the Numbers
Credit Suisse is the most sanguine I’ve seen among those who have thoughtfully tackled the debt issues facing so many developed nations. Good quants that they are, the CS team assigns objective and subjective ratings to each nation and its current financial position. Some of their views are interesting and insightful, but in the end I think they give governments too much credit when the historical record is filled with debits. I happen to think politicians are unlikely to make hard choices unless absolutely forced by crisis to do so. But, while I have my doubts, let’s hope Credit Suisse is ultimately proven right. If they are, it will likely happen because governments start recognizing the debt problem for what it is and begin to act responsibly before it’s too late. Disclosure’s Tom Sanders was lucky. Now we need to follow his example and “solve the problem”.
— Jack McHugh
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