Risk to the upside in the U.S. contrasts to Europe

Today’s commentary

Summary: The latest data out of Europe shows the economy in the euro zone continuing to expand and suggests that we are probably in a technical recovery. In Europe, however, the threat to recovery is to the downside, whereas in the U.S. the main threat is to the upside in the form of asset bubbles.

According to Markit’s Manufacturing Purchasing Manager’s Index released this morning, the eurozone’s manufacturing sector expanded for the fourth month on the trot. While the PMI was still a relatively weak 51.3 in October, up from 51.1 in September, 50.0 is the demarcation line between expansion and contraction. Only Greece and France saw readings below 50.0, demonstrating that the cyclical upturn is widespread.

At the same time, economic data from the U.K., the U.S. and China showed the world’s major economies in expansion mode. Overall, the takeaway should be that the world’s economy is finally at a point again where both developing and developed nations are all simultaneously growing for really the first sustained period since the financial crisis in 2008. This fact alone casts the macro data to support equity markets in a somewhat bullish light. Nonetheless, we should reserve some caution for two juxtaposed reasons.

First, the recent kerfuffle between the U.S. and Germany over the Semiannual Report On International Economic And Exchange Rate Policies released by the U.S. Treasury Department highlights the risks in Europe. Paul Krugman, as is his wont, has taken the issue by the horns and blogged incessantly on it (see here, here, here, here, here and here). Krugman has a pointed and polemical style which can be provocative, causing the Germans to take umbrage at the whole line of argument. However, the arguments Krugman makes in his series of posts do make sense. And the totality of the argument is that the risks in Europe are skewed to the downside.

I would characterize the European policy response to the financial crisis as deflationary because the goal is to reduce sovereign debt burdens in the eurozone relative to the size of the economy, regardless of the consequences. The German position is that fiscal profligacy was at the core of the crisis. The facts belie this as Ireland and Spain in particular had better fiscal numbers than the Germans in the lead-up to crisis. Many German policy makers deplore the fact that Germany itself has been in violation of the eurozone pact for stability and growth over the past decade. The point is that the prevailing economic dogma in core Europe is that the stability and growth pact for the eurozone was not strict enough and that, had it been more strict, we never would have had a crisis in Europe. 

In the context of a fixed currency, a crisis and high public and private debt, adhering to the stability and growth pact, even in a backloaded austerity form, effectively means creating a recession, with the goal being fiscal sustainability coupled with labor and export cost deflation, so-called internal devaluation. The Germans know this but claim that there is no other way. In fact, Germany is concerned about its own public finances – and this is the reason that they have not met the cuts in the periphery with expansion. Most of the heavy lifting of rebalancing will fall onto the periphery.

So that’s where we are: a debt crisis that has unleashed a simultaneous public and private sector deleveraging across a wide swathe of European countries combined with limited countervailing efforts on the part of the Germans and a loosening of the ECB’s traditional monetary stance on a number of issues. Paul Krugman calls this beggar thy neighbour and I agree. Here’s the thing though: it isn’t working as the euro has been appreciating due to the deflationary policy stance in Euroland making real interest rates in Europe higher in relative terms. If Europe doesn’t watch out, it could find itself in Japanese territory – and that means more onerous debt burdens and a rising currency, making internal devaluation more difficult to pull off. This is why the risks in Europe are mostly to the downside.

In the U.S. (and the U.K.) by contrast, the policy response has been much more reflationary with the reflation concentrated in monetary policy. Both U.S. and U.K. governments have backed away from using fiscal deficits as driving policy force to counter private sector deleveraging. Instead the Federal Reserve and the Bank of England have turned to low interest rates and quantitative easing as the main vehicles to fuel reflationary policy.

The risk here – as Janet Yellen put it  three years ago – is that “accommodative monetary policy could provide tinder for a buildup of leverage”. Fed Chair nominee Yellen does not believe we are seeing the excesses indicative of excess leverage and bubbles yet. Rather, she believes that more easing is warranted given low consumer price inflation and high unemployment in the U.S.. Nonetheless, Yellen is clearly aware of the risk.

Nonetheless, the number of articles in the business press pointing to market excess are an indicator that concern has increased about excess. The Wall Street Journal summed it up well today regarding U.S. equities.:

For some investors, it feels a lot more like 1999 than 2013.

Third-quarter earnings have not been spectacular. The U.S. isn’t expected to grow at anything close to breakneck speed next year. And there are few industries experiencing huge profit expansions.

Despite all that, a number of high-profile—mostly technology—stocks are soaring. The heady advances are making shareholders of these companies big money, but they’re also raising serious questions among some analysts about whether the unusual trading is a troublesome sign for the overall market.

I do not expect the Fed to change course on the Fed Funds rate due to these concerns. Even Dick Fisher, the non-voting FOMC member who is head of the Dallas Fed has said that fiscal policy has created a headwind for the U.S. economy. The most I expect the Fed to do is taper its large scale asset purchase program. Fisher, who opposes this program, has said the pace of tapering will be data-dependent. And his view is echoed by James Bullard who says the Fed will cut its LSAP program when the jobs picture improves.

What this effectively means is that monetary accommodation will remain in place for the foreseeable future, with only the signalling of the level and the level of accommodation at question. Are real rates too low? I would say yes because of the low interest hurdle rates and covenant-lite situation for private sector leveraged loans and high yield borrowers. We should expect a lot of excess that will have to be unwound as credit writedowns in the next cyclical downturn. I would go further and say that the die has already been cast due to the policy heretofore, such that these writedowns are baked into the cake. The future accommodation will only make the excess more pronounced.

This points to risks to the upside in the U.S. (and the U.K.) if you will, meaning the rebound in asset prices may have legs, especially in view of the global nature of economic growth everywhere. If and when the Fed does eventually tighten, asset prices will have risen much further and will not reflect the underlying fundamentals.