Improved macro data as year heads into final stretch

Today’s commentary

The news flow over the Thanksgiving weekend and starting this week has been positive. I believe the data support continued global recovery, even in Europe where the data have been the weakest as the latest batch of economic data show Europe’s recovery gaining some steam. In Britain and North America, the question is asset bubbles.

My view for half a year now is that Europe was moving into a cyclical recovery that, given Europe’s economic laggard position, meant the global reflation trade has been successful. And while Europe still remains vulnerable to an exogenous shock, I believe we have finally fully left the fist phase of economic crisis behind. This morning, we saw a raft of manufacturing data out of Europe for November. The numbers were up nearly across the board, with Italy actually leading the way. It was the fifth consecutive month of expanding factory orders in Europe. Germany’s PMI came in at 52.7, the best amongst large eurozone economies. But Italy spiked up to 51.4, the best for 2 1/2 years. Greece remains the laggard, but even there the numbers were the best in 51 months. In other economic news, eurozone unemployment fell for the first time since 2011, making clear that we are seeing an improvement not just in output but also in employment, which will better sustain recovery.

Still, 52.7 as a high number for the PMIs is weak. And youth unemployment is still at 24.4%. Italy is a weak link despite the positive figures. The banking sector is weak and that has negatively impacted small and medium-sized business disproportionately. The Wall Street Journal had a good article on the credit problem today. The ECB is on to this and Marc Chandler reported that the central bank in Italy has proposed giving banks equity in the central bank and paying dividends to those shareholders out of reserves. This move seems to have ECB support. Italy’s two largest banks own more than half of share. So a dividend will top up equity capital nicely. Marc Chandler says this could be worth4 billion euros of capital for Italian banks. Meanwhile, Sober Look reported that the ECB is also considering a new LTRO-type liquidity operation, but only available if banks agree to increase lending to business. And I assume this means small business in the periphery because that is where the problem is.

I see these measures as a clear indication that Europe’s policy makers are taking steps to make sure the recovery sticks. That means that, while fiscal policy will remain tighter than in the UK or the US, monetary policy is becoming looser. And that policy difference favors European equities, which are priced relatively less expensively than US equities.

In Britain and North America, the recoveries have been much stronger. But potential bubbles in equities and in housing are being talked about everywhere. In the links this morning, I noted Robert Shiller, Marc Faber and Nouriel Roubini all out with comments on the potential for bubbles or the existence of bubbles. And Jeremy Grantham’s firm believes US equities are 40% overvalued. So we are getting a very wide cross-section of pundits who see froth or outright bubbles. Yet central banks remain in easing mode, with rates at near zero percent. I don’t believe we are in a bubble right now. But I believe equities are significantly overvalued in the US and that, given the policy stance, a bubble is likely. This overvaluation is in all manner of risk assets like housing, leveraged loans, high yield bonds, equities, digital currencies like bitcoin and elsewhere. Eventually these markets will revert to mean and the higher the valuation is relative to trend, the larger the economic shock we will have. When this will occur is the $64,000 question.

I do not see the markets for government bonds as ‘overvalued’ or in a bubble if we are talking about fiat currencies defended by sovereign central banks. The central banks are giving us guidance that is consistent with the yields in those markets. If rates remain at zero, then the low yields in sovereign government bonds are more than justified. Moreover, from a liquidity perspective, the desire to reduce deficits can only reduce the available safe asset collateral available to finance increased credit. That necessarily creates a desire to shift private portfolios into next best asset classes, bidding up those markets.

It is good to see job growth result from all this easy money. But easy money is at heart a trickle down type of public policy that works through private portfolio preferences and asset price inflation. That is a dangerous thing in my view. Moreover, given the huge run up in a number of asset classes, it is clear that we are going to have a lot of give back in both financial markets and the real economy when the froth turns to bubble and then to a burst bubble. Easy money is not a good solution to economic malaise because it is going to have large unintended consequences when this ends badly. But we are already too far along this path and the economic growth has begun to pick up. Right now, the picture is up. The downside is not on the horizon yet.

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