Monday, 12 December 2011

Despite Europe deal, markets and economies remain at risk

Stock markets were relatively flat last week despite decent gains on Friday following the agreement by European Union leaders on measures to be taken to resolve the region's debt crisis.

On Friday, the leaders agreed on several short-term measures to alleviate the debt crisis. Up to €200 billion will be provided to the International Monetary Fund to help it finance European governments. The European Stability Mechanism will come into force a year early in July 2012, thus running concurrently for a period with the European Financial Stability Facility, whose leverage "will be rapidly deployed".

For the medium and longer term, the 17 eurozone countries agreed to sign an intergovernmental treaty to enforce fiscal discipline. This may be extended to nine of the other EU countries who are not members of the single currency. The remaining non-member, the United Kingdom, opted out of the agreement.

The treaty, to be signed not later than March 2012, will require that government budgets stay in surplus or be close to balance, with automatic consequences for the governments whose budgets fail to do so.

The EU deal helped stocks finish the week on a positive note. The Standard & Poor's 500 Index rose 1.7 percent to 1,255.19 on Friday while the STOXX Europe 600 Index rose 1.2 percent to 240.51.

However, for the week, stock markets were mixed. The S&P 500 rose 0.9 percent last week, its second consecutive weekly gain, but the STOXX Europe 600 Index fell 0.1 percent.

The market gains on Friday only partially reversed falls on Thursday after European Central Bank President Mario Draghi had disappointed investors by saying that the ECB was not prepared to prop up the bond market by buying government bonds.

“We have a Treaty,” Draghi told reporters at a press conference after the ECB's monetary policy meeting. That Treaty “prohibits monetary financing” of governments.

The S&P 500 fell 2.1 percent on Thursday while the STOXX Europe 600 fell 1.5 percent.

Draghi's comment confirmed John Hussman's view expressed in his article last month “Why the ECB Won't (and Shouldn't) Just Print”. Indeed, in his latest article, “Hard-Negative”, Hussman says that for the ECB to buy distressed European debt, there must not only be an agreement on fiscal union among euro-area members but also explicit EU Treaty amendments including changes in the ECB's restrictions and mandate.

“In any event, the problem for bailout-hungry investors is that they will be deeply disappointed if they expect Mario Draghi to turn into Ben Bernanke,” says Hussman.

The title of Hussman's latest article, however, mainly referred to market and economic conditions, of which he is pessimistic.

“Based on a wide variety of evidence and its typical market implications over an ensemble of dozens of subsets of historical data, the expected return/risk profile of the stock market has shifted to hard-negative,” says Hussman.

As for the economy, Hussman continues to estimate “a very high probability of oncoming recession” in the United States.

He points out that this is also the view of Economic Cycle Research Institute Chief Operations Officer Lakshman Achuthan. The latter said in a recent discussion on Bloomberg that while the latest data on US gross domestic product indicate decent growth, these could be revised down. Furthermore, forward-looking indicators are pointing to a deceleration in the economy.

In the meantime, we already have reports showing that the eurozone economy may already be in recession. Markit Economics reported last week that its composite index based on surveys of purchasing managers in the euro area read 47.0 in November. This was up from 46.5 in October but below the contraction threshold of 50 for the third consecutive month. Markit estimates that the eurozone economy may be contracting at a rate of around 0.5 percent in the fourth quarter.

Even fast-growing China has not escaped a slowdown. Last week, it reported that industrial production rose 12.4 percent in November from a year earlier, slower than the 13.2 percent increase in October.

And over the weekend, China reported that exports rose 13.8 percent in November from a year earlier, slowing from a 15.9 percent increase in October. With imports rising 22.1 percent, the trade surplus narrowed to $14.5 billion.

Weakening growth around the world highlights the risk remaining after last week's events. While markets may have reacted positively to the EU agreement on Friday, investors will have to deal with the fact that with the easy solution of an ECB bailout now off the table, the euro area's debt crisis will continue to simmer even as the world's major economies tip closer towards recession.

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