REPRINTED WITH PERMISSION FROM TOWER BRIDGE ADVISORS
Stocks suffered their worst one-day decline since the market’s abyss in the fall of 2008. The decline came in the wake of the downgrade of the United States’ credit rating by Standard & Poor’s and a disheartening reaction to a decision from the European Central Bank (ECB) to begin purchasing bonds of Spain and Italy.
Curiously, yields on Spanish and Italian debt fell yesterday in response to the ECB purchases and Treasury securities rose sharply in price in the aftermath of the ratings downgrade. Clearly no one feels less safe owning U.S. Treasuries today than they did before the ratings downgrade?
So what is going on? In one sense this sharp decline and near panic have the potential to be self-fulfilling. While there is literally no data today that indicates either that we are in a recession or on the cusp of a recession, the markets decline has the ability to increase overall consumer and business angst to a level where they will freeze thus creating a recession that otherwise might never have happened. That is not a forgone conclusion. In 1987, stocks fell 40% in three months and 22% in just one day without creating a recession. In October 1998 and October 1999, swift and scary market swoons reversed in fairly short periods of time without any significant economic impact.
Clearly what is spooking investors today is uncertainty regarding the collective abilities of the U.S. and Europe to reduce debt levels over a period time to manageable levels without creating significant economic disruption. What makes the worries more acute is a lack of confidence in U.S. or European leadership to act boldly to get in front of the problems. In Europe, the core problem centers on an economic union comprised of 17 different voting members with 17 different sets of objectives trying to reach a workable compromise. While funding is readily available to help stem the bleeding in Portugal, Greece and Ireland, there don’t appear to be sufficient funds to bail out Spain and Italy and maybe others. Therefore, a solution, short of a total breakup of the EU and serial defaults, is going to have to be collective and large. It isn’t clear any country has reached the point where it feels ready to commit the resources necessary to provide the proper backstop. Therefore, markets throughout Europe are falling fast. The good countries are suffering as bad as the worst offenders because the market perceives that they are all committed to a one-for-all, all-for-one approach. Moreover, while the weaker nations are gradually committing to proper austerity measures, without accompanying growth initiatives, recession and deflation appear unavoidable.
European contagion is one of the problems facing investors here and all around the world outside of Europe, since Europe comprises over 20% of world GDP. As for the United States, our problems are similar, in that they relate to inflated debt and deficits, but they are different in structure. We don’t have 17 independent entities that need to sign off with 17 different sets of cultural differences. Instead, we have a divided Congress which at the moment is torn apart by a set of mostly freshman Republicans aligned with the Tea Party movement who are only willing to accept spending cuts as a solution. Growth initiatives and tax reform are rejected out of hand because they are deemed to cost money. Tax cuts are fine, as long as there are even greater spending cuts; loophole closing is not.
Almost any economist will tell you that spending cuts alone aren’t the road to salvation. Whether the Tea Party coalition simply doesn’t believe that or whether they are simply willing to take down the economy in an effort to force President Obama into an untenable position that would surely ruin his prospects for reelection doesn’t really matter. What matters is that 70 or 80 members of the House form a solid enough block of votes that, at least for now, has been able to dictate the course of legislation. During the debt ceiling debate, the result was a very tepid compromise that was a start toward a solution but only a weak start at best.
Congress now faces a second step. A group of 16 members of Congress will have to come up with an agreement on the second round of cuts. Barring a consensus, the law forces major cuts in health care and defense spending as an alternative. Since House Republicans can only nominate at most 3 Tea Party supporters to the 16 member panel, this tight block cannot force the fate of the overall decision. Of course, they could align and vote against the compromise which would then require Speaker Boehner to find a different coalition to get the second stage passed.
I don’t expect Tea Party members to do anything than they have done to date. But Congress must be getting an ear full from constituents while they are on recess and members are sure to be facing a lot of anger and pressure. Clearly, they are getting a message to “get the job done”. How they react when they return is largely going to be dictated by how loud and how long the voter angst gets.
I will repeat what I have said before. Our problems are large but they are solvable. They require spending cuts, tax reform and entitlement reform sprinkled with initiatives that inspire job growth. I am not going to repeat the formula other than to say it is fairly obvious and can be accomplished by a broad center of Congress. Notably, it cannot be accomplished by one party alone and certainly cannot be done by the extremes of either party. Thus, what must happen (and the sooner the better) is that a centrist coalition needs to take the Erskine-Bowles suggestions as a starting point and build upon it. If there is a key date nearby, it is August 16 for that is the date that the 16 Congressional panel members have to be appointed. Do we get people like Tom Coburn and Kent Conrad who have the abilities to listen and compromise or do we get ideologues at the edges of both parties?
But August 16 seems a long way away. If the Dow drops 600+ points per day, there won’t be much left by August 16. So what happens between now and then? Today the Fed’s Open Market Committee meets. Unfortunately, there isn’t a whole lot it can say. QE2 helped lift asset prices over the short run but had no real long term impact. Interest rates are already anchored near zero. It can eliminate the 25 basis points it pays banks that deposit money at the Fed window but that is unlikely because, for reasons I won’t go into now, it would likely be devastating to money market funds. It can do a few things around the edges like buy riskier assets or extend maturities but those ideas won’t do much good. If they did suggest an avid interest in QE3, it might spark a short term rally in stocks but such a program would need to be at least a trillion dollars in size and its benefit might only last a few days. About all the Fed can do is tell markets that it will maintain liquidity in any crisis (which it would). Today’s problems aren’t something the Fed can fix. They aren’t liquidity driven nor do they relate to the cost of capital. Raising monetary targets a bit might create a little inflation if confidence could be restores and demand improved. But not now.
Ultimately, markets are going to have to bottom and turn based on valuation. Retail investors are very nervous and withdrawing money from the market but they don’t account for anywhere near the scope of the decline we have seen over the past couple of weeks. Many attribute the severity of the decline to black box and algorithmic traders. There may be something to that. Clearly, they account for a disproportionate share of volume and a lot of the extreme mood swings we see hour-to-hour let alone day-to-day.
For the next few weeks, governments here and in Europe can’t and won’t do much. In Europe, it takes time for 17 nations to approve a central funding facility. Here, Congress doesn’t even return until September. We aren’t suddenly going to see massive new deficits appear and no one, here or abroad, is about to default on debt imminently. Values simply have to get so irresistible that buyers can no longer stay away. Even within the worst bear markets, there are violent rallies. The biggest one-day gain ever occurred in October 2008 during the deepest part of the last bear market. If you bought at the high that day and held thru yesterday’s dismal close, you would have made about 25% on your money in less than 3 years. Values do matter. I know it is very hard to watch what is going on but with 10-year Treasuries now yielding just 2.3%, it is hard to believe that blue chip growth companies yielding more than 3% won’t be good competitive investments over the next several years.
Although markets may be predicting that the U.S. and European governments won’t find the right solution, history suggests that isn’t necessarily correct. Granted, the first solution may not be the right one but ultimate crisis forces rational behavior. Eventually markets get what they want because markets rule. It took two votes to get TARP passed and the Dow fell 1,000 points that didn’t have to disappear but TARP and other efforts gradually stabilized markets. This time around, the crisis isn’t as severe. The U.S. debt-to-GDP ratio isn’t at the break point yet. Spending cuts, tax reform and entitlement reform are the proper response. Declining markets and louder voter disapproval will force proper action. When? Good question. But it will happen and it will happen a lot sooner than many inside and outside of Congress anticipate because markets are a lot less patient than Congress. Once again, markets and the public rule. If markets don’t stabilize soon, I see no way at least some entitlement reform doesn’t happen in 2012. When Congress does the right thing, markets will respond quickly. That’s the beauty of free market capitalism. Politicians will know with 48 hours if they get it right. Until then they can fuss, they can fight and they can try. But all they will get from those efforts are more anger.
The right answer won’t be a quick fix but it will be a fix. We won’t grow as a nation at 3-4% per year until housing clears and the deleveraging process is complete. But the alternatives to the right brave solutions that will require some sacrifice from everyone range from bad to terrifying. Nothing is going to happen in August, beyond the appointments to the Congressional committee that will change the economic course here or abroad and markets in the interim will have to find their own bottom. They will. Rallies are likely to be intermittent and sharp. Try to keep a sober mind and don’t panic.
James M. Meyer, CFA
610-260-2220
jmeyer@towerbridgeadvisors.com
Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.
Fed Watch
SPECIAL REPORT: Morning Comment by James Meyer, CFA
REPRINTED WITH PERMISSION FROM TOWER BRIDGE ADVISORS
Curiously, yields on Spanish and Italian debt fell yesterday in response to the ECB purchases and Treasury securities rose sharply in price in the aftermath of the ratings downgrade. Clearly no one feels less safe owning U.S. Treasuries today than they did before the ratings downgrade?
So what is going on? In one sense this sharp decline and near panic have the potential to be self-fulfilling. While there is literally no data today that indicates either that we are in a recession or on the cusp of a recession, the markets decline has the ability to increase overall consumer and business angst to a level where they will freeze thus creating a recession that otherwise might never have happened. That is not a forgone conclusion. In 1987, stocks fell 40% in three months and 22% in just one day without creating a recession. In October 1998 and October 1999, swift and scary market swoons reversed in fairly short periods of time without any significant economic impact.
Clearly what is spooking investors today is uncertainty regarding the collective abilities of the U.S. and Europe to reduce debt levels over a period time to manageable levels without creating significant economic disruption. What makes the worries more acute is a lack of confidence in U.S. or European leadership to act boldly to get in front of the problems. In Europe, the core problem centers on an economic union comprised of 17 different voting members with 17 different sets of objectives trying to reach a workable compromise. While funding is readily available to help stem the bleeding in Portugal, Greece and Ireland, there don’t appear to be sufficient funds to bail out Spain and Italy and maybe others. Therefore, a solution, short of a total breakup of the EU and serial defaults, is going to have to be collective and large. It isn’t clear any country has reached the point where it feels ready to commit the resources necessary to provide the proper backstop. Therefore, markets throughout Europe are falling fast. The good countries are suffering as bad as the worst offenders because the market perceives that they are all committed to a one-for-all, all-for-one approach. Moreover, while the weaker nations are gradually committing to proper austerity measures, without accompanying growth initiatives, recession and deflation appear unavoidable.
European contagion is one of the problems facing investors here and all around the world outside of Europe, since Europe comprises over 20% of world GDP. As for the United States, our problems are similar, in that they relate to inflated debt and deficits, but they are different in structure. We don’t have 17 independent entities that need to sign off with 17 different sets of cultural differences. Instead, we have a divided Congress which at the moment is torn apart by a set of mostly freshman Republicans aligned with the Tea Party movement who are only willing to accept spending cuts as a solution. Growth initiatives and tax reform are rejected out of hand because they are deemed to cost money. Tax cuts are fine, as long as there are even greater spending cuts; loophole closing is not.
Almost any economist will tell you that spending cuts alone aren’t the road to salvation. Whether the Tea Party coalition simply doesn’t believe that or whether they are simply willing to take down the economy in an effort to force President Obama into an untenable position that would surely ruin his prospects for reelection doesn’t really matter. What matters is that 70 or 80 members of the House form a solid enough block of votes that, at least for now, has been able to dictate the course of legislation. During the debt ceiling debate, the result was a very tepid compromise that was a start toward a solution but only a weak start at best.
Congress now faces a second step. A group of 16 members of Congress will have to come up with an agreement on the second round of cuts. Barring a consensus, the law forces major cuts in health care and defense spending as an alternative. Since House Republicans can only nominate at most 3 Tea Party supporters to the 16 member panel, this tight block cannot force the fate of the overall decision. Of course, they could align and vote against the compromise which would then require Speaker Boehner to find a different coalition to get the second stage passed.
I don’t expect Tea Party members to do anything than they have done to date. But Congress must be getting an ear full from constituents while they are on recess and members are sure to be facing a lot of anger and pressure. Clearly, they are getting a message to “get the job done”. How they react when they return is largely going to be dictated by how loud and how long the voter angst gets.
I will repeat what I have said before. Our problems are large but they are solvable. They require spending cuts, tax reform and entitlement reform sprinkled with initiatives that inspire job growth. I am not going to repeat the formula other than to say it is fairly obvious and can be accomplished by a broad center of Congress. Notably, it cannot be accomplished by one party alone and certainly cannot be done by the extremes of either party. Thus, what must happen (and the sooner the better) is that a centrist coalition needs to take the Erskine-Bowles suggestions as a starting point and build upon it. If there is a key date nearby, it is August 16 for that is the date that the 16 Congressional panel members have to be appointed. Do we get people like Tom Coburn and Kent Conrad who have the abilities to listen and compromise or do we get ideologues at the edges of both parties?
But August 16 seems a long way away. If the Dow drops 600+ points per day, there won’t be much left by August 16. So what happens between now and then? Today the Fed’s Open Market Committee meets. Unfortunately, there isn’t a whole lot it can say. QE2 helped lift asset prices over the short run but had no real long term impact. Interest rates are already anchored near zero. It can eliminate the 25 basis points it pays banks that deposit money at the Fed window but that is unlikely because, for reasons I won’t go into now, it would likely be devastating to money market funds. It can do a few things around the edges like buy riskier assets or extend maturities but those ideas won’t do much good. If they did suggest an avid interest in QE3, it might spark a short term rally in stocks but such a program would need to be at least a trillion dollars in size and its benefit might only last a few days. About all the Fed can do is tell markets that it will maintain liquidity in any crisis (which it would). Today’s problems aren’t something the Fed can fix. They aren’t liquidity driven nor do they relate to the cost of capital. Raising monetary targets a bit might create a little inflation if confidence could be restores and demand improved. But not now.
Ultimately, markets are going to have to bottom and turn based on valuation. Retail investors are very nervous and withdrawing money from the market but they don’t account for anywhere near the scope of the decline we have seen over the past couple of weeks. Many attribute the severity of the decline to black box and algorithmic traders. There may be something to that. Clearly, they account for a disproportionate share of volume and a lot of the extreme mood swings we see hour-to-hour let alone day-to-day.
For the next few weeks, governments here and in Europe can’t and won’t do much. In Europe, it takes time for 17 nations to approve a central funding facility. Here, Congress doesn’t even return until September. We aren’t suddenly going to see massive new deficits appear and no one, here or abroad, is about to default on debt imminently. Values simply have to get so irresistible that buyers can no longer stay away. Even within the worst bear markets, there are violent rallies. The biggest one-day gain ever occurred in October 2008 during the deepest part of the last bear market. If you bought at the high that day and held thru yesterday’s dismal close, you would have made about 25% on your money in less than 3 years. Values do matter. I know it is very hard to watch what is going on but with 10-year Treasuries now yielding just 2.3%, it is hard to believe that blue chip growth companies yielding more than 3% won’t be good competitive investments over the next several years.
Although markets may be predicting that the U.S. and European governments won’t find the right solution, history suggests that isn’t necessarily correct. Granted, the first solution may not be the right one but ultimate crisis forces rational behavior. Eventually markets get what they want because markets rule. It took two votes to get TARP passed and the Dow fell 1,000 points that didn’t have to disappear but TARP and other efforts gradually stabilized markets. This time around, the crisis isn’t as severe. The U.S. debt-to-GDP ratio isn’t at the break point yet. Spending cuts, tax reform and entitlement reform are the proper response. Declining markets and louder voter disapproval will force proper action. When? Good question. But it will happen and it will happen a lot sooner than many inside and outside of Congress anticipate because markets are a lot less patient than Congress. Once again, markets and the public rule. If markets don’t stabilize soon, I see no way at least some entitlement reform doesn’t happen in 2012. When Congress does the right thing, markets will respond quickly. That’s the beauty of free market capitalism. Politicians will know with 48 hours if they get it right. Until then they can fuss, they can fight and they can try. But all they will get from those efforts are more anger.
The right answer won’t be a quick fix but it will be a fix. We won’t grow as a nation at 3-4% per year until housing clears and the deleveraging process is complete. But the alternatives to the right brave solutions that will require some sacrifice from everyone range from bad to terrifying. Nothing is going to happen in August, beyond the appointments to the Congressional committee that will change the economic course here or abroad and markets in the interim will have to find their own bottom. They will. Rallies are likely to be intermittent and sharp. Try to keep a sober mind and don’t panic.
James M. Meyer, CFA
610-260-2220
jmeyer@towerbridgeadvisors.com
Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.
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