Kass: The Sword of Damocles
By Doug Kass - 11/28/11 - 2:00 PM ESTReal Money Pro on Nov. 28 at 8:27 a.m. EST.
The eurozone's economic union and banking system, a house built on pillars of sand -- that is, too much sovereign debt, reckless leverage and unmarked-to-market accounting by the banking industry -- are now in jeopardy. Given the disparate economic, political and legal interests in the E.U., the regimes of some monarchs and prime ministers have been toppled, but the heavy policy lifting lies ahead. The lesson learned in the American economic crisis and Great Decession of 2008-2009 and now in the eurozone crisis of 2011-???? is that debt cannot grow beyond the ability to service it. A period of subpar economic growth is the best outcome for the eurozone. At worst, the European economies' downturn will be far deeper, bank credit will be restrained, the euro could vanish, currency and trade wars might erupt, and the European banking system could collapse -- or a combination of these factors could occur. The only practical solution in Europe appears to be going the route of the U.S. and our Fed three years ago and embarking upon its own brand of massive European-style quantitative easing. -- Doug Kass, "Easing Won't Be Easy in Europe"Over the past several months, investors have lived in constant fear as the eurozone's debt crisis hangs over the world's risk markets like the sword of Damocles. In the tale, Dionysius II of Syracuse offers to exchange places with one of his courtiers, Damocles. Cicero utilizes the title object, which Dionysius II has hung over Damocles' temporary throne, to convey a sense of the constant fear in which (the great) man lives. The theme -- or moral, if you will -- being that virtue is sufficient for living a happy life. I have long suggested that the fragile, uneven and still not self-sustaining (incapable of independent or unassisted growth without the support of fiscal and monetary encouragement) domestic economic recovery was exposed to exogenous shocks. And the eurozone's growing contagion and confidence loss is the sort of external shock that has the potential to jeopardize the U.S. recovery if it leads to more restrictive credit conditions. The eurozone's debt crisis has already upset the U.S. stock market despite continued evidence that our economic recovery is improving moderately and that the muddle-through baseline case remains a reasonable expectation. Few expected such a rapid deterioration in credit conditions that occurred in the last month: I was blindsided, as I certainly didn't see the loss of confidence (and rise in sovereign debt yields) happening with such swiftness. Rather, my recently expressed rising market optimism emphasizes and reflects the improving body of evidence and increasing probability that the rate of growth in the domestic economic recovery was about to reaccelerate. Many of those critical of that more sanguine economic view have typically cited ECRI's statistics, which were flashing recession and at odds with my view that domestic growth was reaccelerating in a muddle through backdrop. Though the eurozone's escalating debt crisis has squashed the markets, thus far my view of a slowly improving domestic economy not moving toward a double-dip has been materially correct. Lakshman Achuthan's well-regarded ECRI Indicator, which signaled recession 45 days ago, has actually turned up in each of the last three weeks, and numerous other high-frequency economic data points (e.g., LEI, regional PMIs, confidence surveys, existing-home sales, jobless claims, income growth, retail sales) point to a continued, though moderate, path of economic growth.
Risk markets are losing their patience. The eurozone situation is approaching a major climax. This is by far the most important story to follow in the coming days and weeks. U.S. economic data has been quite encouraging, and the economy remains muddling along. If Europe took care of business quickly, global stock markets would rally sharply. The S&P 500 could possibly make a run at the bull market highs. Unfortunately, there is a major ongoing political crisis in the region. -- Tyler Durden, Zero HedgeIt is the rapidity of the loss of confidence and the quickness with which European sovereign bond yields have risen that have served as 2011's sword of Damocles hanging over stocks. As stated previously, few, including myself, anticipated how the rising tension in the eurozone's debt markets would trump the improvement in high-frequency economic statistics in the U.S. The world's markets have broken down under the weight of the eurozone crisis in a punishing and incessant display of selling over the past two weeks. As a result, our stock market is now discounting recession. I am not dismissive of the seriousness of the European debt crisis. The heightened pace of contagion and growing risk at the core of the European economies, the need for a unified and effective policy response by European leaders and central bankers have materially increased in order for the world's stock markets to stabilize. If preemptive moves are not made soon, the likely contraction in credit availability will flow from Europe to our shores, and I will be forced to change the economic and stock market outcomes and probabilities that I currently envision. As investors, we always sit under Damocles' sword, but it is that uncertainty and growing fear that is typically a condition for fertile investment opportunities. In conclusion, the tail (i.e., the European sovereign debt crisis) that wags the dog (i.e., the world's economies and capital markets) has taken center stage -- and, for now, that dog has grown undomesticated as it has soiled the carpet of confidence and capital (markets). It is now up to Europe to forcefully address, arrest and reverse the negative credit trends that have taken hold of our markets with forceful policy (easing and the implementation of euro bonds). As Zero Hedge's Tyler Durden writes, the outcome looks binary -- either policy is implemented and the world's risk markets experience a sharp rally or the absence of policy to stem the European debt contagion leads to a bear market. History shows that our world's leaders rise to the occasion in the face of crisis. It happened (and worked to correct the impending doom in our credit markets) in the U.S. in early 2009, when all seemed in chaos. My investment bet (and hope) is that shock-and-awe policy will soon replace tame-and-timid policy in Europe in the days and weeks ahead.