Please, click here to read this article in pdf format: july-26-2010 We start the week without the uncertainty of the Euro stress tests and with further data on the US macro picture, namely, the two factors driving discussions and action last week. On the stress tests, readers by now know our position from day one: [...]
Please, click here to read this article in pdf format: july-26-2010
We start the week without the uncertainty of the Euro stress tests and with further data on the US macro picture, namely, the two factors driving discussions and action last week. On the stress tests, readers by now know our position from day one: They are flawed by method and any comparison against the US case is misleading.
Banks in the US were financing a stock of assets, mortgages, the counterpart of brick-and-mortar investments, whose generation collapsed much, much earlier than the tests carried out in March 2009. When the US were doing their stress tests, they were actually counting their dead. European banks were and continue to finance fiscal deficits, which lack an identified pool of assets backing them. The generation of deficits has not stopped at the time of the tests and will continue for the foreseeable future. The Euro zone banks are not counting their dead, they are simply speculating whether they can survive if the illness becomes mildly worse. Therefore, they must present their illness as mild. There was an element of surprise on Friday, hours prior to the announcements: The stress tests were carried out on the banks’ trading books. With this, we think, Euro zone financial authorities surrendered every last drop of “moral authority” to defend their case. Time will tell, and in the meantime, the only thing that markets will now care about will be the evolution of fiscal deficits. Rightly so!
We had anticipated our opinion that the Euro would drop on the news. As the chart below shows (source: Bloomberg), it did drop intraday, right after the disclosure that the tests were on the trading books, but it managed to close higher, although within what seems to be an increasingly clear renewed downward trend, since it last peaked at 1.30+, on July 20th:
The US macro picture is challenging. On one hand, we are seeing earnings that surprise on the upside, but on the other, activity indicators are neutral at best. In credit, spreads are tightening, by the mere fact that there is more demand for spread than supply. The question here is whether the trend towards lower spreads, driven by the gigantic amounts of cash stored on the sidelines, will fuel the last push required to avoid a double dip. This concern has shifted also to the analysis of monetary policy.
While months ago we were debating what was the most appropriate way to a approach an orderly exit strategy by the G-3 central banks, today everyone is focused on how best can monetary policy accommodate a moderate growth. Back in the ‘30s, Keynes had clearly conceived a recovery where monetary policy would have to be accommodative. We first raised this point more than a year ago, on April 28th, 2009 ( “A Keynesian Perspective”, www.sibileau.com/martin/2009/04/28 ), and have very often quoted one of his famous paragraphs, from Chapter 13th, of his “General Theory”:
“…whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happen if the propensity to consume is falling off…(…)…Finally, if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…(…)…And when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest...”
Every research note on interest rates today, is pointing at the slowdown in the growth of monetary aggregates. This had been foreseen by Keynes, who openly, just like Krugman, was in favor of an increase in the quantity of money. The problem with this approach is that it is not dynamic, it is short-sighted. Monetarists (i.e. Milton Friedman) blamed “expectations” for the failure of Keynes’ approach. Given the market’s expectation that higher amounts of money would trigger inflation, prices were increased in a self-fulfilling path, if “capacity”, slack in the system, was gone. Today’s Keynesians don’t disagree, which is why Krugman is always reminding us how weak activity is.
The Austrian school, however, looks at the problem from a different perspective. Unlike monetarists or Keynesians, Austrians acknowledge that credit expansion is non-neutral, generating what people generally refer to as “asset bubbles” or asset inflation. As the problem of asset inflation compounds, its final version, general inflation, becomes more evident. The level of activity or its opposite, the level of slack in the system is irrelevant. That was the reason behind our bullish call on stocks all along 2009 and that may be what is fueling the recent strength in stocks. However and unlike in 2009, this latest strength would be based on the speculation that the quantity of money necessary to maintain a given rate of interest will increase. In 2009, the rally was based on facts. In 2010, it is trying to survive on speculation. The chart below (source: Bloomberg) shows that since July 20th, when the Euro last peaked, the S&P500 is making higher highs and higher lows, although still below its 200-day moving average, which stands at 1,113pts. We doubt the S&P500 will break this trend without the actual monetary increase supporting it. And if such monetary support shows up, we doubt the price of gold will remain indifferent vs. stocks, like it did in 2009.
Martin Sibileau
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