Lots of Little European Stuff

European package – if you can’t fix it, smother it with money. The IMF, the ECB, the member states of the European Union are all throwing money at the problem of the miscreant states of southern Europe. The package of loan guarantees, liquidity tools, austerity packages and such that was assembled is supposed to buy the PIIGS enough time to tighten their belts and learn to live within their means. Well, not really within their means, but at least close to their means. Perennial deficits of up to 3% of GDP are perfectly okay with the ECB and EU. We can’t recall a single European government that has run a surplus in their fiscal budget lately, maybe the Norwegians during the height of their energy boom. (Keynes is probably rolling in his grave.)

These largely socialist economies generally have much bigger public sectors than the US. In much of Europe, the state owns the electric company, the gas company, the water company, and the telephone company. The healthcare system is usually government run. Many major industries either are run by the government or have the government as a major stakeholder. The transportation system is often government owned and operated – trains, planes, busses and subways are public. We have a lot of that going on here as well. The public sector in many European countries is between a third of the economy and half. In the US it is now about 21%, on its way to over 30% with the huge increase of government activity in the healthcare system. The issue becomes how much of the economy works to support how much of the economy. In the case of the Greeks, half of the economy in the public sector was too much.

There are two major problems with this model, beside the whole set of ‘liberty’ issues: one is that the public sector is seldom (if ever) more efficient at anything as the private sector usually is; the other is that public operations don’t pay taxes, they eat taxes.

The whole efficiency thing is fodder for a missive at some other time, but the whole eating taxes as opposed to paying taxes is important. If the subway is run by a private company and if that company makes money, it pays taxes. If it doesn’t make money it stops operating at some point. What is funny is that a century ago, when many of these utilities began, they were private. Private industry tended to build these infrastructures originally, but either an uneconomic business model or hard times brought them down. In some cases, it was just a change of government that dragged these operations into the public sector. But, the losers went on the government dole in most cases. The public sector doesn’t have the same priorities as the private sector. That can be a good thing or a bad thing. But, economically it is usually a bad thing. 

When Maggie Thatcher tried to de-socialize the UK back in the 70s, she privatized a whole lot of utilities and sold-off the government’s ownership in most private companies. That brought a one-time boost to government coffers, but it also took many of these operations out of the camp of tax eaters and put them in the camp of tax payers. Not all of it worked. Some of the utilities couldn’t make it on their own, but the move did shift the dynamic of tax eating sufficiently to give Britain a boost for nearly a quarter century. There is likely a lesson in there for the Greeks, the Spaniards and the Portuguese.

Aftermath of the hiccup – circuit breakers that might actually work? We have circuit breakers set-up on the equity and futures markets which didn’t get used during last week’s mini-meltdown. The original circuit breakers were installed after the Crash in 1987 but have been eroded over time so that today nothing happens circuit breaker-wise until the market falls 10%, and then we only take a half-hour breather before we get back to the carnage. Originally, the first circuit breaker went off at 2.5% and entailed a half-hour stoppage of trading in the futures markets for index futures. After 5%, we stopped the futures for an hour and at 10% we shut-down stocks for the remainder of the day. Now, before we get a full stoppage, we have to drop 20%. All this is in the name of ‘price discovery’ the rallying cry of all the hedge fund types and academics. The original circuit breakers kept getting hit during the huge rallies in the 90’s, so they had to go. Maybe 2.5% is too tight? But circuit breakers that provide relief for stockholders from the potentially relentless selling of index arbitrageurs and hedge funds are a necessity. ‘Price discovery’ can take an extra day or two once in a while.

Tip of the iceberg explained. We were looking at some employment statistics for March and were amazed by the size of the numbers. The US labor force is about 155,000,000 people, about 15,000,000 people are now unemployed and would like to find work. Another about 8,000,000 people are employed but are working part-time or temporarily and would like full-time work. Something like 4,250,000 people got jobs in March. At the same time, 4,000,000 people were ‘separated’ from their jobs, either ‘voluntarily’ (quit, retired, went on unpaid leave or whatever) or ‘involuntarily’ (were fired, laid-off, the job went away). Therein we get the result for the March revised employment gain of 260,000 jobs. The actual numbers of people moving around in the workforce are staggering. It takes fairly small changes in the rates of new job openings and job losses to make a really big change in the tip of the iceberg number we all seem to focus on every month. If the number of new jobs rises by 10% or 425,000 and the number of jobs lost falls by 10% or 400,000 that is an 825,000 swing in the jobs number that month. Though the numbers aren’t highly likely to move that far that fast, that is about how far they’ve moved since last summer when we were having the worst employment reports of the recession.

No one expects the employment numbers to go to 1,000,000 new jobs a month, but once we start adding 300,000 to 400,000 jobs a month, and that could happen fairly quickly, we will begin to see the unemployment rate start to fall pretty steadily. That sort of jobs gain will lead to all sorts of good results: higher incomes, higher spending, better consumer sentiment, smaller fiscal deficits. What we need are a few more jobs opened and a few less jobs ended and we’ll be fine.

Crisis of the Week

Ah, it’s good to not have to write about Greece for a change. Actually, we came up with a drinking game about last week’s missive, where every time we wrote Greece, Greek, Grecian or Hellenic, you take a swig of coffee. By the end of this Crisis segment, you’d be buzzing. The same might translate into some other drink, but we won’t speculate on that.

There have been several slow-fuse crises that have snuck-up on us while everyone’s attention was riveted in the wrong direction. One big one is the US federal deficit and what to do about it. Obama is starting a Deficit Reduction Taskforce to study the deficit to death and not actually do anything about it. At the same time, Pete Peterson is having his own gathering of deficit experts across town from the White House. At Peterson’s gathering will be the likes of former President Bill Clinton, former Treasury Secretary Robert Rubin and former Fed Chairman Alan Greenspan. Since the last time the US didn’t run a deficit these were the guys in charge, maybe we ought to hear what they have to say? You can guess there will be a lot of self-congratulatory comments and I-told-you-so’s going on.

There is plenty of blame to go around for the current state of affairs. Folks on the left argue that the Bush tax cuts shifted the weight to the poor (not really) from the rich (who don’t pay any more taxes than they feel like). Folks on the right argue that it was run-away spending and shifting all sorts of things onto the federal budget that have put us in this pickle. You could also blame the mis-aimed stimulus spending, the bail-outs and all that for the deficits, but these ought to go away now that the economy is getting back on its feet (we crack ourselves up sometimes!). We surmise that once allocated, money will be spent whether the need remains or not.

The one thing Greece taught us is that there is a limit to how much the government sector can grow before the sheer weight of it brings down the economy. The US economy has several impending spending issues to deal with: Social Security, Medicare, the new healthcare entitlements, aging infrastructure, global competitiveness, and so forth. Somehow, having Congress (the opposite of progress) address these issues doesn’t give us much room for sanguinity.

Economic News

The trade balance came in roughly in line with expectations at -$40.4 billion. Both exports and imports grew robustly from the month before. Trade flows are recovering from the steep fall they took during the global recession.

The budget deficit came in at -$82.7 billion in April. Remember that April is the month when the government has to pay the largest share of tax refunds. While tax payments are fairly evenly spread throughout the year, the refunds all pretty much come out at once, so annualizing that number would be sort of misleading, fun but misleading.

Retail sales rose by 0.4% in April, ex-autos the gain was also 0.4%. The gain was stronger than expected. Sales figures for February and March were also revised higher by 0.2% as well. Beyond sales of autos, gasoline and building materials, three fairly volatile and seasonal sectors, sales were down 0.2%.

Industrial production rose 1.0% in April and factory utilization rose to 73.7%. The gain in production was widespread. Factory utilization was aided by modest increases in usage and a record level of abandonment of un-used capacity.

Consumer Sentiment (the University of Michigan/Reuters version) was higher in May. The gain to 73.3 from 72.2 in April was expected.

Weekly Stuff

Another turbulent week! Maybe we could follow the lead of the European airlines and when there is a problem, we could just shut-down? At least the gains on Monday were enough to give us gains for the whole week. With the direction of most of the inputs to the valuation process getting better: the fundamentals – earnings, dividends, sales, margins and the like; the interest rates we use to discount the future; lately the price; the only element that can account for the recent change is the risk assessment of investors. We believe that people were just starting to feel bullish when all this sovereign credit stuff came up. Because they had just started feeling bullish, their risk tolerance had just started to get higher. Now, we have undone that progress and regressed a little bit. Give it some time and people will begin to feel bullish again. It will probably take 12,000 on the Dow to make that happen. That could take some time.

Maybe the way to look at this isn’t through the prism of US stocks but through European stocks. We have monitored the Dow Jones Euro Stoxx 50 index for a few years now. That index contains 50 of Europe’s leading companies. It got as low as roundly 1800 back last year in March, was as high as 3000 in January and now is about 2680-2780 lately. At the height of the crisis, the index was flirting with 2600 and has made a small recovery since. For an index that hit 4500 back in mid-2007, this is some fall from grace.

The index includes most of the European companies you’ve actually heard of – British Pete, but also Royal Dutch – Shell, the big telecoms, a few other utilities, industrial groups like Siemens and Erickson, consumer companies like Nestle and Unilever, the whole gamut of companies. Like their American peers, these are global companies with huge exposure in the US, the emerging markets and all across Europe. So, European anxiety ought to show-up here fairly significantly. The funny thing is it has. The drop in the Stoxx from early January to the most recent bottom was 11% compared to the Dow drop over the same time frame was about 5%. The Dow has recovered to post year-to-date gains while the Stoxx is still deeply under water about 7%. But we see stabilization and even progress in the Stoxx. That gives us some hope that we can put this anxiety behind us.

As mentioned, a volatile week but one that lead to gains pretty much across the board. Stocks gained, bonds gained, real estate gained, but commodities did their duty and slipped. That’s non-correlation. The drop in commodities was despite a modest gain in crude oil prices. The fear of slow to no growth in Europe and the news that China has begun to rein in growth caused many to think the commodity run might be over for a while.

Real estate securities had a bounce that greatly exceeded that enjoyed by the financials last week. There was little good news to account for any new bullishness on real estate, so we’ll just blame momentum investors flocking to the hot investment concept.

Bonds did rise, though for the US Treasury sector the gains were labored. The Treasury had its mid-month refunding last week and sold ten-year and thirty-year bonds. Most high grade segments of the bond market did well last week. High yield bonds snapped back from a couple of disappointing weeks.

Foreign bonds had to again battle a dollar gain. We saw modest gains in British bonds, likely due to political issues getting resolved there. Many emerging markets were stronger as the risk trade came back on last week. Japan and Germany weren’t as lively with losses in their benchmark government bonds.

US stocks gained enough on Monday to withstand a drop on Thursday and Friday. Foreign stocks were also generally higher with big gains in most of developed Europe, some strength in Asia and Latin America.

Have a great week.

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.