Some clarification is in order. My past two articles have naturally confused many readers and I’d like to tie my views together with today’s article. While my technical model suggests a 100% cash position (see Long Term Indicators Still Bearish), many leading economic indicators I track suggest moving into equities in anticipation of an economic recovery and out of bonds (see Bill Gross – Wrong on Bonds Again?). However, what I feel we have in the current situation is much like 2008, but now in the reverse. If that is the case, then despite forecasted improvement in US economic activity heading into 2012, even the US economy may eventually be pulled down by Europe.
2008 Revisited
Back in 2008 and even in late 2007 the theme I kept hearing over and over again was “decoupling.” The decoupling theme was first used to reject the possibility of a US recession. Analysts and economists cited how great corporate balance sheets were and how corporations would pick up the slack from a weak consumer. As corporations began to miss earnings and the economy slowed, then in late 2007 the theme was that exports would keep the US out of recession as the rest of the world was growing strongly. I debunked both of these myths late in 2007 (see Debunking the Decoupling Theory) and then even debunked the notion that the rest of the world would somehow magically decouple from the US economy (see Be Careful What You Wish For). In essence, there was way too much economic deterioration and financial risk in 2007 to believe that the US would be able to avoid a recession because of a strong corporate sector or due to strong US exports with growing emerging markets. There was no way that the world economy would be able to avoid a recession without being pulled down by the US economy.
Fool Me Once, Shame on You. Fool Me Twice, Shame on Me
This time around many pundits and economists are forecasting a budding recovery for the US economy heading into 2012. My own article last week highlighted that the economic indicators I track also suggest a US recovery. However, what was so glaring in 2008 was the US mortgage bubble was coming unglued and would spread globally, and this time around the European sovereign and banking crisis remains unsolved and cracks are surfacing within the Eurozone. These cracks are likely to become canyons in which Europe is likely to pull the rest of the world down with it. Given the close proximity of the past 2007-2009 US led credit-crisis, central banks and politicians have been quicker to react to market conditions. However, the US is far more unified politically and monetarily than Europe is and is much quicker to put out any credit fires that occur. The big worry is that Europe is going to need a Lehman-like event to bring them together and act quickly. Unfortunately, chances are we'll see at least one sovereign default before that occurs with the fallout largely unpredictable given the interconnectedness and opacity of the global financial system. For example, small villages in the outskirts of Eastern Europe were found to hold toxic US mortgage-backed-securities (MBS) back in 2008. With bank balance sheets so opaque, it's hard to tell exactly how much exposure US banks and others have to a potential European default.
Watch the Credit Markets
Perhaps one of the greatest things I learned going through the 2008 crisis is to respect the message of the credit markets. When they and the equity markets diverge it's time to be cautious as usually the credit markets get it right.
Because of the importance I place on the credit markets I’ve written several articles with updates on what the credit markets are saying, with my last article (Message from the Credit Markets, “We Ain’t Buying It!”) highlighting that we are not out of the woods yet. Some of the key credit spreads I track continue to hit new highs indicating financial stress within the US and European financial system continues to rise despite the so-called “plans” and facilities European authorities have setup. A few weeks ago there was a coordinated central bank intervention to reduce the price of existing USD liquidity swaps. What was the end result of this action: lower credit spreads? NO! In fact, the stress in the credit markets has worsened.
The Ted spread, LIBOR-OIS spread, and Euro and USD 2-yr currency swap rates continue to head higher since bottoming in the summer. Coincident with their rise was the stock market selling off, and while the market has staged a rally off the August and October lows the credit markets have continued to worsen as shown below.
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Source: Bloomberg
Looking at how banks view the world also does not present a pleasant picture. Overnight lending rates between banks continues to rise as banks are becoming more and more leery of lending to each other. Note the lack of easing in these spreads after a coordinated effort by global central banks to ease conditions in November.
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Source: Bloomberg
Like the Ted spread for the US, the euro equivalent also shows counter-party risk continues to rise in Europe as the spread is higher now than at any time except for the peak in the 2008 credit crisis. What is key to note is how quickly the credit spread jumped in 2008, rising from less than 1% to nearly 4% in a matter of days.
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Source: Bloomberg
Summary
It is my view that unless the ECB prints near the magnitude of trillions to support the European sovereign debt market and banks, then things are likely to get worse than better. Additionally, despite a US economic recovery, the message of my technical monitor and the general message from the credit markets suggests the US stock market is on shaky ground. If the ECB was going to come out with a massive quantitative easing program then spreads would contract and Europe would not pose the same threat to the current US economy as the US did to Europe and the world in 2008. Until that happens, defense and capital preservation remain paramount to investing.
