Posted on July 13th, 2011

Net from end of the first quarter to the end of the second quarter the US stock market has not moved (S&P500 1,325), and it’s still there today. “Boring” would say an uninvolved observer.  “Anything but that” would retort anybody who had to make ongoing investment decisions over the period. Given the news background, the fact that the stock market is unchanged is a testimony to the assessment that it wants to go up.  And if and when it gets some pause in the bad news, it will.
The second quarter started with the realization of one of the grave risks that had been visible before (The US Stock Market Wants to Go Up: Part I, The US Stock Market Wants to Go Up: Part II). The Japanese interruption of the supply chain worldwide, together with some bad weather plunged US economic growth into a ‘soft patch’. A very visible example of this effect is in the auto industry that cut back production well below what had been planned and is now expecting a major boost in production in the present and next quarters. In Japan itself, production has already recovered much of its post Tsunami plunge.
Some of the other risks that had been easily foreseen in the first quarter were also aggravated in the second quarter. One of the most threatening of these developments is the worldwide planned and executed tightening of economic policies. To understand the force of such uniform action in a globalized economy it’s enough to look at the way the world economy shook off the last recession.  When the dimensions of the collapse became clear, practically all governments adopted expansionary fiscal and monetary policies that almost in a whiff translated into an economic turnaround.
In China and India, such policy moves proved pretty soon to be an overshoot that with an unrelated rise in food and oil prices caused an unacceptable upturn of inflation. Both countries had turned policy around and have been tightening economic policies for quite a few months now. In the case of China, that is reflected not only in a rapid increase in interest rates and in bank reserve requirements but also in placing more stringent limitations on off- balance sheet bank lending and other means of government persuasion. In his latest visit to Europe, premier Wen declared victory over inflation a week ago.  But interest rates were raised almost immediately afterwards. And since monetary policy has no direct effect on food prices, the chances are that China isn’t done yet and that eventually it will overshoot again.
Many other Emerging Market economies (e.g. Brazil and to a lesser extent Russia, Korea, Taiwan etc.) have suffered from overheating and inflation. These were aggravated by an influx of hot money whenever it was possible and the geopolitical environment seemed stable. And as interest rates were raised, barriers had to be erected against such fund flows.
Meanwhile, in most of the developed world, after the bounce from the recession, economic growth slowed down. Despite that, economic policies have been tightened and further tightening is being debated practically worldwide.
In Japan, the rehabilitation after the tsunami required a large increase in government spending. But Japan already has a large sovereign debt, albeit mostly domestically held. Thus the Japanese authorities are now planning tax increases and spending cuts to reduce its budget deficit.
In Europe, one of the major measures taken in view of the debt problems of the peripheral countries was a cutback in the budget deficits all across the Euro zone. England joined in that move and while some of these measures are already effective, others will become so in the near future. Of course, these measures have further weakened the weaker economies of Europe.  What such measures can cause in the extreme case can be seen in Greece, whose economy had shrunk 5.5 percent in the year ending Q1 2011, and this may have accelerated by now, all despite a €110 billion of subsidized EMU and IMF loans budgeted. It is not clear if such measures have reduced the budget deficit in Greece or in the other weaker economies of Europe. It is likely that the deficit as a share of GDP has actually been increased. It is obvious, however, that the aid already given or now being contemplated was designed to help the lenders and sellers of CDS’s, rather than its recipients.
Against this background it had to be expected that the short sellers of sovereign debt would turn next to the larger economies of Europe.  Not that the debts of Spain and Italy were unattractive short sales on their own.  But speculators certainly were emboldened by their successes in the debts of the small peripherals and since those are already trading at prices that reflect the restructuring, other targets had to be found. In reaction, Spain and Italy are now in the final stages of accelerating major, long-term fiscal tightening moves.
Finally, back in the US, the economy rebounded smartly with the aid of large federal government deficits. But these have been increasingly neutralized by cutbacks in much larger state and local government sectors. Receipts of the latter sector have also recovered nicely but those government entities that were slow to adjust are still laying off tens of thousands per month.
Turning back to where it all started, the amounts budgeted to help the housing sector in general and homeowners in particular were very small relative to the size of the problem and the number of people affected, even if one only counts those people that can pay their mortgage with reasonably little help from the government and write-down from the lender. Worse still, even the funds budgeted went unused because terms and conditions were too stringent . In particular, the means test should have been eased or even better dropped altogether and replaced by limited size government support. As a result, house prices are still going down, although excluding forced sales they may have turned up on very small volume.
Against this background, it is no surprise that the U.S. government and the Fed seem to be trying to push the dollar down in order to reduce the trade deficit. Congress did come to the rescue here with its debate on raising the debt ceiling. But in this battle to debase the currency, Europe does seem to have the upper hand. And U.S. economic growth in the second quarter did come dangerously close to a stalling race.

The US stock market is attempting to go higher, based on actual and expected corporate profits and low interest rates. It can’t do so, however, as long as the foreseen risks keep materializing or just aggravating over time.
The list of major risks has not changed dramatically over the past quarter. Topping it in terms of potential damage is the risk of loss of confidence in all fiat money. This may be triggered by a collapse of the Euro, the Dollar – if Congress fails to raise the debt ceiling, or even from China. Geopolitical risks emanating from Libya, Syria, Pakistan, Afghanistan and elsewhere are also near the top. So also is the risk of concurrent tightening of fiscal and monetary policies worldwide.
The risks are of course heightened by widespread economic weakness in the developed world. They are well reflected in the new highs made by gold prices.


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