Who’s Worse Off - America or Europe?
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Who’s in Worse Shape – America or Europe?
2. More Tricks Up Bernanke’s Sleeve?
3. Gold Investors Taking a Huge Risk
4. More on the S&P Downgrade of US Debt
Who’s in Worse Shape – America or Europe?
The US has received criticism from pundits around the world in recent weeks. First, there was the very disappointing GDP report at the end of July, showing growth of only 0.4% in the 1Q and 1.3% in the 2Q, both well below expectations. Next, global observers expressed distaste with the debt ceiling debacle which threatened to push the US government into default. Making matters worse, Standard & Poor's downgraded America's credit rating from AAA to AA+.
As a result of these and other factors, stock markets around the world plunged lower, highlighted by panic selling almost everywhere. Yet US Treasury bond prices – yes, those just downgraded by Standard & Poor’s – have skyrocketed, proving that the world still views Treasuries as being safe and sound. In any event, the US has gotten a lot of criticism of late.
As regular readers know, my focus over the last several weeks has been on the deteriorating financial situation in Europe, not the debt ceiling debacle. In Europe, the financial crisis spread from the periphery countries of Greece, Portugal and Ireland to Spain and Italy, and last week we began to hear fears that even France may be in trouble.
The European Central Bank (ECB) has calmed things down for the moment by buying bonds from Spain and Italy, and says it stands ready to buy even more if need be. Interest rates have reportedly backed off in Spain and Italy, at least for now. But as I discussed last week, the ECB and the European Financial Stability Facility (EFSF) are woefully under-funded. Europe is not out of the woods by any stretch.
Still, because of what has transpired over the last several weeks, the US continues to get most of the criticism. All of this leads to the following question: Who’s worse off – America or Europe? There are good arguments on both sides as both have very serious structural problems. But if we’re facing another 2008-style financial crisis, my bet is that it begins in Europe, not in the US.
In the big picture, you could say the US is worse off economically than Europe. Even before the latest stock market meltdown, the US fiscal path was unsustainable, what with an aging population combined with an enormous national debt and even larger entitlement commitments. And as noted above, the US economy is slowing down. The only way out, many say, is to implement massive tax increases or draconian spending cuts, or both.
Here are some other statistics on the US debt problem. According to the Organization for Economic Cooperation and Development (OECD), the US federal, state and local government deficit (NOT the federal deficit alone) jumped from 2.9% of GDP in 2007 to 10.6% in 2010. Excluding debt interest payments and adjusting for the economic cycle, the so-called “primary deficit” rose from 1.5% to 7.0% of GDP, the biggest in the world. And the ratio of US debt to GDP jumped from 62.0% to 93.6% in 2010.
The Eurozone is nowhere near as bad, with an average annual deficit of 6.0% of GDP, a primary deficit of 1.1% of GDP and a debt-to-GDP ratio about the same as America's but rising nowhere near as quickly. In Europe, growth is holding up better than in the US. The IMF raised its growth projection for the Eurozone in late June to 2%. Of course, that number will not likely hold up as a result of the market turmoil of late which will cause Europe’s consumers to pull in their horns.
While America’s financial problems are dire, the US has one huge advantage over Europe at this moment, and that is the luxury of time. As noted above, the reaction of the world’s investor community to the recent financial turmoil has been to rush into US debt. What that means is US borrowing costs will continue to decline, and that buys the US time to get its act together and put in place a real plan to reduce the deficits and restore American growth, assuming our leaders are really serious, which is highly questionable.
The Eurozone, on the other hand, has no such luck. Borrowing costs for its weakest economies — the PIIGS, including Portugal, Ireland, Italy, Greece and Spain — remain highly elevated. That puts pressure on those governments to implement fiscal reform programs with great haste as well as pressure on the rest of the Eurozone to take more and more dramatic action to stem the financial crisis contagion.
As noted above, the European Central Bank swooped in last week to buy billions of dollars of Italian and Spanish debt, pushing down the yields on their bonds and easing the debt crisis at least for now. This is a major deviation from the ECB’s usual policy, and as I have cautioned, the ECB is under-funded. So it is unlikely that the ECB (and the ESFS) can handle the crisis on its own over an extended period of time.
And the ECB may not be seeing much help anytime soon. The Eurozone simply does not have enough cash allocated to fighting the debt crisis, and that is unlikely to change in the near-term. Some blame the self-centered nature of European politics. If you think Washington is dysfunctional, take a look at what goes on in the Eurozone. Major decisions require the agreement of the Zone’s entire leadership. Getting anything done is a nightmare, especially since every member has to worry about how new policies will play with voters back home.
That’s why the dominant member of the Zone, Germany, has to be dragged kicking and screaming into any effort to resolve the euro crisis. Chancellor Angela Merkel is facing a near revolt from her own supporters over her agreement to new rescue efforts.
Therein lies yet another reason why Europe is a bigger danger to the global economy than America. EU members are simply not willing to make the sacrifices necessary to resolve the debt crisis. Sound familiar? Yes, the US has serious political divisions, but at least everyone here – conservatives and liberals – believes they are acting in the best interests of the nation. As a nation, we can pass reforms if we choose to. Europe, on the other hand, faces fundamental political and economic change, which all must agree upon, if its debt crisis is to be truly resolved.
It will take a level of political and economic integration the individual members of the Eurozone have been unwilling to consider so far. That may mean adopting dramatic reforms that directly impact national sovereignty, like the merging of national budgetary policies — specifically, a unified fiscal union to match the euro monetary union.
Ultimately, the survival of the euro depends on the creation of some kind of united fiscal union. Creating a fiscal union cannot take place overnight but a useful first step might be to agree on a timetable for the creation of such a union. At the moment, the political will is lacking but, as the financial crisis continues to worsen, the choice will become increasingly stark.
America has serious problems, not to mention that our debt continues to explode. But the US is far from a sovereign debt crisis, as illustrated by the recent herding into Treasury notes and bonds, despite the S&P downgrade of our debt. As noted above, the US still has the luxury of time. For how long, I do not know.
Numerous countries in Europe have no time left or very little. If one sizable country defaults on its debt, that would turn European sovereign debt into something toxic like the subprime mortgage securities of the 2008 crash, and a banking crisis would almost certainly follow.
Bottom line: Europe poses a greater danger to the global economy at this moment than the US, in my opinion.
Bernanke May Have More Tricks Up His Sleeve
The Fed Open Market Committee (FOMC) met last Tuesday, amidst all of the market turmoil, and the usual policy statement that afternoon was disappointing to many. The FOMC statement announced a decision to keep short-term interest rates near zero through at least mid-2013. Prior to last Tuesday’s announcement, most forecasters felt that the Fed would begin raising short-term rates by mid-2012. Of course, that was before the latest stock market meltdown.
The Fed’s 1:15 EST announcement last Tuesday was enough to drive the stock markets higher with the Dow gaining 400 points by the close. However, on Wednesday, the Dow plunged 500+ points. As noted above, many analysts were disappointed that the FOMC did not vote to launch another round of “quantitative easing” or QE3.
By the way, these policy statements from the Fed every six weeks or so tend to be very mundane and much of the language doesn’t change from report to report. But if you read the entire FOMC policy statement last Tuesday, as I did, you found something new and interesting in the last paragraph:
"The Committee discussed therange of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.” [Emphasis added, GDH.]
As a Fed watcher for over 25 years, here’s what this new statement means to me: Even though the Fed didn’t announce QE3 last week, it won’t hesitate to do so at any time if need be. I also think this statement was purposely open-ended so as to give Bernanke the maximum latitude.
Keep in mind that the Fed holds an Economic Symposium every August in Jackson Hole, Wyoming. Fed Chairman Ben Bernanke will speak at the symposium on Friday, August 26. You may recall that Bernanke hinted at this same symposium last year that the Fed was about to embark on another round of quantitative easing – QE2. QE2, which ended in late June of this year, consisted of purchases of apprx. $600 billion in Treasury securities.
So, will Ben announce QE3 on August 26? If the stock markets continue to tank, I would think the answer is a definite YES. You might recall that Bernanke already hinted at QE3 on July 13, shortly after the end of QE2, but recanted the next day telling lawmakers that the Fed “…isn’t prepared ‘at this point’ to enact more stimulus.” We’ll see about that.
A year ago, when Bernanke announced QE2, rumors were that he wanted to buy up to $2 trillion in Treasury securities, but the more conservative members of the FOMC reportedly forced him to scale it back to only $600 billion. Some now feel that the $1.4 trillion difference ($2 trillion less $600 billion = $1.4 trillion) could still be on the table.
Personally, I hope the Fed doesn’t do it. That would push the Fed’s securities portfolio over $3 trillion. Plus, there are questions as to how well QE2 worked. I would say, not very well. But they may do it anyway. President Obama and Treasury Secretary Geithner met with Bernanke last Wednesday, just one day after the Fed downgraded its view on the economy. Hmmm.
If Bernanke hints at another large round of quantitative easing, QE3, on August 26, that should be quite bullish for stocks – especially if it’s a trillion dollars or more. Of course, who knows where the stock markets will be by August 26.
Some think Bernanke could also announce in Jackson Hole that the Fed will discontinue paying banks 25 basis-points interest on the $1.6 trillion excess reserves they have on deposit with the central banks. In theory at least, if banks can no longer earn a safe 25bps from the Fed, maybe they would consider lending more. Of course, that assumes that there are lots of businesses wanting to borrow, which is far from certain.
Whatever major decisions the Fed makes just ahead probably won’t be formally announced until the next FOMC meeting on September 20. But that doesn’t mean Bernanke won’t leak the plans publicly at the Jackson Hole symposium when he speaks on August 26 as he did last year, or even sooner for that matter.
Retail Gold Investors Taking Huge Risks
I have purposely not commented about the recent skyrocketing price of gold because, frankly, it has gone beyond anyone’s wildest expectation, including the life-long “gold bugs.” But now investors who would have never considered buying gold are considering jumping in even at these never-before-imagined record highs. We are getting calls most every day from clients and readers who ask if we would advise getting on board now with gold over $1,700 per ounce.
Obviously, I have no idea how high (or low) gold might go from here. Personally, I think it is a disaster waiting to happen, and it could fall off a cliff any day now, as gold is so prone to do. But here are just a few generic thoughts on gold that I think you should consider before jumping in.
The vast majority of retail investors who invest in gold hold the Exchange Traded Fund GLD. GLD is priced at roughly 1/10th the spot price of the underlying bullion. The fund is fully backed by gold held in the HSBC vaults in London. The recent “flight to safety” has seen the price of gold (and thus GLD) rise considerably, having recently peaked at $175.13 per share as gold has topped $1,700 per ounce. Of course, this increase in price has also increased the risk of holding the yellow metal (read: it could fall out of bed at any time). Here are a few of the risks investors can experience in GLD (from the prospectus page 6):
Retail investors may have considered one or more of the above before investing (but likely didn’t). What virtually none of the retail investors considered as a risk to investing in GLD was an increase in the “margin requirements” on gold futures contracts. In a nutshell, margin is the collateral that an investor puts up for a position in futures contracts to cover the credit risk.
The Chicago Mercantile Exchange announced last Thursday that initial margin requirements to trade gold futures rose to $7,425 per 100-ounce contract from $6,075, and maintenance margins increased to $5,500 from $4,500. Maintenance margin is the level at which you get a margin call to bring your collateral back up to $7,425. Those unable or unwilling to put up the additional capital are forced to sell. Gold futures fell on the news of the margin increase, and GLD fell even more than the futures.
This could be but the first in a series of increases for gold margin, not unlike the margin increases we saw in silver earlier this year that resulted in a massive four day plunge in silver prices from a high of $49.82 to $32.22. This same scenario could play out with gold.
The point is that retail investors seeking a safe haven from the equities markets have no idea how much risk they are taking in GLD or the various other methods of investing in gold. At today’s record prices, gold can incur significant losses at any time with or without additional increases in the margin requirement.
More on the S&P Downgrade of US Debt
Last week, I made some initial comments on Standard & Poor’s decision to downgrade the US debt rating to AA+. Now that a little more water has run under the bridge, there are some additional observations I can make.
First, Standard & Poor’s has been pretty much beaten up since its downgrade decision, especially when the two other credit ratings agencies – Moody’s and Fitch – didn’t agree. President Obama chastised the S&P by claiming that it incorrectly calculated future deficits. Others called into question the need for any rating firm to judge US government solvency, since it has the power to print money to pay its debts.
As I read many Internet posts on the S&P debt downgrade, it seemed that the majority had a bigger problem with the audacity of Standard and Poor’s to downgrade government debt due to a subprime crisis that it helped to create. After all, it wasn’t the government that gave AAA ratings to subprime mortgage debt. Others felt that the latest US credit downgrade, going it alone, was an attempt by S&P to get its reputation back.
Reaction in the investment industry was mixed. PIMCO bond fund manager Bill Gross agreed with S&P’s downgrade, while Warren Buffet criticized the move saying that US debt should be quadruple A (AAAA) rated, if such a rating existed. The mixed reaction to the S&P downgrade, when the other credit rating agencies left our credit rating unchanged at AAA, should rightly have raised big questions, and I couldn’t agree more that the S&P downgrade should be challenged. I also question the media’s over-reaction.
Some believe it might just be possible that Standard & Poor’s fired a shot across Congress’ political bow in an attempt to wake up our elected officials to the need for meaningful action. Guessing that the other two rating firms would probably not likely follow suit, S&P may have concluded that it could make its point without having any major adverse effects. Boy were they wrong!
Others believe that S&P wanted to be first out of the gate to downgrade US debt in an attempt to resurrect its reputation after its shameful rating of subprime debt as AAA back in the years leading up to the financial crisis. I would suggest that this was definitely part of the reason.
There were even some others who suggested that the S&P downgrade was meant to support the Tea Party position that the recent deficit reduction plan didn’t go far enough. Others felt that the action was more than a little payback to the government for legislation and regulations aimed at reining in the abuses that helped to create the subprime debacle.
Whether or not the move was purely political on S&P’s part, it certainly could have been. What we have seen during the healthcare, debt ceiling and deficit reduction debates are backdoor deals, outright bribes and smoke and mirrors tricks more suitable for a circus sideshow than leaders of the greatest country in the world. It’s time for this foolishness to come to an end!
The way out of the current economic malaise will require tough decisions that will likely be very unpopular with certain segments of the population. What we need are statesmen (and women) who will put service before self and make the hard decisions, no matter what the consequences may be for their future re-election.
Do we have such individuals in the House and Senate? Frankly, I don’t know but I think we might, especially with the many conservatives elected in 2010. But they are often drowned out by partisan sound bites from members of both parties who seem to be more intent upon maintaining power (read: re-election) than fixing America’s problems.
Will Standard & Poor’s action awaken the wisdom necessary to govern, despite its very questionable motives and judgment? Only time will tell, but I’m not holding my breath. Both the Congress and President Obama have gone on summer vacation, so they must not be too concerned.
Wishing you limited losses,
Gary D. Halbert
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