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Why The Eurozone Could Be A Problem For Stocks

  • Written by Syndicated Publisher No Comments Comments
    September 10, 2014

    A few weeks ago I asked a simple question: “Can The U.S. Economy Stand Alone?”

    “The following chart is food for thought. There are extremely high expectations that the U.S. economy will achieve “lift off” in terms of economic growth eventually achieving 3-4% annualized growth rates. The chart below shows the nominal GDP of the Eurozone and U.S.”

    GDP-US-EuroZone-081414

    Is it possible, that in globally interconnected economy, the U.S. can stand alone?

    It certainly seems that the answer to that question is currently “yes” as financial markets hit “new all-time” highs and economic data has rebounded in the second quarter following a sharp Q1 decline. However, as is always the case, the issue of sustainability is most critical.

    Sy Harding recently wrote an interesting piece entitled “The Eurozone Is A Growing Problem For U.S. Economy?” in which he cited three very crucial points relating to the issue of sustainability:

    • The 18-nation euro-zone is the largest economy in the world, eclipsing that of the U.S.
    • The euro-zone is the largest trading partner of the U.S. (the largest importer of U.S. goods, the largest exporter of goods to the U.S.).
    • The euro-zone is in an economic crisis.

    The chart of GDP above clearly illustrates the importance of Sy’s points. Importantly, the economic conditions in the Eurozone are getting “worse” rather than “better.” According to Sy:

    “It slowed further to 0.0% quarter-over-quarter in the second quarter.

    Worse, Germany, the euro-zone’s largest and previously strongest economy, unexpectedly saw its economy contract to negative -0.2% in the second quarter. France, the second largest euro-zone economy, saw its growth slow to 0.0% for the quarter. Italy, Europe’s fourth largest economy, slid back into recession, its GDP at negative 0.8% in the second quarter, its second straight quarterly contraction.

    Reports this week indicate the problems are worsening in the third quarter.

    Retail sales in Germany plunged 1.4% in July, after declining 0.4% in the second quarter.

    Germany’s Ifo business confidence index fell in August for the fourth straight month, to its lowest level since July 2013. Market research group GfK reported its German consumer expectations index ‘collapsed’ in August to its most pessimistic level since 1980. Perhaps for good reason, since the overall euro-zone’s unemployment rate remained in double-digits at 11.5% in July, just 0.5% lower than its peak of 12% in 2013.”

    The following chart of wages, labor costs, and price inflation clearly shows the increasing problems facing the Eurozone economies.

    Euro-Area-Wages-CPI-090214

    The negative feedback loop to the Eurozone economies from declining wages and overall deflationary pressures has nullified attempts by the European Central Bank to spark some inflation across economies. While there is continued “hope” that the ECB will launch further successive rounds of monetary interventions, there is clearly a diminishing rate of return of each dollar spent.

    Furthermore, given the fact that the ECB, unlike the Federal Reserve, relies on the “generosity” of its member countries to fund its “coffers,” which primarily falls on the shoulders of a weakening German economy, there is a limit to what ECB can achieve.  There is also the question of when Germany will just say “Nein” to continued bailouts of its failing neighbors with respect to its own economic prosperity.

    The rising deflationary pressures in the Eurozone economy will also reduce the nascent inflationary pressures domestically. The uptick seen domestically was primarily a function increased economic activity during the second quarter rebound which was primarily an inventory restocking cycle. With deflationary pressures increasing in the Eurozone, the feedback to the U.S. will reassert itself in the coming quarters ahead.  (Chart below shows the high correlation between domestic and Eurozone inflation)

    Inflation-US-Eurozone-090214

    Given Sy’s points with respect to the size and importance of the Eurozone economy, exports comprise roughly 40% of domestic corporate profits; it is unlikely that U.S. profits will remain unaffected. As I have discussed recently, corporate share buybacks have been a major boon to increasing profits on a per share basis over the last couple of years. Share buybacks have also been an important driver of asset prices in conjunction with, and due to, the expansion of the Fed’s balance sheet and suppression of interest rates.

    “The boom in buybacks also owes much to the Federal Reserve’s suppression of long-term interest rates via quantitative easing and stagnant growth in Europe, an important foreign market for many S&P 500 global companies.

    Record-low interest rates in the corporate bond market have helped fund large buybacks, but with the central bank on course to conclude buying bonds under QE in October, fuel for buybacks is ebbing and non-financial debt issuance has slowed.

    Andrew Lapthorne at Société Générale says companies have exploited the generosity of financial markets to fund their share buybacks and as that fades, the equity bull market faces losing a key source of support.

    Share buybacks have grown by $1.56 Trillion since 2011, but those repurchases peaked during the first quarter of this year at 159.28 billion before sliding back to $120.21 billion in Q2.  The risk for the markets here is that with the Federal Reserve reducing the flow of cheap liquidity, and potentially raising borrowing costs in 2015, two of the major supports of the markets will be removed.”

    The correlation between the Eurozone financial markets has been, and remains, extremely high. As shown in the chart below.

    Eurozone-SP500-090214-1

    The current divergence between the two markets, and given the underlying weakness in the economic underpinnings of the Eurozone itself, brings the question of sustainability into focus.

    Eurozone-SP500-090214-2

    I have to agree with Sy’s conclusion:

    “It has also been more than three years since the market experienced even a normal 10% to 15% correction, while on average it does so every 12 months. And of the 25 bull markets of the last 100 years, this is the fourth longest running since 1929.

    You do have to at least ask yourself if that is justified, especially given the still anemic economic recovery. The market is higher than in 2000 and 2007. Even in those years of booming economic conditions, the market was not able to drive even higher, the S&P 500 instead losing 50% of its value in those apparently forgotten bear markets.

    I know, it’s all about the Fed’s easy money policies and near-zero interest rates. But still, at those market tops, and indeed all market tops, there were also reasonable explanations of why ‘this time is different’.”

    While anything is certainly “possible,” given the weight of evidence, keeping a watch on the “probable” seems to be the more prudent course of action.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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