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Are We Getting Lost at the Cliff?
10/04/2012 12:07 pm EST
US investors are so focused on the elections and the "fiscal cliff" that nears that they're not seeing the real danger as Spain disintegrates and the EU continues its swoon and the massive implications across the global markets, warns John Mauldin of Thoughts from the Frontline.
Investors in the stock market, especially professionals, are obsessed with risk, your humble analyst included.
We try to measure risk in any number of ways, looking for an edge to improve our returns. Not only do we try to determine probable outcomes, we also look for the “fat tail” events, those things that can happen which are low in probability but will have a large impact on our returns.
I have found that it was the surprises that were not in my model that were the true drivers of portfolio performance. We like it when surprises produce a positive result, and we often find a way to congratulate ourselves for our wise choices.
No one in 1982 thought that price–to–earnings ratios would rise by five times in the next 18 years. Yet that simple driver accounted for 60% of the last bull market (20% was inflation and only 20% was actual increased earnings).
And while a few people began to invest in technology in the early 1980s, many of those early technology stocks ended up being disasters. (Remember Wang? Osborne? Sorry, I know, you were trying to forget.)
“In 1910, the British journalist Norman Angell published a book called The Great Illusion. Its thesis was that the integration of the European economy, and by implication the global economy too, had become so all–embracing and irreversible that future wars were all but impossible. The book perfectly captured the zeitgeist of its time and fast became a best seller.
“In some respects, the early 20th century was a period much like our own—one of previously unparalleled global trade and exchange between nations. Human beings appeared largely to have outgrown their propensity to mass slaughter, and everyone could look forward to to a world of ever increasing prosperity. War, Angell compellingly argued, was economically harmful to all, victors and defeated alike. Self interest alone could be expected to prevent it happening again.” (Jeremy Warner writing in the London Telegraph)
On the eve of World War I, bond markets throughout Europe were not pricing in a conflict. Everyone “knew” there would not be a war. It was all bluff and bluster. And then the world got a surprise. Archduke Ferdinand was assassinated and armies began to march.
And while no one expects a war today in Europe, there are certainly plenty of tensions.
An Uncertain Spain
The Spanish government announced this week a rather severe austerity budget. They promise they will hold their budget deficits to 6.3%, while slashing spending almost 9% and raising taxes. And of course there will be no wage increases for government workers. They also assume that growth will only fall to –0.5% in the face of that austerity, which most observers think is woefully optimistic.
Even though the ECB has committed to buying Spanish bonds, they have made it clear that they will do so only as long as Spain is committed to bringing its deficit under control.
“European Central Bank Executive Board member Joerg Asmussen said on Friday that he would only support purchasing the bonds of struggling Eurozone countries if pressure on them to reform their economies remained high. ‘Only under strict conditionality and only if there is continued pressure to reform,’ Asmussen said of the bond purchase plan announced by ECB President Mario Draghi earlier this month.” (Reuters)
And if things were not already difficult enough for Spanish Prime Minister Rajoy, one of my favorite regions of Spain, Catalonia—which includes the beautiful city of Barcelona—is seriously talking about seceding from Spain. As much as 20% of the population (1.5 million) turned out for a march supporting independence last week.
Prime Minister Rajoy met with Catalonia’s president and flatly rejected any autonomy or more money. Catalonians are not happy that they send a great deal of money to Madrid, which goes to other regions as they deal with their own crises. So much for “all for one and one for all.”
The situation is complicated by the fact that the Basque region of Spain has been given a great deal of autonomy in its budget. If Spain were to compromise and give Catalonia the same deal, it would cost the Spanish government a great deal of money and enlarge the already gaping hole in their budget.
“Separately, the parliament of Spain’s most economically important region, Catalonia, approved holding a referendum on independence. Saenz de Santamaria threw down the gauntlet to Spain’s most economically important region, arguing that Madrid could use a constitutional measure to block any attempt at a separatist vote. ‘Not only do instruments exist to prevent [a referendum], there is a government here that is willing to use them,’ she said.” (The Financial Times)
Casually browsing news on the Catalonian crisis, I came across an article on previous referenda concerning independence, held on a city–by–city basis in Catalonia. Independence was favored in nearly all cities by margins of 90% or more. This was rather surprising to me, as I am not certain I could get 90% of my neighbors to agree on the time of day.
In addition to the Basque and Catalonian regions, there are two other northern Spanish regions that send net revenues further south. If you give Catalonia budgetary autonomy, let alone political autonomy, then what do you do for the other two?
Which brings up the uncertainty in the entire euro project. It is one thing to create a common market in which goods and services can freely trade. It is another to impose monetary and fiscal authority on a sovereign nation. If economic tensions within the regions of Spain begin to move voters to push for independence from central control, how much more inclined will voters in the various eurozone nations be to do so?
Germany is just now entering a recession that has the real potential to get much worse. If Germany is asked to write checks and send them to other countries when they are in the midst of their own financial crisis, how will that play in Bavaria?
The only thing I can be certain about regarding Europe is that Europe is an uncertain mess. But the markets go on treating all these pressures as if they were not real. And, indeed, perhaps the mess will all get sorted out.
It is my belief that we focus on risk because it is something that we can model. The economics profession has physics envy. Economists like to think of themselves as scientists, but I must say that I am not convinced. Economics has a great deal to teach us, but it cannot tell us much about certainty. It can’t even help us all that much to avoid risk.
I fear we don’t pay enough attention to uncertainty because we cannot reduce it to an equation. How did you price in the risk of Catalonia seceding from Spain, even two months ago? The answer is that no one did.
The US market seems to be focused on the “fiscal cliff” that will inevitably create a recession unless Congress does something. The fact that doing nothing will clearly create a recession gives me some confidence that even Congress will figure out a way to avoid doing nothing.
What has not been priced in is what Congress will do about the deficit. Depending on what they do, what we get will be hugely positive or negative. But we remain totally uncertain as to what they will actually do. And so for years we have ignored the looming train wreck that is unfunded liabilities.
It is the fact that the results of inaction on the deficit are uncertain that allows Congress to keep postponing the inevitable.
“About these matters there is no scientific basis on which to form any calculable probability whatever.”
We live in most uncertain times.
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