European Debt Crisis and US Politics

The European debt crisis and US politics was center stage this weekend. European leaders approved a capital infusion of up to 100 billion euros (approximately $126 billion) to shore up Spanish banks after the southern European nation conceded that assistance was necessary in the face of increased costs of capital. The initial reaction to the news was euphoric sending the Spanish stock market higher and sovereign debt yields lower. Oddly enough, as of the time of this writing this morning, the Spanish stock market has pared its gains and bond yields are actually HIGHER that before the bailout announcement.

The yield on the Spanish ten year sits at 6.36% and has been above the critical 6% level for 22 straight trading days. This higher yield has been partly responsible for the lack luster market performance over the past month. Not a very encouraging sign given the size of the bailout (roughly 10% of Spain’s GDP) and the upcoming Greek elections that some fear will spread uncertainty throughout the euro region.

Spain’s GDP is greater than Ireland, Portugal and Greece combined (the three other bailout recipients), so it is understandable and commendable that European leaders abandoned a dithering stance and quickly reassured the markets that they are prepared to act in the face of Greek election uncertainty, albeit providing a treatment to the sickness and not the cure.

What is the cure?

Last week we commented on the possibility of a Greek exit from the euro as possible capitulation and resolve to the crisis that has been dragging on for years. This past week, we read an article in the Financial Times that further elaborated on this possible solution.

“What if the European elites have got it entirely wrong and, rather than fearing and avoiding a “Lehman moment”, Europe in fact needs one in order to move beyond this interminable state of crisis? Could Greece play the part of Lehman Brothers? There is a strong argument that it should…

To restore stability, the eurozone needs to institute jointly guaranteed eurozone bonds underpinned by ironclad and enforceable centralised fiscal discipline; eurozone-wide deposit insurance; and mandatory recapitalisations. But political will to do this will not be fully mobilised as long as the alternative of “buying time” appears available: politicians will always choose that option if it is open to them.”

The author of the oped continues, “After a Greek exit, eurozone leaders would not be able to buy further time. They would face a very clear choice: unite immediately behind a comprehensive fix to secure the countries next in line (Spain, Portugal, Ireland etc) or watch the entire eurozone project disintegrate…

It is now time to let Greece go in order to catalyse and legitimise the measures needed to save the rest.” Europe needs its ‘Lehman moment’ to help it tackle the realities – Michael Tory – Financial Times – 6/5/12.

As we stated last week, a controversial stance, but one that is perhaps needed to stave of euro extinction.

US Political Season

It has been a tough few weeks for President Obama and his re-election efforts.

- The employment report for May showed an abysmal 69,000 new jobs created with the unemployment rate climbing to 8.2%. Watching the administration rummage through the report in an attempt to gleam something positive was hard to watch as the Dow Jones Industrial Average plummeted over 270 points.

- Former President Clinton took to the airwaves in an attempt to campaign on behalf of President Obama. Expressing his views on Romney’s “sterling” career at Bain Capital and his belief that the Bush tax cuts should be extended for all, regardless of social class, must have had the Obama team scratching their heads asking who this guy is campaigning for. These actions had many wondering what this politically calibrated former President was up to, with some publically stating he was “undermining (President Barack) Obama” to lay the “groundwork” for Hillary Clinton’s presidential run in 2016.” This coming from Ralph Nader, former Green Party presidential candidate.

- Organized labor’s failed attempt to recall Wisconsin governor Scott Walker after his hardline stance on collective bargaining for public employees in the state, as well as major blowouts in both San Jose and San Diego as it related to the public vote in favor of decreasing public union benefits for state employees.

- The latest monthly fund-raising reports show Mitt Romney and the Republican Party for the first time had raised more campaign money than President Obama.

- Last but certainly not least was President Obama’s gaffe this past weekend when holding a conference to discuss economic and European concerns, when the President said, “the private sector is doing fine.”

Our opinion is that this latest slip-up on the part of our President may come back to haunt him as it did Arizona Senator John McCain during his 2008 presidential run when he stated, “the fundamentals of the economy are strong”. Nothing really remarkable about that statement except it was made in late 2008, when Bear Stearns and Lehman Brothers were going out of business, the stock market had plummeted over 40% and the entire global financial system was in jeopardy of collapsing probably causing the second Great Depression. Probably not the best timed proclamation and something he never quite recovered from.

Probably more important is that it shows the Obama administration does not have the proper mindset to fix this economy. Unfortunately, many of the Republican solutions also miss the mark. We have written countless times that increasing taxes and cutting spending in a time when the global economy is slowing (and possibly heading for recession) is anti-stimulative and anti-growth.

On taxes, the President went on to clarify that more money is needed to boost the public sector, aka bigger government and that it should be subsidized through higher revenues (this is the new politically correct way of saying higher taxes).

The Romney camp went on to state, rightfully so that higher taxes and bigger government is not the appropriate strategy needed to tackle our economic woes. In an opinion piece in the Wall Street Journal, “What a Romney Recovery Might Look Like” 6/7/12, Phil Gramm and Glenn Hubbard go on to compare this recession with the recession of the early 1980’s. Both recessions suffered unemployment rates above 10%, both downturns were caused by financial crises (in 1980 interest rates were raised aggressively to stem off inflation which in turn exacerbated the savings and loan crisis) and both had new Presidents step into an economic mess.

The major difference between the two scenarios was the economic ideology of each President. President Reagan practiced supply side economics and pressed forward with a stimulus plan that centered on tax cuts and limited government. President Obama practices Keynesian economics and centered his policy on increased spending and a greater role of government.

The Romney camp will make comparisons that show under President Reagan’s plan, fifty-three months into the economic recovery, the US economy produced 7.5 million new jobs, the labor-force participation rate was 65% (up from 63.8%) and real per capita gross domestic product increased by $2,870, up 11% from when the recession started.

Fifty-three months into the Obama administration recovery, there remains 4 million jobs lost since the start of the recession, labor-force participation is 63.8% (down from 66%) and real per capita GDP declined by $964 or 2.2% lower than when the recession started.

The debate over the effectiveness of supply-side and Keynesian economics is beyond the scope of this weekly newsletter. We agree and disagree with several Democrat and Republican concepts, and we certainly believe the notion of RAISING taxes on anyone in the midst of an economic slowdown is the wrong move. Last week we opined on the coming fiscal cliff and the potential damage it would do to economic growth

The market may remain under pressure from the threat coming from the European debt crisis as well as a messy election season. We are patiently waiting to start building new positions once this correction plays through.

Joseph S. Kalinowski, CFA