Housing has very likely been affected by the weather. We believe the housing market continues to show improvement but were disappointed by the recent data releases that showed existing home sales fell by 2.6% and housing starts dropped by 5.8%. However, the forward looking building permits number rose 4.5%—boding well for future activity. And, even within the disappointment there were glimmers of positive news as the drop in starts was almost entirely attributable to the volatile multi-family component falling 16.9%. Finally, inventories continued to decline—existing homes on the market are down 22% relative to a year ago.
The Index of Leading Economic Indicators (LEI) rose for the sixth straight month, although upcoming seasonal adjustments suggest an upcoming weaker report. And, one odd note on the auto sector. We’ve noted the sharp rebound in auto sales and the resulting contribution to economic growth, but that could be in near-term jeopardy due to a potential shortage of a resin known as nylon-12 used in brake and fuel systems. The potential shortage comes as a result of a chemical plant explosion in Germany that is expected to take production offline for at least three months. Auto executives have expressed serious concern.
Fed holds but continues to confound
The recent Fed meeting provided few surprises as interest rates remain near zero and questions regarding future potential monetary operations remain. We continue to hope that the Committee will lean toward more normal monetary policy going forward but they do appear willing to up the ante and provide more stimulus if economic conditions deteriorate.
The Fed will likely keep its ammunition at the ready due to the potential hit to the economy that is currently scheduled to come at the beginning of 2013 in the form of massive tax increases and blunt-force spending cuts. We remain hopeful that something will be worked out to minimize the potential impact but are concerned that the current political environment does not lend itself to any easy compromise solution.
Europe's confidence game slipping
As dire as the situation sometimes seems in American politics, we can always look to Europe for an example of even greater problems. Sentiment regarding the eurozone debt crisis was boosted by the double shot of European Central Bank (ECB) three-year bank loans and the perception of progress by individual country governments toward structural reforms and fiscal austerity. However, since the beginning of March, uncertainties have risen because governments have either been thrown into upheaval or backpedalled on deficit reduction and reform goals; and the major impact of the ECB's three-year loans has faded.
Spain in particular has been a focus, as it is viewed as too big to fail, yet also too big to bail out. Spain's situation can be thought of an inter-related four-legged stool of problems: a deteriorating economy, a housing bubble burst, a weak banking system and an elevated government deficit. When one leg of the stool deteriorates, the others feel the pressure.
The Spanish government's credibility has been called into question because it missed its 2011 fiscal deficit target by over 40%, with the deficit registering 8.5% instead of the 6.0% target. This increases doubts about the ability to slash the deficit in 2012 and 2013, not to mention what appear to be overly optimistic assumptions in the deficit reduction plans in our opinion. We don’t believe the situation in Spain necessitates an imminent bailout, but markets are nervous that the situation could deteriorate, necessitating a bailout over the next couple years.
The ECB's three-year loans, also known as their long-term refinancing operations (LTROs), reduced the threat of a global banking crisis in our view. While the money was partly credited with yields plunging on debt of weak countries, the effect on government yields is fading. It may sound like a bit of a shell game, but after posting peripheral debt as collateral with the ECB to receive money, some banks in the periphery used the LTRO money to buy more debt of their home countries. This negatively increased the ties between weak banks and weak governments.
Now, the ability to use LTRO money is running out due to banks’ capital rules. As such, the ability for Spanish banks, for example, to support Spanish government bond auctions, is waning. New bond issuance is increasingly dependent on foreign investors, at a time when foreign investors are increasingly shunning exposure to peripheral countries. The move in France and elsewhere toward policies that are unfriendly to businesses (banks and energy companies in particular), reject austerity, increase taxes on the wealthy and toward protectionism, are the wrong prescriptions in our view.
Additionally, the socialist way of life may need to be re-examined, because many governments need to reduce spending. Healthcare and pension programs take up a large share of spending, which is likely to increase as populations are aging. Tax rates are already high in many countries, but better collection and reduced complexity of tax laws could likely bring in more revenues.
The way out of the “austerity trap,” where weakening economic growth contributes to missed fiscal deficit reduction targets and new rounds of austerity, is growth. More concrete and aggressive policies need to be made to:
- increase flexibility of labor markets, and
- reduce restrictions on the ease of doing business.
Structural reforms will take time to reap rewards; however, we don’t see a magic cure in the short-term for the eurozone’s ailments.
Eurozone economic downside risk
In the meantime, transmission to the real economy of the eurozone sovereign debt crisis is to weaken the banking system. The LTRO money provided new buyers for maturing bank debt, with the ECB acting as a substitute for capital markets. However, as ECB President Mario Draghi recently said, "This is not capital," and “If banks don't have capital, (they) better raise it now."
