Special Update – End of October

by MacroTides

Stocks

Since last July the stock market has been concerned about the potential of a double dip in the U.S. economy, and the risk that the European sovereign debt crisis would spread outside of Greece, causing another Lehman Brothers moment in the process.

News that the U.S. economy grew 2.5% in the third quarter has alleviated the double dip worries, and raised expectations for 2012. Consumer spending added 1.54 points to GDP, but this level of spending is going to be tough to maintain since disposable income fell -1.7%. Business investment added 1.72 points, which will weaken in 2012, unless the tax credit deduction that expires on December 31, 2011 is extended. We are confident the U.S. economy will not grow 2.5% in the first half of 2012.A graphical summary of the GDP report and some related data follows:

The announcement last week that Europe has arranged a plan to contain the sovereign debt crisis gave the global markets a big lift, with most gaining 3% to 5% last Thursday.

The relief markets received from these developments will last as long as the illusion of improvement in the U.S. and Europe are not confronted by reality.

As long as institutional investors believe the markets have turned the corner, selling pressure will remain light, and the market will hold on to the gains. This will pressure investment managers who are under invested going into the end of the year, and force them to commit some of their cash. This could push the market up into year end.

This sanguine scenario is predicated on the unrealistic expectation that there will be no negative news to remind investors of the true underlying weakness in the U.S. economy. Unless job growth accelerates to 200,000 new jobs a month, and income growth rises, most consumers are going to continue to be squeezed by the higher cost of living. Europe’s solution will only temporarily distract investors from the primary problem, which led to the sovereign debt crisis in the first place. There is simply too little growth in too many E.U. countries to support debt levels. And, with the potential of a recession taking hold in the first half of 2012 in much of Europe, this point will be quite clear.

While all the focus has been on Greece, Italy has been quietly simmering on the back burner. The graph below shows that the Italian bond yields have return previous highs:

Over the last 10 years, Italy’s economy has averaged an annual growth rate of just 0.28%. See the table below. Italy must now adopt austerity measures that will be extremely unpopular, and result in even slower economic growth. If global investors doubt Italy’s ability to deliver, interest rates on Italian debt will rise. Italy’s debt to GDP ratio is 120%, so any increase in interest rates will make it even more difficult to grow their economy and service their debt load. The early results are not encouraging. Since the announcement of Europe’s plan to contain the sovereign debt crisis, the yield on Italy’s 10-year government bond has climbed to 6%. In early August, the ECB bought Italian bonds aggressively, which pushed the yield down to 5% from 6%. Unless the ECB buys more Italian bonds, yields appear headed higher.

EU GDP History

We believe this is a bear market rally, even as noted in our October 21 letter to paid subscribers, the S&P may climb to 1300-1320 by mid December. Sentiment, which was excessively negative in September, has already begun to shift, now that all the problems have been solved! With so little upside left, selling into strength seems prudent.

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About the Author

Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at [email protected].