Investing ahead of a recession is like a trip to the dentist for a filling when the Novocain isn’t quite right. You know you are in for some pain, but it’s unclear just how much, and how long it will last. Europe is accepting the German path forward, which will at a minimum, lead to plenty of pain for many countries. Spain, Portugal, Greece, Belgium, Italy, and France are all experiencing, or likely to experience, a recession. Forward looking indicators have turned down, confidence has been dashed, austerity is being implemented, European financial assets are down sharply, and interest rates are higher. The ECB is taking a minimalist approach to fighting the recession and the 17 countries in the Eurozone have different agendas, interests, and policy aims.
In the background of the economic recession, there will be outrage at governments (for not doing enough), the ECB will appear inept, and politics will become vitriolic. It is my belief that the implementation of a comprehensive solution for the Eurozone could have staunched some of the pain, avoided the tourniquet, and led to a better collective outcome. A comprehensive and sudden solution would have sparked some moral outrage in Northern Europe, but it would have been practical and it would have led to a better economic environment for the region much quicker. Growth over time helps cure economic problems and negative growth exacerbates them.
There are a number of items which typically happen during recessions. Unfortunately, the following are likely in 2012:
- European equity markets will remain under pressure while the second derivative of European economic growth is negative. The process of economic deceleration is scary because you never know just how bad economic activity will actually get (until after it starts getting better again).
- Earnings estimates for European corporates will be way too high. In a real recession, the extent of downside to profits is universally underestimated. Sales and margins will be getting hit at the same time and there will be some corporate results in Europe that are shockingly bad.
- The euro will weaken, which will help long term competitiveness but will also cause some capital flight to safer havens.
- Politics will become less predictable, and unsound populist measures will be proposed.
And the abovementioned items are a reasonable baseline if the plan works. If it doesn’t, and the Eurozone breaks up, it will be much worse. The deeper the European recession, the greater the chance some countries will lack the political will to ride things out until the longer term.
For US investors, there has been a roadblock erected during the Santa Clause rally. The US economy has outperformed other developed markets around the world while the stock market has been essentially flat for the first eleven months of the year. Market valuations have come down this year, which set the stage for a rally as long as the world could just reclaim a little visibility. The result of last week’s ECB meeting and the Eurozone Summit clouded the outlook as opposed to clarifying it. On the one hand, many positive fundamentals are persisting in the US, and there shouldn’t be too much direct gearing towards a European recession. On the other hand, there are two issues with nonchalance:
1) China’s exports are geared towards Europe, so an EU-17 recession will exacerbate the Chinese slowdown and increase hard landing risks. China should have some monetary policy bullets to shoot but they are waiting to shoot them and the risks are heightened.
2) US multinationals with European business will be double hit. First, the recession will slow volumes and business activity and depress European profit margins. Second, a declining Euro will reduce the translation of the European profits which are already lower.
The now wider range of potential outcomes will increase risk aversion and market participants may not be as quick to buy shallow dips but may be very quick to square positions during any rallies. There are reasons to be longer term bullish on the US market:
- A stronger USD should lead to capital inflows and a higher market multiple
- A stronger USD will help cap some of the appreciation in energy and commodity prices.
- Less inflation around the world will enable emerging markets like China, Brazil, Turkey, India, Indonesia, and Mexico to go full throttle on monetary policy easing.
- Many US multinationals are as geared to EM as they are to the Eurozone.
- US corporate governance, regulation, liquidity, and depth of financial markets are still the best in the world
- That the Federal Reserve Board operates with a dual mandate will become more globally appreciated during a European recession.
In a market environment that has been difficult for a long time, experienced high volatility, and continually retraced to the same place, it is hard for most investors to focus on the longer term positives. The options are to take more risk than usual and invest looking far out into the horizon, or to acknowledge that the uncertainty is heightened and reduce both risk and return expectations until the economy in Europe stabilizes and normal visibility returns.
If the recession in Europe started in the fourth quarter, it will likely last until the summer. Just about the time when the world will be set to focus on what will be a highly contentious US Presidential election where business success and wealth creation are prone to viscous populist attacks. Perhaps investing isn’t going to get a whole lot easier through 2012.