It’s Friday and my mind is wandering so let’s play 3 things….
1) The Euro crisis is not over.
I know I sound like a broken record about this, but the crisis is not over. Every “fix” they’ve implemented is a band-aid on a gushing wound. This crisis is not overly complex. Here’s what happened. You have a bunch of countries relinquish the right to print currency and enter into a single currency system. This also eliminated floating exchange rates. So you had a serious structural imbalance by design – you were guaranteed to get trade imbalances due to the single currency because there was no floating exchange rates to rebalance and no ability to print money to offset the imbalance. So we ended up with periphery nations buying everything from the core and then borrowing more to continue this unsustainable trend in “growth”. The party ended when bond traders realized the periphery nations couldn’t borrow forever. So here we are. And the only fix is to fix the currency union. That involves creating currency sovereignty. So we either break-up or we create some sort of fiscal entity that essentially guarantees the debts of the periphery nations and eliminates the risk of sovereign default. Until then, bond traders will continue to rule the roost in Europe.
2) Corporate profits trends are becoming worrisome.
As I highlighted earlier this year, the outlook for corporate profits doesn’t look all that great. Margins have likely peaked, corporate America can’t cut all that much more and revenues appear to be sagging. Just 43% of companies are beating earnings this quarter and we’re beginning to see fragility in reporting that very much reminds me of the late 2007/early 2008 period when corporate profits were good, but clearly deteriorating. Mean reversion in profit margins is one of the few things that is a relatively reliable profit occurrence. Of course, timing that event is practically impossible since it occurs over such a long period, but it’s clear that we’re likely facing headwinds here. And as we know from the Kalecki profit equation, the risk of the fiscal cliff could torpedo profits since the budget deficit has been a huge driver of growth. I’ll have more on profits in the coming week.
3) The risks to the market are building
I’ve been dialed in to this market pretty well over the last few quarters. In early April I was looking for a sell-off and then in early June I was expecting a rally. I think we’re nearing a point where the market once again looks increasingly risky. We’ve had about a 9% rally off the June lows and I am having trouble thinking of a positive catalyst at this juncture. The key to understanding most of the market rallies in recent quarters has been dialing into big policy moves. Every time the Fed or ECB has responded with a big policy maneuver the market has rallied. Now, there’s a chance that the Fed implements QE3 at the August 1st meeting, but if we don’t get it there then the market has to wait a full 6 weeks before any policy response occurs. And that’s all as Europe’s woes just tumble on without action. I’m trying to think like a chess player here and consider the possible future catalysts, but I just can’t think of too many. I’m sure readers have some opinions here. If so, please chime in….