“Credit is a system whereby a person who can’t pay gets another person who can’t pay to guarantee that he can pay.” — Charles Dickens (1812 – 1870), English author
Early last week, the stock market cheered a $1 trillion bailout package to contain
Europe’s debt crisis. The Dow Jones Industrials went up more than 400 points on Monday. By the end of the week, however, worries returned that European austerity plans would slow economic growth. The euro sank to a four-year low. Just a while ago, the euro was being touted as the world’s primary currency in-waiting.
On Friday, the Dow dropped 1.5% to trim the week’s gain to just 240 points. The S&P 500 snapped a two-week decline to close +2.2%. So far in 2010, both the S&P and the Dow are up by 1.8%.
The financial markets currently fear the outcome of the fiscal situation in Europe. The 2008 recession was all about leverage too, but that involved overextended homeowners and financial institutions. Governments bailed out some and let others fail. But how does a government, or group of governments, bail out other countries? A country like Greece or Portugal can’t actually declare bankruptcy.
In pre-euro times, fiscally irresponsible European countries solved their problems by devaluing their currencies. If a country owed one million drachmas, for example, the creditor would be repaid, but the new drachma would only be worth a smidgen of its former self as valued in other currencies. In the European Union now, with 18 countries using the euro, single country devaluations are no longer possible. All European countries are dragged into the fiscal mess of the irresponsible whether they like it or not.
The fiscal problems of Greece and Portugal, perhaps even Spain, are fixable. The
markets fear, however, that this problem will spread to more countries and become unmanageable. This is referred to as “financial contagion,” the fiscal equivalent of an epidemic. It could even threaten the viability of the euro, and possibly freeze the credit markets in a manner reminiscent of the time of the demise of Lehman Brothers. This is a worst case scenario, of course, but almost anything seems feasible after 2008.
More likely, the European Union will solve this crisis but the budget cuts and tax
increases required will slow economic growth in Europe for a while. Slow growth in the EU would reduce the demand for U.S. goods and services. But how important is Europe for U.S. exports? Not very much. Trade with Europe accounts for less than 1% of total U.S. GDP. The top four destinations for U.S. exports are Canada, Mexico, China and Japan, not Europe. Exports to the entire European Union account for just 20% of total U.S. exports. Asia’s emerging markets are far more important to the U.S. than Europe.
While the European fiscal crisis is making the headlines, investors are overlooking continuing good news of the U.S. economic recovery. Last week, the Commerce Department reported that retail sales here rose 0.4% in April, building on a robust 2.1% in March. Year-over-year, U.S. retail sales are higher by 8%. And the most forward looking measure of manufacturing, the ISM index rose to 60.4 in April. Any figure above 50 denotes economic expansion. Also, as reported by Bloomberg, the number of jobs advertised on the Internet last week jumped to the highest level since November 2008. All four regions of the U.S. and all 22 industry categories registered gains in job listings.
The unwinding of the worldwide credit bubble raises concerns among many investors. Yet, such uncertainty should be seen as a positive, not a negative. Ambiguity and fear causes assets to sell below their fair market value. We want to be buying when situations like the European financial mess are making headlines, creating bargains. When confidence and certainty return, as always happens, asset prices will be much higher. Short-term anomalies like this are a temporary condition.
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