The Third Depression, Downgrades and More Spending

* The Third Depression – it takes a while for mainstream economists to embrace the “between a rock and a hard place” reality which I have been flying around on my broomstick about, for the better part of the last 2 years. In yesterday’s NYTs, Paul Krugman penned an article entitled “The Third Depression”, which takes a shot at the austerity measures which are being advocated by EU governments and the tea party/Republican coalition in the US. A reader previously made the comment that Krugman never met a spending plan he did not like, and this article is consistent with that viewpoint. Krugman argues that the economic contraction which will occur on the heels of austerity plans, will reinforce the concerns which a falling bond markets implies. Of course these concerns have more to do with the fact that there is no way government’s overseeing a depression will generate enough income to assuage bond investors. Instead, these governments will have to hope that investors determine that sovereign debt is better than a whole host of other investments, which will be suffering on a grand scale.


I disagree with Krugman on one specific point: Krugman argues for more spending, while I insist that whatever spending which occurs, needs to support activities which have an economic multiplier effect. Giving the states money to keep teachers hired, who need to be fired in the first place, does not have much of a multiplier effect. Spending money to subsidize the creation of new factories, which will create jobs, and do not need to be subsidized until eternity, makes much more sense. One of the complaints about such spending programs is that they take a long time to plan and implement. To that comment, I suggest that we had better get going now, because when the economy is on its back in a year, it would be nice to see some of these construction projects underway, with the eventual prize being hundreds or thousands of jobs per factory. 


A news headline today has Caterpillar Corporation (CAT) making plans to expand a factory to produce excavators (very large construction equipment) in China, to meet the demand they see occurring in China. Why doesn’t CAT build the factory in the US? From a business standpoint, it probably costs less to establish a factory in China, as well as lower operating costs due to lower labor costs, and none of the concerns about pension and health care costs. In addition, once the excavators are built, if they are already in China, then there is a layer of transportation costs which are saved. Just like Japan’s plan to build cars in the US in the 1980s and 1990s, establishing businesses in China is one way to insure a company’s relevance as the world’s economic energy mobilizes to China. It makes sense. This is where the world’s foreign currency reserves are going, and as I argued yesterday, China has acquired the US’s mojo. So it makes sense that China is becoming the center for US company’s expansion plans. It does not help the current situation at home in the US, but it does touch on a major reason why our domestic economy is struggling, and why China cannot contain its growth.


* Where is the ECB? – since the EU’s broad trillion dollar rescue plan, announced in late May, massive purchases of short term sovereign debt of Greece, Spain and Portugal pushed yields significantly lower. Since then, it seems as if the ECB has stopped buying these assets. The first graph on the attachment shows that Greek 2 year bond yields have since risen by 3% from 7% to 10%, following the ECB’s support program which was launched in late May. This is especially notable, because this is the maturity sector which the ECB’s buying had been focused on. Has the ECB run out of money, or have they just stopped doing something they wished they never had to do? The bulk of the ECB’s 500 billion euros was supposed to be raised through the issuance of debt which is to be guaranteed by each of the EU’s members. I believe that the individual countries have passed legislation backing those guarantees, but to my knowledge, the EU has not funded this facility yet. So I wonder if there is some hesitation on the part of the EU or ECB. I mean, it is one thing to purchase 30 billion Euros of debt, but do they really intend on spending hundreds of billions of euros? So, where the rubber meets the road, the EU and ECB seems to have put on the breaks.


A look at 10 year Greek debt yields, see the next graph, which was beyond the scope of the ECB’s purchases a few weeks ago, shows that yields have retraced a greater percentage of their rate drop, following the ECB’s purchases in the short end in late May. This is the most telling of the two charts, and highlights the lack of market’s confidence in the current EU plan. In contrast, German 10 year yields have attracted investment flows, as the current crisis has pushed these yields lower, while Greek yields have risen. This is displayed on the next graph.


One news item over the last few weeks was the downgrading of Greek debt by Moodys to double B, consistent with an earlier S&P move. This forces Greek bonds out of some of the investment grade rated indices, which should have forced some selling, and the lower Moody’s rating has caused in increase in the haircut investors must take when borrowing against Greek debt. While there are reasons why Greek debt yields should have risen, the ECB was in a position to hold the line on the level of Greek debt, and they did NOT. That is one of my points, and concerns.


In contrast to the situation in Greece, where yields are at junk levels, Spanish government bonds yields resemble that of an investment grade rated corporate bond, with yields at 3% (2yr maturity), and 4.5% (10 year maturity). Nonetheless, as the next two graphs show, Spanish debt yields are as high, or higher, than yields were when the ECB began their intervention in late May.


And here is my take-away: Despite the EU’s pronouncements about supporting Greek and other sovereign debt markets, they are not walking the walk. The markets are speaking, and at some point in the future, debt yields will go even higher. Then the ECB will forced back into action. And consistent with previous EU policy responses, they will once again be behind the curve. This is not good at all for risk assets and related markets. 


* Tesla CEO slams CNBC’s Cramer: Tesla, the electric car company went public today, and in a CNBC interview, the CNBC reporter mentioned to theElon Musk, the CEO of Tesla, that Jim Cramer did not like Tesla’s prospects. To that the Musk reminded the interviewer that Cramer recommended Bear Stearns right before that stock went down. Touche!


* Stocks – are poised on top of the 1040 support level this morning. If we take this level out, perhaps as soon as later today or tomorrow, watch out below. I included 2 charts which depict the current state of affairs in the stock market. I had debated whether I should cover my shorts and instead go short via put options and voted against that. At the money options cost about 30 points for the next 2 and a half weeks, and that seems a bit pricey. In addition, I am usually suspicious of markets when they test a level for the third time, which is what is occurring today. Stay tuned.