Appetite for risk returned with a vengeance. A nearly 4% rise in the S&P 500 left it on track for its best month since 1987. Vague on details, the European proposal to quell its sovereign debt crisis was cheered by investors. Meanwhile the US economy continues to churn out signs of moderate growth, which is enough to please markets which seemed convinced of a double dip recession just weeks ago.
- Monday – Caterpillar, a good indicator of economic activity, announced double digit profit growth and raised their outlook for next year.
- Tuesday – Consumer confidence for October drops to the lowest level since March, 2009, the bottom of the last bear market.
- Tuesday – Netflix drops over 30% on worse than expected subscriber losses.
- Wednesday – September orders US Durable Goods ex Airplanes rose 1.7%, above expectations.
- Wednesday – A rumor circulated that China may help with the European stability fund. It is yet to be determined if they will play a meaningful role.
- Thursday – US preliminary Q2 GDP shows a 2.5% gain, ahead of most expectations.
- Thursday – European leaders announce a plan to contain their debt crisis. It involves forcing a 50% write down on existing Greek debt holders and a reference to leveraging the 400 billion Euro stability fund.
As we have said for some time, a viable solution for Greece, involving significant losses for bond holders, was needed and would be welcomed by markets. It became a reality with the powers that be settling on a 50% haircut. This should be sufficient to give Greece at least a few years to get their budget under control. Until then, they will rely on lifelines from the likes of the ECB, EFSF and IMF. It may be unpleasant for the Greek population to learn to live without unlimited borrowed money, but the solution is critical for global markets because it puts some visibility on actual losses and will keep Greece in the Euro for the foreseeable future.
The rest of the agreement was extremely light on specifics, other than clarifying that the EFSF fund will be leveraged – perhaps as much as 4x to 5x. Markets seemed to like this, but if things do go bad for Italy or Spain, it will mean a complete loss of the EFSF funds (mostly German) and would leave Europe without any truly strong players—a scary thought. We can’t judge the specifics of the leverage plan because they have not been released. We can’t help but note the irony of fixing a borrowing problem with more borrowing.
Perhaps the most important part of the Europe announcement was ancillary pledges (again not terribly specific) by Italy to cut costs and reduce budget deficits. If this proves successful, it will be hugely bullish but it’s hard to be terribly optimistic given the political realities in Italy.
In the end, the key thing to remember is this is a solvency crisis, not a liquidity crisis. The recent moves buy time, but if governments aren’t able to get budgets in line with revenues Europe will self-implode. To use Mr. Buffet’s analogy, the tide (in this case in the Aegean/Mediterranean) has gone out and everyone knows who is not wearing their swimsuit. Hopefully the whole of Europe (and to be fair the US and Japan as well) will make changes. This week’s summit was an encouraging sign that they will try.
Meanwhile, at home, durable goods orders exceeded expectations, and preliminary GDP growth for Q2 came in at a very respectable 2.5%. We are not surprised, but it is nice to see it.