This commentary originally appeared on Real Money Pro on Dec. 12 at 8:18 a.m. EST.In last Monday's column, I proposed the possibility of an uber rosy scenario -- a set of potentially more positive developments in U.S. politics, in the trajectory of domestic economic growth and in Europe's attempt to contain the debt crisis that could have a salutary impact on business, consumer and investor confidence. I opined that these factors could conspire to create a surprisingly good backdrop for the U.S. stock market in the period ahead. Today we will consider the shorter-term challenges and headwinds to that uber rosy scenario. Some have already emerged; others might emerge in the months ahead and disappoint markets. By means of background, what we do know for sure is that there are continued risks associated with the impact of the current balance-sheet retrenchment and the challenges of numerous secular and structural headwinds could weigh like an albatross around the neck of economic growth. The end result is that the world's economic recovery remains imperfect and likely experiences only moderate growth relative to previous recoveries. There is little margin of safety concurrent with continued threat and a higher probability of tail risk. Offsetting the above is that most now understand and have acknowledged these risks. As a result, stocks are reasonably priced -- particularly as measured against any valuation model that incorporates the current low level of interest rates and contained inflation and inflationary expectations. As I have written, there are four conditions that I thought would make or break the U.S. stock market:
- the market's volatility would need to subside;
- the sharp division in Washington, D.C., must turn to compromise;
- forceful policy in the eurozone was necessary to stem the debt crisis; and
- we wanted to see a stability/improvement in the hard domestic economic data, which would negate the possibility of an economic downturn or double-dip.
Heightened VolatilityThe binary outcomes of a stock market without memory from day to day have continued, as reflected in the daily fluctuations of risk-on/risk-off. As a result, retail investor outflows (from domestic equity funds) continue uninterrupted, as investor confidence further erodes against a backdrop of limited market visibility in an uncertain and unpredictable world.
The Eurozone's Solution (All Hat, No Cattle?)The European leaders did the minimum amount necessary to stem the debt contagion. We got timid and tame instead of shock and awe. Though the market rejoiced on Friday, the reluctance to mimic the U.S.'s quantitative-easing approach renders the European sovereign debt and bank recapitalization program unresolved and will likely constrain stock market valuations and the prices of other risk assets. The initial plan argues for a deeper recession in 2012-2013 amid the heavy lifting of austerity punctuated (at best) by uncertainty of outcome and (at worst) by the dissolution of the euro. (My friend/buddy/pal John Mauldin does a good job in presenting the situation in this week's "Thoughts from the Frontline: A Player to Be Named Later.") As a result, it is my expectation that, as soon as this week, a hangover will immediately follow the EU's announcement on Friday, with a high probability that sovereign debt yields (in Spain and Italy) begin to climb again. And so will an imminent downgrade of France follow the new but toothless EU fiscal framework that fails to counter the debt crisis with a more aggressive printing strategy. Furthermore, with the economic outlook for the eurozone weakening (posthaste), investors will likely remain skeptical that the proposed enforcement actions against deficit-ramping sovereigns will be effective. The concept of an EU repo man, frankly, is almost comical. The EU will basically ask fiscally crippled sovereigns that fail to meet their new "stress tests" to escrow monies that they don't have or can't afford. Another question is whether a meaningful escrow will even be demanded. The new rules seem squishy to me and without substance or much strength to alleviate a deep-rooted contagion and debt crisis. My guess is that the crisis continues, the initial framework unravels and more aggressive steps are taken, in the fullness of time.
The Political Theatre in Washington, D.C.There was no grand bargain in late November, as our representatives in the Super Committee did the minimum amount necessary to fix our country's fiscal imbalances and budget problems. With the November 2012 elections growing closer, there is now little expectation that timely, pro-growth fiscal policies will be offered to resuscitate our economy and confront the structural headwinds of unemployment, housing oversupply and fiscal imbalances (at the local, state and federal levels). Also on the political front, a surprisingly close match between a cautious and middle-of-the-road Mitt Romney and a more volatile and change-reagent Newt Gingrich could fracture the Republican Party. In its extreme, this could result in a third-party candidacy by Ron Paul, which could divide the Republican vote and give way to a surprisingly large Democratic win in November (in the presidency and in the House of Representatives and Senate). This outcome (or a growing expectation of such an outcome) would adversely impact market valuations.
Threats to the Domestic Economic RecoveryThe one condition that has improved over the last month is the U.S. economy. Jobless claims, purchasing manager and confidence surveys and many other indicators have met or exceeded consensus expectations. We have to recognize and must be guarded to the chance, however, that fourth-quarter 2011 GDP could represent the peak rate of growth -- this is ECRI's Achuthan and ISI Group's baseline expectations -- based on the following considerations:
- fiscal (policy) drag in 2012;
- weakening and worsening European growth;
- moderating prospects for China and other emerging markets (Brazil, India, et al.);
- 2011 personal consumption expenditures have benefited from a reduced savings rate, and any break in consumer confidence caused by any of a number of exogenous shocks (e.g., in a rising price of oil, in a more volatile or downward move in stocks, geopolitical crisis, etc.) could cause a sharp hike in the rate of savings and a sharp drop in retail sales;
- 2011 business capital spending has benefited from a pull forward due to more favorable tax credits, and the capex write-off allowance halves in 2012.