Tuesday, January 10, 2012

The U.S./Eurozone decoupling continues

With 2-yr swap spreads as a proxy for systemic risk, we see that conditions in the Eurozone have been deteriorating for the past two years, and especially since last July, thanks primarily to the growing risk of sovereign debt defaults in the PIIGS countries. Meanwhile, investors have been terrified that defaults in the Eurozone could lead to another global banking crisis and a global economic collapse. Those fears have depressed equity prices and economies everywhere, even as corporate profits have been very strong. But markets can only worry so long about the end of the world being right around the corner. 

Despite all the fears, the U.S. equity market has diverged significantly from Eurozone equities. The two charts above compare the S&P 500 index to the Euro Stoxx index, and here we see a significant divergence between the two starting in August of 2010. Since that time, U.S. equities have outperformed Eurozone equities by over 30%. This is a major difference between two huge players on the global stage. We've seen divergences of this magnitude before, but as the top chart shows, this is the first time that the Eurozone has underperformed the U.S. Whatever is happening in Europe is increasingly being contained in Europe.

I think this fits with my thesis that Eurozone sovereign debt defaults are not likely to be as destructive to the world as the market has feared. By staging a major divergence, equity markets are slowly coming to that realization. The impact of the Eurozone debt crisis has already hit the Eurozone economy: it doesn't take a default to cause a loss, because the market has already priced in defaults of $1 trillion, and because the money that the PIIGS borrowed was squandered long ago on unproductive activities that sapped the underlying strength of the Eurozone economy. All the losses are water under the bridge. Europe is foolishly trying to postpone the recognition of this reality, when it should instead be wiping the debt slate clean, recapitalizing its banks, and shrinking the size of its bureaucracy. While Europe dithers, the U.S. economy moves slowly ahead.

This is not to say that the U.S. is golden, of course. We have our own debt binge to worry about, with the federal government having borrowed $5 trillion in the past three years. That's an awful waste of money, but our debt/GDP ratio is still within the range of being payable, and we don't have the problem that Greece has of owing money in a currency we can't control. I believe the U.S. economy would be a lot stronger today if we had spent and borrowed less, because like the Greeks, much of what we have borrowed was spent on unproductive activities (e.g., transfer payments). At the same time, our federal debt was not concentrated in our banks, the way it was in the Eurozone.

Meanwhile, believe it or not, federal spending as a % of GDP has declined meaningfully in the past three years, thanks to a dramatic decline in the growth of spending. Amidst all the bad news there are some tidbits of good news to be found in the U.S.


brodero said...

Unfortunately I think you need to
see the 2 year euro swap spread
declining to see a sustained global
equity rally....

Benjamin Cole said...

Boy, look at the Clinton and R-Party Congress years of the 1990s.

Those were the days. federal spending as percent of GDP plummets. Then booms under Bush jr and Obama.

Maybe the next Obama Administration will be a replay of the Clinton years. I hope so.

brodero said...

Why is it no one or very few quote
debt service to GDP?? Debt to Assets...Debt service to GDP

Squire said...

For Obama to have a Debt:GDP replay of Clinton and the Republican Congress, Obama would need not only a Republican congress but a bubble, like the dot com false economy of the late 90s.

Benjamin Cole said...

point taken, but federal spending was clamped down in those days, with welfare reform and defense speeding growth slowed. There was some revenue from capital gains, but mostly it was payroll and income taxes....

We can do it again. A general economic boom, and a return of defense spending to levels pre 9/11 would do a lot of it....holding the line somehow on Medicare outlays would help too. ..

Little noted in Paul Ryan's proposed budget was a shrinking of federal agency outlays, including defense, to under 3 percent of GDP in coming decades. And then you have Ron Paul.

So there may be receptivity in the GOP to cutting defense outlays back to 2 percent of GDP, as compared to 6-7 percent now.

There is a powerful defense lobby, aligned with Congressmen and Senators who sit on Defense appropriations and authorization committees, and who have defense spending in their districts. About six million Americans have jobs tied to defense outlays, and they all vote. A very, very tough nut to crack. Once on the federal money hose, it is hard to pry someone off.

But it can be done.

Squire said...

The problem I have with cutting defense spending is the same one why I don't want taxes raised. The money will still be spent and will be spent on consumption. After all the life style spending is finally and completely under control, then raise taxes to pay down the national debt, and, lay-off defense people and put them on unemployment and welfare. Hopefully, jobs will be growing by then.

Squire said...

On a calendar year basis, using debt as a proxy for spending, it appears spending is way down.
This is the increase in total Federal debt by calendar year from the Treasury’s debt to the penny.
2011 1,197,724,826,742.50
2010 1,713,865,541,196.50
2009 1,611,544,812,899.90
2008 1,470,632,205,393.79
2007 548,948,279,132.13

Benjamin Cole said...


I would rather people exiting the economically parasitic defense sector move into productive, private-sector work. I think they can, and should.

BTW, they say Obama is a socialist anti-capitalist, who plays the class card. Sometimes I agree.

But here is Rick Perry today, who makes Obama look like a capitalist tool.

By Michael Finnegan
January 10, 2012, 11:28 a.m.
Reporting from Fort Mill, S.C. -- —

Rick Perry, the lone Republican campaigning for president today in South Carolina, likened Mitt Romney to a greedy Wall Street “vulture” who was indifferent to the plight of workers who lost their jobs in deals that enriched his investment firm.

Squire said...

Excess military is welfare and should be trimmed. Public sector employees are parasitic and should have their pay and numbers reduced most especially the first responders. Lawyers living off social engineering and IRS accountants should get real jobs. Let us get rid of all the parasites. Government created such high costs in education and health care that those people have become privileged parasites. And most of all, the Medicare and social security recipients are gigantic ticks and mosquitoes sucking the blood of the youth should be squished and swatted.

Bill said...


Shouldn't I get anything back for the medicare and social security taxes I've been paying for the past 25 years?

Benjamin Cole said...

I like your sound, Squire!

Donny Baseball said...

You should get all your soc sec and medicare back plus reasonable interest...but no more than that. Therein lies the problem. If you are typical, statistically speaking, you are likely to take out alot more than you put in before you leave us. Regarding medicare, you contributed Ma Bell/copper wire dollars and will extract iPod/wireless data healthcare services.

William said...

brodero said...
"Why is it no one or very few quote
debt service to GDP??"

Nominal "debt" is about $14 Trillion now and GDP is approaching that number. Therefore debt is about 100% of GDP.

But if all the unfunded contingent debt of Social Security, Medicare, Medicaid, veterans benefits, federal and military retirement benefits are included as debt, I believe that number approaches $80 Trillion - more than 5.5 times GDP.

John said...

Debt to GDP ratio dove during the Clinton years because, in part, the Democrats passed a modest tax increase. Remember that? Back in 93? We could easily do the same thing with similar results - if Republicans weren't so afraid of Grover.

Bob said...

Clinton's administration achieved a budget surplus, but at the expense of economic growth. Bush Jr. inherited a GDP of less than 1%.

Nominal taxes of somewhere around 15% that includes all but the most destitute Americans should raise more than enough capital to run this country.

We should be focusing on how much we need to run the country rather than trying to figure ways to pay for all the excesses.


brodero said...

William....If debt is a balance sheet issue then what are the assets??? John Rutlegde sighted
that at the end of 2008,,the United
States had 188 trillion in assets..