A Whipsaw Summer Gets Put On Ice

With the stock market in position to post its biggest one-month gain since 1974, you might think political leaders in America and Europe had finally found the answers that eluded them this summer as they struggled with fast-growing mountains of government debt.

The truth is less dramatic. Yes, there has been progress, and the mood in financial markets is vastly better than it was just four weeks ago, when I wrote that the market plunge was an overreaction to government problems that have little to do with corporate profits. But last week’s monster recovery (which I promise will be the only Halloween reference in this commentary) was not a sign that the developed world’s fiscal problems are resolved, or even that a clear path toward resolution has been found.

The rally, after all, only brought the S&P 500 index back to where it was around the beginning of August, when President Obama and congressional leaders compromised on raising the U.S. government’s borrowing limit to stave off a threatened, though improbable, default. Most of the tough decisions were postponed at that time, and everyone knew that the agreement would probably lead at least one rating agency to cut Washington’s AAA credit rating. Yet when Standard & Poor’s cut its rating a few days after the deal was reached, the financial markets responded with horror. (That’s just a noun, not a Halloween pun.)

If we take an even bigger-picture look, the U.S. market is barely above the level at which it started the year, having erased a hefty rally in the spring and a big dip in late summer. Many world markets are still down for the year, though they are well above their lows. 10 months through 2011, corporate stock values overall are about where they began.

Once the U.S. debt ceiling faded from the news, Europe’s debt crisis took centre stage. Last week, at their 14th summit in 21 months, the continent’s leaders agreed to relieve Greece of a sizable chunk of its debts and to force European banks to raise large amounts of new capital. These are essential steps toward resolving the issues that threaten to break up the euro currency zone. The markets reacted to the agreement as if it were a deus ex machina, a device that was employed in ancient Greek theatre to resolve plot twists that were otherwise impossible to untangle, usually by divine intervention.

But last week’s agreement was only part of a process that has taken about two years so far and still has a long way to go. Back in July, these same European leaders first conceded that Greece will not be able to pay its debts, and that banks which hold around $140 billion of that debt will have to take a loss that was then estimated at 21 per cent. Financial markets never believed that this would be sufficient to resolve Greece’s problems. The latest agreement calls for banks to take a 50 per cent write-down and to raise large amounts of new capital with which to absorb the blow. Though details are still sparse, governments apparently stand ready to help the banks raise that capital if needed, while the European Central Bank continues to make oceans of liquid funds available to the banks so they can continue their day-to-day operations.

From the market reaction, you might think this outcome was a surprise. It was not. It has been clear for some time that governments are not willing to let any major financial institution fail the way Lehman Brothers did in 2008. Last week’s deal illustrated that even a previously unspeakable failure by a eurozone government to pay its debts will be managed in a way that will prevent a meltdown of the financial system. Taxpayers will, unhappily, be on the hook, so politicians must make a prolonged show of inflicting pain on banks and defaulting borrowers, but the end result is going to be that unpayable debts will be written off, and the losses will be widely shared.

This has been the year of the market whipsaw. Stock indexes plunged in the first quarter, especially after Japan’s earthquake, then rose sharply in the second quarter before dipping again. The third quarter was one of the worst in decades – and then October was the best month in a generation.

All these gyrations mean nothing, other than to remind us once again that trying to time short-term market movements is a losing proposition. Our basic problem is a financial system that became terribly overleveraged over a long period of time. It is going to take a lot of time to resolve that problem.

In the United States we are making progress on the private side of the ledger, with strong corporate balance sheets and consumers who are steadily paying down debt. Government is lagging, but the political winds have shifted and public debt and spending are also on the way to being pared. The process is painful and long, but healthy in the long run.

With some exceptions, notably in England and Ireland, Europe has lagged in the de-leveraging process, but it is starting to catch up. Greece’s effective default is part of the recovery process. Continuing pressure on Portugal, Spain and Italy should likewise bear fruit over time. We have to be prepared for setbacks and frightening moments (still not a pun) along the way, but the outlines of an eventual resolution are fairly clear.

sceptics point out that last week’s agreement does not address the eurozone’s structural problem of requiring countries with weak government finances, like Greece, to share a currency with those that have healthy treasuries, like Germany. The Greeks ended up with an overvalued currency and unpayable debts, and the Germans have an undervalued currency that helps their exports but requires them to bail out their neighbours. The only plausible solutions are tighter integration or the opposite – allowing countries like Greece to exit the euro.

This is true, but in the long run it does not matter much. Either countries like Greece will get their finances in order, or they will leave the common currency that they arguably should never have joined in the first place. There will be a big cost, but we can chalk it up to experience. It is not the end of the financial world as we know it.

The whipsaw summer is over. Snow is already flying (improbably) over Wall Street, ghosts and goblins are traipsing through our neighborhoods (OK, now I broke my promise), and maybe the markets will take a deep breath and calm down. We can all use a little rest.

Happy Halloween, everyone.

 

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