Global Economics Update

The European Sovereign Crisis continues to hang over financial markets, driving day-to-day volatility in stocks. One day, bad news comes out of Europe and the market falls 3%. Then on days like today, perceived goods news comes out and markets rise 3%. This sort of volatility will continue until a more permanent solution is implemented.

Today's actions by the FED and ECB are a good first step towards long-term solvency of the EU (See link: http://www.marketwatch.com/story/global-central-banks-move-to-bolster-liquidity-2011-11-30?link=MW_popular). However, further monetary intervention will be required by the ECB, who has been very resistant to the idea. U.S. banks are drastically reducing their exposure to European banks, causing interbank lending to fall and short-term rates to rise. The ECB (read Germany) must be willing to do more than buy sovereign bonds, and will eventually need to provide more liquidity.

Today's rally of nearly 4.5% is clearly based on the hope that the ECB will become more proactive. However, I believe the situation will deteriorate further before the ECB takes substantial action. A permanent fiscal plan in each of the PIGS countries is likely far from becoming reality and will be exacerbated by a slowing European economy. At some point the ECB will need to ease monetary policy, provide greater liquidity, and buy more sovereign bonds. The other option is a painful unwinding of the EU.

While the European crisis may sound frightening, and it is, the United States economy is growing at a moderate pace. The fundamental economics of the United States remains far more consistent and strong than market volatility implies. Recent economic data has been relatively strong, although certainly not great, but is largely overshadowed by the global macro issues. Lets take a look at some key data.

Employment
Although still bleak, the national employment picture is improving, especially in the private sector. The private sector added 206,000 and 130,000 jobs in November and October respectively. Local, state, and federal job cuts will likely continue, especially as the Iraq and Afghanistan wars draw down, but the private sector has seen positive job growth for several straight months now.
Consumer Spending
The consumer is beginning to spend again; retail sales were up 7.3% YOY in October and earlier indicators point towards a strong holiday sales season. The American consumer is in a better position to release pent up demand, because they are substantially deleveraged. Consumer confidence readings are also improving substantially. I believe consumers will continue to spend at a slightly faster pace through 2012, especially if job growth continues.

Housing Market
The U.S. housing market remains very weak, although existing home sales have seen a bump recently and the overall supply has decreased to 8 months. The major concern is that prices continue to fall, which is driven by many factors, but I believe the main reason is that overall economic uncertainty is keeping would be home buyers on the sideline.

Perhaps more damaging to the overall economy, is that an estimated 10.7 million households are underwater on their mortgages. Vast numbers of underwater mortgages mean foreclosures will likely remain high through 2012. New household formations are also very concerning; many new graduates are moving home and younger adults that formerly would buy a house or live alone are moving in with others. Fewer households means less spending on consumer durables.
What to Do
American economic growth will improve, but remain sluggish for the foreseeable future. I believe central banks will inevitable take the necessary steps to shore up the European sovereign debt crisis. However, political issues at home and in the Euro Union will likely ensure the crisis drags on for several months to come. I recommend investors maintain  a defensive portfolio with increased exposure to the American consumer, including overweight on consumer discretionary, health care, Tech, and Utilities. High dividend, multi-nationals are selling at multiples that historically have brought good returns.

I wrote in August that Mega-cap growth companies looked very attractive relative to value and small-caps. This theme has played out, especially in small-caps which fell substantially. I maintain this stance given the great uncertainty in global economics.