Opinion

James Saft

Europe, not election, the driver: James Saft

November 7, 2012

Nov 7 (Reuters) – Obsess exclusively over the fiscal and
monetary impact of the U.S. election at your peril: the real
news may be coming out of the euro zone.

An election producing a split Congress and a second Barack
Obama term was greeted on Wednesday with a sharp divergence in
financial markets, with stocks falling and Treasuries and the
dollar rallying sharply.

Since most of us in the U.S. have spent nearly every waking
hour in recent weeks being bombarded by news, advertisements,
images, lies, statistics and still more lies it is no wonder
that most analysis of the market is attributing the moves to the
election’s implications.

The news out of Europe, where European Central Bank chief
Mario Draghi was decidedly downbeat and where a key Greek vote
over an austerity plan may not pass, could prove the true
drivers.

To be fair, the election-market links are there. A split
U.S. Congress seems unlikely to reach a growth-friendly grand
bargain on fiscal policy, making it more likely that whatever
half-measures are agreed in the looming lame duck session only
serve to highlight the real economic drag of the spending cuts
and tax rises to come. There is a possibility that a
Republican-controlled House plays hardball, potentially making
the process disorderly as well as dysfunctional.

The election also does much to ensure a measure of
continuity in monetary policy, with Obama likely to appoint
someone in Ben Bernanke’s image if, as expected, he steps down
early in 2014. That argues for a continued appetite for
Treasuries by the Federal Reserve.

But except for some Senate gains, the results are pretty
much exactly what betting markets and many prognosticators were
predicting, so ascribing all of the moves to the election
doesn’t seem likely. The prospect of higher taxes on capital
gains and dividends should come as no surprise.

The strengthening of the dollar is also hard to fit into
this line of thought. Continued quantitative easing and
recession-inducing fiscal policy is hardly the stuff of which a
stronger dollar is made.

In fact the dollar, and much of the rest of trading in
financial markets, was probably driven by renewed fears over the
situation in the euro zone. From a European perspective, the
euro needs to weaken, both as one of the few indirect means of
easing conditions for the ailing south, and, frankly, as a balm
to a Germany whose economy seems to be flagging sharply.

ENTER THE DRAGHI

A weaker euro would help both issues, and obviously would be
bad for profits and sales in the U.S., making it a strong
negative for U.S. shares. Fixed income investors are also, as
they usually do, likely seeking safety in Treasuries, which will
have performed very well in euro terms just recently, and which
also don’t carry anywhere near the type of systemic risk
associated with euro zone government bonds.

Into this situation the day after the election stepped
Draghi, who was decidedly downbeat, almost like a man trying to
tell you he was going to have to do something to help his
economy.

“The weak overall economic situation, combined with slow
money growth, means that the risks of inflation are currently
very low over the medium term,” Draghi said in a speech at a
conference in Frankfurt. “Germany has so far been largely
insulated from some of the difficulties elsewhere in the euro
area. The latest data suggest that these developments are now
starting to affect the German economy.”

The ECB is not expected to lower rates when it meets on
Thursday, but it would not at all be surprising if more
euro-negative comments come out of Draghi’s press conference.

The risks are not all at the ECB. Greece is, amid street
protests, in the process of holding a parliamentary debate ahead
of a key vote on austerity measures, without which the next
tranche of bailout money may not arrive, leaving the country in
the embarrassing position of not being able to pay its bills.

Even if the bill, as expected, passes, this is just a
foretaste of future votes and future opportunities for Greece to
jeopardize its position within the single currency area.

To paraphrase former U.S. Treasury Secretary John Connelly,
the euro is their currency but a shared global problem. If the
euro zone is going to hang together as currently constituted,
which Draghi seems to have underwritten with his bond buying
plan, then we are looking at waves of deflation and recession
for at least the coming year. If it does not hold, then we’ll
get one big wave, and a far more destructive one.

That argues for bonds and the dollar to rally and stocks to
fall, which is exactly what is happening, and what may continue
as the year heads to a close.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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