- Political uncertainty this past week contributed to a global market slide that sent many major stock indexes into official correction territory.
- In Europe, German politicians announced a short-sale ban early in the week and approved Germany's contribution to the joint EU-IMF bailout.
- In the US, the Senate passed a financial reform bill—but it has yet to be reconciled with the House's version.
- The recent market slide smacks of a fear-based correction, not the start of something worse.
Political uncertainty spiked this past week on both sides of the Atlantic, contributing to a global market slide that put many major stock indexes into official correction territory.
In Europe, an ill-advised German short sale ban had investors wondering if things were worse than they thought—even as another bailout vote loomed in parliament. Germany is the biggest economy in the eurozone, so its bailout contribution is likewise the biggest. Much of the German public has been strongly against sending aid to their struggling Mediterranean neighbors, making it a very politically sensitive issue for Angela Merkel's ruling coalition—and consistent communication has not been their strong suit of late. Yet for all the worry, what happened? The German parliament approved the €147.6 billion contribution to the €750 billion total aid package for struggling eurozone countries Friday—thus removing a major sticking point and source of investor speculation.
German political overtures seemed to make investors forget why they were worried in the first place: That a eurozone country might default and thus imperil the euro. Yet, amid the worry reflected in falling stock prices and jumpy exchange rates, PIIGS sovereign debt yield —arguably the best indicator of perceived default risk—barely budged all week. That fact alone was a likely sign of fear, not careful consideration of facts. Through it all, the PIIGS auctioned debt. Portugal and Spain sold 10-year bonds at oversubscribed auctions with yields at 4.05% and 4.52% respectively—not all that much higher than US 10-year bond yields just a few months ago. Ireland sold €1.5 billion of bonds, with demand tripling supply. Ironically, now that Germany is officially on board and the bailout is on firmer ground, the PIIGS may not even need to tap into the funds (precisely because the safety net's there). PIIGS debt auctions have been mostly at lower yields than the EU-IMF aid package—and for longer-term debt! As long as it's cheaper for the PIIGS to borrow in the market, then that's just what they'll do. And although the euro has taken a hit lately, it actually ended the week up 1.9% relative to the dollar—the strongest week for the euro since mid-September 2009.
For a change, it wasn't just Europe contributing to uncertainty. Back home, Congress pushed the Senate's version of financial reform (the "Restoring American Financial Stability Act of 2010") to a vote and eventual passage.
The bill calls for creation of multiple agencies and would establish a number of new financial rules—adding to an already muddled regulatory apparatus (there are way more acronymic agencies than we'd care to count). There's plenty aimed directly at the downturn's poster child, "too big to fail." The FSOC (Financial Stability Oversight Council) will keep an eye out for systemic risks and promote "market discipline"—a vague mandate if we've ever heard one. The "Hotel California" clause widens the Fed's jurisdiction to include regulation of "systemically important" non-bank financial firms, bank holding company or not—that means you, Goldman Sachs and Morgan Stanley. The "orderly liquidation panel" (OLP) would wind down giant firms in the case of collapse—yes, to "prevent" another AIG or Lehman Brothers.
All this is squarely predicated on events just passed, replete with misconceptions over the causes and assuming an identical panic will threaten us in the future. Yet little in the bill actually addresses the underlying reasons for the crisis, like inappropriately applied accounting rules (FAS 157). But the bill isn't far off from what one might expect after a major financial crisis. And though the Senate's version has yet to be reconciled with the House's version, some iteration will likely pass and may be a mild negative for the financial industry—as we've said. More importantly in the near term, final passage should give markets something substantial to chew on and discount, instead of fretting what madness could be pending.
The recent market drop stemming from fears about a deteriorating PIIGS situation that has largely stopped deteriorating, a euro slide when the euro isn't sliding, a contagion that isn't spreading, and financial reform with little immediate impact outside the Financials sector—all against a backdrop of continuing and, indeed, accelerating economic recovery—smack of fear-based correction in our view, not the start of something worse.