Three elephants in the room responsible for equity markets taking a hit

Outlook

We don’t really know the effect of the Feds rejecting the “living wills” of the 11 biggest banks (four of which are European), but confidence has to be taking a hit. The Fed and FDIC say the winding down (bankruptcy) plans submitted fail to identify the path to an orderly failure and banks have to go back to the drawing board. "Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn't require unrealistic assumptions and direct or indirect public support." The FDIC wanted to use the phrase “not credible” in referring to the plans, according to the WSJ, but the Fed opted for softer lan-guage. Oh, dear. Not to be Miss Grundy, but if the world’s foremost capitalist country can’t regulate the banking system in a sane and reasonable way—as Adam Smith himself said was necessary—it only increases the number of folks hoard-ing gold and Campbells soup in a bunker.

We say “too big to fail,” aka moral hazard. is near the top of the list of worries we should have these days. We have waited patiently since Dodd-Graham was first written in 2010 to see how the US would deal structurally with the crisis. Consistent with the long-standing US policy of letting industries regulate themselves—as opposed to imposing draconian reforms from the top-down (damned intrusive guv’mint), the banks were allowed to establish their own exit strategies. And they botched it. Mr. Peccora and others of the 1930’s reforms would be appalled at giving the banks so much lee-way.

The WSJ identifies three elephants in the room that are being seen at last and are responsible for the equity markets tak-ing a hit. First is acknowledgement that the Fed really is taking away the punch bowl and risky assets will fall out of fa-vor, including emerging markets. The second elephant is the likelihood that China can’t continue to disguise that the transition from “over-leveraged investment-led growth to consumer-led growth” is a tough path and not working out so well, at least so far, as the HSBC PMI shows. Third is geopolitical risk in general and Ukraine in particular.

We say there is a whole herd of elephants. To moral hazard and the Wall Street Journal three, we would add diverging economies—US pretty good but Europe slumping—and the Draghi Mystery. Draghi is a smart guy and has already demonstrated he knows how to herd cats (“whatever it takes”), but can he manage economies, too? Too-low inflation, foundering industries even in Germany, and consumers frightened to the point of paralysis—what can Mr. Draghi do and say? Restoring vitality and confidence is not really the job of a central banker, but there is no other leadership in Europe. Mr. Juncker doesn’t even come close.

Then there is the collapse of Mr. Murdoch’s effort to buy Time-Warner, which would have put an ideologically biased team of extremists in charge of a big swathe of US news and entertainment. The industry itself was appalled and it takes a lot to get a rise out those jaded folks. But the Murdoch deal was only one of many. The FT writes “Tuesday, August 5 2014 is likely to go down as one of the darker days in the history of Wall Street’s mergers and ac-quisitions market. In the space of a few fraught hours, deals worth more than $100bn collapsed, sparking con-cern about the sustainability of a transaction boom that has gathered pace since the start of the year.”

In the context of all these elephants, data looks pretty puny. We get the June US trade deficit today, expected about the same ($44.6 billion) as $44.4 billion in May. The recent decline in energy imports is being offset by imports of consumer goods, so demand is okay. At a guess, nobody is paying much attention to the US trade deficit, least of all the Fed (as long as we are not getting any imported inflation). We get a slew of data from China this week, including factory output and property investment, sales and construction. The Bank of England starts a 2-day meeting on Wednesday and the ECB meets on Thursday, with the ECB facing inflation down to 0.4% and the effect of Russian sanctions.

The big news will be whatever Chancellor Merkel cooks up in talks with Putin. In the US we hear a lot about Secretary of State Kerry (jibber-jabber) and Pres Obama (“leave me out of it”), but the right place to look is Berlin. So far nobody is speaking of a shooting war that includes any member of NATO, but Putin is pushing his luck.

Until at least some of these elephants get corralled, the dollar has a straight shot at ever-better levels, punctuated by the usual pullbacks (as we saw Sunday night). Risk aversion plus a more robust economy is a good recipe for the dollar to rise.