Market Memo: 'The Pond' shrinks

As of 06-29-2012

It is common among Americans and Europeans to refer to the ocean that separates them as “The Pond,” a reference to our common cultural heritage yet significant political and structural differences. The United States was built on risk-taking, meritocracy, and at times, unbridled capitalism, while Europe pursued a more socialized economic structure that limited differences in outcomes but often resulted in lower growth and advancement. Yesterday, in less than 24 hours, the pond between us shrank. We became more like Europe, and Europe became more like us. The implications for equity markets are mixed, but we think, overall positive.

Socialized medicine, here we come!
On Thursday morning, we got the surprising news that ObamaCare is constitutional after all—because the “individual mandate” is not an unconstitutional mandate, but a constitutional tax! This decision was certainly a setback for a private sector that has been “on a roll” in its campaign to turn back the tide of growth-depressing government involvement in the economy.

Roberts sends a message

We’re not going to deny that we were surprised that the Supreme Court upheld the individual mandate and almost all of ObamaCare. But stepping back for a moment, it’s worth noting the brilliant lesson sent by Chief Justice John Roberts. According to various accounts, the head of the nation’s highest court went out of his way to uphold the law, and avoid the charge of the Court being seen as activist or partisan. In this, Roberts’ rose above the partisan bickering of both sides and did his part to maintain the Court’s lofty role in our nation’s history.

It’s a lesson that we all may take to heart at a time of seeming little middle ground. Indeed, it was about this time last summer that the markets were abuzz by talk of a grand compromise, a $4+ trillion package primarily of entitlement reforms and some tax increases to address future deficits and fiscal cliffs. It collapsed in the partisan rancor in the final days of the debt-ceiling debate, as neither side seemed to have the gravitas to put aside political interests for the potential betterment of the country.

To be clear, Roberts didn’t abandon his conservative roots—if anything, he strengthened them with his actions yesterday. As noted above, he acted to get the court out of the way of government, not involved in it. Perhaps more noteworthy, he sided with the majority in finding the individual mandate in violation of the Commerce Clause, an act that keeps the door open to blocking Congress and/or the White House from trying to become more involved in our lives.

The coming months will determine if Congress and the White House may share this higher calling for common ground. We’d be shocked, in this election year, if either does. But Chief Justice Roberts reminds us of what our country can do when we work for a common purpose and hold true to the institutions for which we are called to serve.

After 10 years of government expansion, which has accelerated sharply over the last three, it had begun to seem to many that America’s vaunted capitalist economy might be staging a renaissance of sorts. A slew of Republican governors elected in the 2010 elections had begun to scale back state-level spending and powerful government sector state unions, freeing the private sector to grow faster. And the payroll numbers of late have highlighted this trend, with government worker payrolls down by 161,000 over the last 12 months and private payrolls up by nearly 2 million. Then, just at the beginning of this month, we had the surprising election outcome in Wisconsin, a traditionally big government/big union-leaning state, giving Republican Gov. Scott Walker the green light to continue his campaign to scale back government union pensions and bargaining power. That same day, two municipal governments in left-leaning California did the same thing.

So it seems to us that the mood of the country is moving back towards the private sector, and away from big government. Had the Supreme Court then knocked down ObamaCare, we were ready to declare “the high-water mark of the government,” which we believe would be bullish for stocks. We got the opposite, and stocks sold off sharply yesterday morning.

Europe to the rescue!
Ironically, even as President Obama labors to make America more like Europe, with a broader safety net, more middle class entitlements, and less reward for hard work and initiative by “taxing the rich” and the many small business entrepreneurs who drive growth, the European model built on these premises is coming apart at the seams. In fact, the Europeans, led by the Germans, have realized this and are trying to become more like us. Yesterday evening, we got word that this process is accelerating.

The Europeans seem to have figured out that to survive as a single-currency system, they need not just a monetary union, but a fiscal union, a banking union and a financing union (a “Eurobond”) while at the same time, they need to downsize governments and free up labor laws to make their economy more flexible and growth-oriented. Although the Europeans currently can’t fully agree on the sequencing of these goals (the Germans want fiscal union first, the Italians and Spanish want financing union first, and virtually all agree they need labor market reform), we count as progress that they now pretty much agree on where they’re heading. And last night we got a clear indication that plans are underway to bring them that much closer to a banking and fiscal union, at least. This is progress, and the markets responded positively today to this development.

The path ahead
We expect the path ahead to be rocky and volatile, as the outcome of political developments on both sides of the pond remains uncertain in the near term. In the U.S., the presidential and congressional elections are still ahead of us, and those elections increasingly are looking like a national referendum on big government versus the private sector. In Europe, last night’s salve notwithstanding, lots more heavy lifting will be necessary to bring about a true fiscal, banking and financing union within Europe’s monetary union.

However, as the summer progresses into fall, it is certain that these uncertainties will be increasingly resolved on both sides of the pond. This alone will be progress for markets that hate uncertainty and are currently priced—at 12 times forward earnings against a Treasury yield below WWII levels—for a very bad outcome. And heaven help the bears if, perchance, the uncertainties get resolved with both sides of the pond moving increasingly towards a private sector solution to their current malaise. The latter would be very positive for longer-term economic and earnings growth expectations, and could carry equity markets to new highs.