At current levels the market is expecting a lot more than it's going to get.  Investors are breathing a sigh of relief that the U.S. did not fall into a recession following the 2011 mid-year slowdown and that the likelihood of an agreement between the EU and Greece will, at least, avert a Greek default on March 20^th.  While that is true as far as it goes, the U.S. economy is still highly fragile, and the EU agreement is the least bad among a choice of lousy options.

Although the U.S. economy has not fallen back into recession, it is far from out of the woods.  This has easily been the weakest recovery of the post-war period. Since the cyclical trough in 2009 the strongest quarter has witnessed annualized GDP growth of only 3.9%, an anemic number for an economy that one economist recently described as in "a self-sustained cycle of growth".   By comparison, in the last 57 years there have been 51 quarters with growth of 5% or more----sometimes much more----all during economic expansions. 

Moreover, even this weak recovery is facing significant headwinds in 2012 as a result of 1) a slowdown in global economic activity; 2) fiscal tightening; 3) a continued weak housing market; 4) the need for more household deleveraging; 5) high levels of uncertainty among households and business; 6)) an unsustainable decline in the consumer savings rate; and 7) possible financial market turmoil from the European sovereign debt crisis.  We have written in detail on each of these factors in recent comments.  In addition the economy has benefitted from some temporary factors such as the 4^th quarter inventory restocking, the 100% depreciation provision on capital goods that ended on December 31^st and the unusually warm and snowless winter that has distorted seasonal adjustments to economic data and made growth look stronger than is actually the case.

In addition the stock market can no longer count on the ever increasing corporate earnings outlook that has overcome a lot of the other drags from the U.S. and global economic picture.  Only 63% of 4^th quarter earnings results have beaten estimates, the lowest since the 3^rd quarter of 2008.  Only 43% exceeded revenue estimates, the lowest since the first quarter of 2010.  Furthermore, consensus year-over-year earnings estimates for the 1^st quarter of 2012 are now down to zero, and the trend of estimates is falling.      

As for the probable deal to bail out Greece for a second time, all it does is avert a Greek default on March 20^th when 14 billion Euros in bonds become due.  A default would cause widespread havoc and cause Greece to leave the EU, leading to deep depression, unemployment and a wipeout of a substantial portion of the nation's savings along with political social upheaval.  Having said this, the outlines of the prospective agreement is no panacea.  While it would prevent imminent default, the required austerity measures would depress the economy, raise unemployment and probably increase the deficit as a result of declining tax revenues.  Depression and deflation would be the likely outcome for years ahead. 

In either case Europe is entering a deep recession, particularly in the so-called periphery countries, but also in the more prosperous northern tier.  Banks are not providing credit, but are selling assets and exacerbating the downturn.  This will impact exports from the rest of the world, including the U.S., China and emerging nations.  Chinese exports and imports are already declining sharply while their housing and commercial real estate markets are slowing.  This will spread to the emerging markets that are mainly producers of commodities.  All in all, it appears that the global economy is slowing and is likely to provide a serious headwind to an already fragile U.S. economy.   

There's a reason the EU settlement with Greece is taking two years to work out-----the necessary fiscal, monetary and economic measures are just too painful for both sides to bear.  And the alternative is a disorderly default that would be even worse.  Today's outline of an agreement among the various Greek political parties to accept some harsh austerity measures has been presented to the EU, which is meeting in Brussels tonight.  EU officials have already indicated that there will be no final approval today, and we think the negotiations may still drag on until close to the March 20^th deadline for repayment of 14.5 Euros of coming due.  Although a settlement by that time is more likely than not, the results will further weaken an already deteriorating European economy, and ensure slow growth for years to come.  With the global economic growth slowing down as well, the fragile U.S. recovery is also in jeopardy.

The Greek governing coalition had an exceedingly difficult time coming to an agreement as they were pulled in a tug of war from two different sides.  On the one hand they realized the necessity of getting the funds they needed to avoid default.  On the other hand they are facing elections within two months and have to ensure that their successors would not renege on the agreement that is certain to enrage the majority of the population that has already undergone major government spending cuts, layoffs, wage decreases and tax hikes.

For its part the EU wants assurances that Greece, which already failed to meet the conditions of its first bailout, will comply with this one.  One high official of the EU said "It's up to the Greek government by concrete actions through legislation and other actions to convince its European partners that the second proposal can be made to work."  Another stated that "We want to see real implementation of the measures needed by the Greek government and also full commitment of all leaders in Greece for further measures."

Even after a final agreement is reached the Greek government may have trouble implementing its provisions.  The nation has already made sharp cuts in government spending, jobs and wages while increasing taxes.  All of this has devastated the economy.  The November unemployment rate was 20.9% and December production dived 11.3% from a year earlier.  Another dose of austerity can make this even worse and actually increase deficits rather than reducing them.  So even with a debt agreement in place, we probably have not seen the end of the problem.

While European markets generally have calmed down lately, we've seen this movie before.  Portuguese bond yields have soared and the economy has weakened significantly.  ECB bond buying has helped to lower yields on Spanish and Italian bonds, and, as a result, both nations have been able to place new debt.  However, the calendar of upcoming financing remains quite heavy, and economic deterioration caused by austerity can cause rates to rise again.  Overall, much of Europe is either in a recession or about to enter one.  In this connection we note that the OECD leading indicator is below a year earlier, a condition that has always led to recession.

At the same time the global economy appears to be weakening.  Chinese electric production in January was down 7.5% year-to-year.  Japan has entered a recession and its trade balance has turned negative.  Deteriorating economies in Europe, China and Japan means lower purchases of commodities, the key to growth for most emerging nations.

The U.S. will not be immune to the downward pressures.  In the weakening global environment, exports will drop.  Consumers have increased spending by reducing their savings rate as wages continue to stagnate.  Since the 2007 economic peak most of the increase in consumer disposable income (DPI) has come from higher transfer payments, while wages, as a percentage of DPI, has dropped off a cliff.  And unlike the period of 2003 to 2007, consumers cannot make up for the shortfall it by converting rising house prices to ready cash.  Corporate earnings, too, are becoming less positive.  Only 59% of companies exceeded their 4^th quarter estimates, the lowest since early 2008.  Last June year-to-year 1^st quarter earnings for 2012 were estimated to be up 12.7%.   Now the estimate is for an increase of only 1.9%. 

All in all, both the U.S. and global economies are likely to encounter rough sledding in 2012, a factor not discounted at current stock market prices.     

"A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets----bonds, stocks, real estate and commodities alike----is now deleveraging because of excessive risk and the price of money at the zero-bound.  We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time." 

This quote from Bill Gross's February comment for Pimco neatly summarizes in one sentence the main theme we have been emphasizing in our own comments for many years.  Periods followed by credit crises are almost always followed by many years of below average growth, anemic expansions and frequent recessions.  The most recent example is the experience of Japan since 1989.  It is now happening in the U.S. and much of the world, and will not end anytime soon.  

In the U.S., total domestic debt is now 341% of GDP, compared to about 150% in 1980.  Gross federal government debt is about 100% of GDP, up from 32% in 1980.  Household debt is 87% of GDP, compared to 49% in 1980. The period of abundance ended with the severe credit crisis of 2008 that was followed by the worst recession since the Great Depression.

Similarly, the recovery has been the weakest since the 1930s.  Real GDP, over the last four quarters, has grown at the meager rate of 1.6%.  Although the recently reported fourth quarter GDP growth of 2.8% was the best of 2011, the underlying data was extremely weak.  The growth was driven largely by inventory accumulation, while final sales were up only 0.8%.  Consumer spending increased by only 1.5%.  Furthermore, nominal GDP growth (before deducting inflation) was only 3.2%, down from 4.4% in the prior quarter as the implicit price deflator was only 0.4%, against 2.6% in the third quarter.  Had the same deflator been applied to the fourth quarter, growth would have been only 0.6%. 

Looking ahead, consumer spending is likely to remain weak as households seek to deleverage and increase their savings.  December real retail sales were down 0.1% as consumers raised their savings rate from 3.5% to 4%.  The savings rate generally averaged between 8% and 9% from the 1950s to the 1980s.  Declining household wealth, mostly a result of dropping home prices, is another factor inhibiting spending.  While initial unemployment claims have dropped, new hiring is still in the doldrums, and wages increases are minimal.  Since capital spending growth generally follows consumer spending by a quarter or two, this segment is likely to remain tepid as well.  In addition, 2011 capital spending was boosted by a 100% tax credit that expired by year-end, thereby pushing some potential 2012 spending into the prior year.

Inventory accumulation will probably decline after the fourth quarter rise.  Exports should be under pressure as a result of weakness in Europe and declining global growth.  Fiscal stimulus will be less this year than last, while government spending is dropping at federal, state and local levels.  Furthermore, last week's FOMC meeting and Bernanke's testimony today indicate to us that the Fed is essentially out of ammunition, while government is likely to remain dysfunctional in a hotly contested election year.  Given all of these factors it is difficult to see where economic growth will come from.

Although the strong point of the economy until now has been corporate earnings, even this area is showing some early signs of faltering.  Only 59% of corporations so far have beat fourth quarter earnings expectations, the lowest since the third quarter of 2008, while only 43% exceeded revenue forecasts, the lowest since the first quarter of 2008. The combined results for those who have reported and the estimates for those yet to report show an increase of 11.5% over a year earlier.  The increase, however, would be only 1% without AIG and Apple.  Furthermore, the number of companies reducing guidance exceeded those raising guidance by about 3%.  In view of our outlook, we think that earnings disappointments will mount throughout the year.

The Fed is worried, and you should be too.  That is the major take-away from yesterday's FOMC statement, combined with its release of updated projections and Bernanke's press conference.  Despite the market's cheering of the promise of a near-zero fed funds rate until late 2014 and the prospect of QE3, the Fed is fighting a lonely battle against severe economic headwinds----and they know it.  In answering a reporter's question, Bernanke made it crystal-clear that he does not believe that the recently optimistic economic releases are sustainable.  He has good reason to think so.

The FOMC reduced its current central tendency 2012 GDP growth projection from 2.5%- 2.9% to 2.2%-2.7% and its 2013 number from 3.0%-3.5% to 2.8%-3.2%.  The previous projections were made in November.  Although they reduced their unemployment projection slightly, they are still projecting unemployment rates as high as 8.2% to 8.5% for 2012 and 7.4% to 8.1% in 2013.

It's significant that these reductions were made despite better than expected economic releases in the last few months in jobs, production and consumption.  Although some may wonder what the Fed knows that others don't, the reasons for their caution are no mystery to anyone familiar with the numbers.  Disposable income is growing very slowly, and even this tepid pace is a largely a result of temporary tax cuts and transfer payments, while real wages are flat.  Consumer spending growth was supported mainly by a reduction in household savings rates from 5% in June to 3.5% in November.  December retail sales have already weakened as holiday sales were disappointing. 

Employment growth is still not enough to raise real wages or reduce unemployment by much.  While initial unemployment claims have declined, new hiring is still disappointing and household wealth has been declining as a result of the continuing slide in home prices. We also point out again that household debt is still far too high and there is a long period of deleveraging ahead, meaning more saving and less spending.

Capital spending growth is likely to slow down as well.  While today's report on durable goods orders for December was fairly strong, few mentioned that the 100% tax credit for capital goods spending expired at year-end.  It is highly likely that potential orders for 2012 were crammed into 2011.  Exports, too, will probably be impacted by the turmoil in Europe and the slowdown in global growth including the emerging nations and China.

All of these headwinds are valid concerns even before considering the risks associated with the EU debt crisis, potential conflict with Iran, the outcome of the Arab Spring and uncertainty in Iraq, Afghanistan and Pakistan.  And let's not forget the continuing paralysis in Congress regarding debt ceilings, deficits, budgets, taxes and efforts to increase jobs in the middle of an election year.

In our view the Fed's new policy is an act of desperation rather than something to celebrate.  The FOMC has used all of its conventional weapons and a lot of unconventional ones and is essentially out of ammunition.  The banking system is swimming in excess reserves that it is not using----adding more won't make much of a difference.  This is a classic liquidity trap where further easing will not be much help.  The stock market strength assumes that the economy is getting stronger and that company earnings will remain at elevated levels.  We think that this will not be the case, and that the market is subject to substantial downside risk.    

Although a number of economic indicators have recently improved, the economy is now entering a period of high risk.  In their now well-known book, "This Time It's Different", Rogoff and Reinhart showed that once a nation's government debt-to-GDP ratio reached and exceeded 90%, the period ahead was marked by credit crises, exceedingly slow growth and frequent recessions.  The latest example, among many, is the experience of Japan in the years following 1989 and continuing until today.  As everybody now knows, after going through last year's debt ceiling debate, the U.S. federal government debt/GDP ratio is now about 100%.  In addition, as we have written about ad infinitum, the ratio of household debt to both disposable income and GDP is far above historical averages.  

Although the book, which came out over two years ago, may have been regarded by some as too theoretical or impractical, so far the economy has essentially followed the slow-growth trajectory anticipated by the two economists. Since the economic trough in 2009, GDP has grown at an average annualized rate of only 2.5%, and at a rate of only 1.5% in the last four reported quarters.  Real personal income less transfer payments are still below the previous peak and industrial production has only come back to the level reached in 2005.  Employment is still at the same level as in early 2000, while real median income has declined in a recovery for the first time in the post-war period. 

In our view, even the mild recovery seen to date is unsustainable.  When we look at the numbers, it is difficult to tell where additional growth will come from.  Although consumer spending, which accounts for 70% of GDP, picked up from June through November, this was accomplished largely by reducing the household savings rate from 5% to 3.5%, the lowest rate since the economy peaked in 2007.  Without even further reductions in this already low rate, there is little in the economic picture to drive spending. Household net worth is down.  Real wages and disposable income less transfer payments are not growing.  Employee hiring is still tepid.  Housing is still in the doldrums with additional home price decreases still likely as a result of the backlog of foreclosures.  Note, too, that December retail sales crept up by a paltry 0.1%, indicating that holiday sales were disappointing despite all the hoopla and exaggerated predictions following "black Friday".    

Government spending is another key area that is likely to be a drag on GDP.  The impartial Congressional Budget Office (CBO) is projecting a 1% decline in federal government spending in 2012 at the same time that states and local governments are also cutting back.

Exports, which have accounted for almost half of the GDP growth since the bottom, are another unpromising area.  Even if the European sovereign debt crisis doesn't blow up, (not a sure thing), Europe is, at best, entering a recession and overall global growth is softening.  This week the IMF lowered its global growth forecast, saying that prospects have turned bleak as contagion from the European Union is spreading to the rest of the world----and this was their base case.  Underlying their base case was a more ominous assessment of what could go wrong in Europe's currently precarious position.  Anecdotal data indicates that China, too, is feeling the adverse effects of the global slowdown.  Although this is barely reflected in the official numbers, most of those who know China well regard their data as suspect. 

U.S.  capital spending is also subject to strong headwinds in 2012.  Spending last year was boosted by the 100% accelerated depreciation allowance for items installed by year-end.  This probably shifted a significant amount of capital spending from 2012 to 2011.  Furthermore, in contrast to some economic theories, the empirical data clearly demonstrates that capital spending lags consumer spending by one or two quarters.  In other words, capital spending is a response to consumer demand, unless influenced by meaningful tax incentives.

Summing up, we see lower consumer spending growth, declining government spending at all levels, less exports and lower capital spending.  That pretty much accounts for the entire GDP.  The upshot will be heavy downward revisions in upcoming corporate earnings estimates and a negative shock for those looking at what they regard as an increasingly strong recovery.  Under this scenario the current market rally does not have far to go and the downside risks are high.