In National Lampoon's European Vacation, Clark Griswold has tremendous difficulty negotiating a traffic circle in London, so much so that he gets stuck in one for hours.  Ultimately, movie watchers see an exasperated and temporarily insane Griswold exclaim repeatedly, "I can't get left!"

We are reminded of Griswold's driving difficulties today as we ponder the eurozone, which is not afflicted by an inability to get left but rather by a seeming sense that it cannot get right.

What's happening in the eurozone is troubling on a number of levels, not the least of which is the recognition that it is an illustrative case for the US. 

Fiscal austerity is necessary here, as it was in the eurozone, and that puts the US at risk of getting stuck in the same traffic circle the eurozone is in.

Eurozone Turned Upside Down

Greece is a ward of the state; Italy is being led by a technocratic government; Spain's unemployment rate is over 25%; and Germany, the core of the eurozone, is starting to feel the economic effects of its troubled neighbors.  Those are just a few of the problems.

Social protests are occurring more often; radical political parties are on the rise; demographics are unfavorable; and reaching a political consensus is a never-ending battle of brinkmanship.

The political and economic environment in the eurozone is polluted with unrest.  Cleaning it up hasn't been -- and won't be -- easy.

Much like the Federal Reserve, the European Central Bank (ECB) has been a mainstay of support with its unconventional policy.  Its pledge to defend the euro and to buy sovereign bonds of member countries seeking bailout assistance from the European Stability Mechanism have drawn the ire of many political critics. 

At the same time, the ECB's stance has drawn approbation from financial markets which have generally defied the reality of the troubled real economies.  Sovereign spreads have typically narrowed in the last six months, most European bourses are showing gains for the year, and the euro itself is up slightly against the dollar since the end of 2011.    

It is a fundamental divide to be sure, but investors there aren't fighting the ECB much like investors here aren't fighting the Fed.

Cautious about Being Carefree

Both central banks though are in the late rounds of their heavyweight fights and their punches aren't as forceful as they used to be.  That is clear in the persistently low pace of economic growth.

The eurozone, however, is one up on the US.  It is already bearing the brunt of fiscal austerity on top of the deleveraging that has occurred in the wake of the financial crisis of 2008-2009. 

Government spending cutbacks have hurt some in the US, but it will get worse if political leaders find the gumption to do more to get our escalating debt under control.

Frankly, we are amazed by the market's carefree perspective when it comes to contemplating a fiscal cliff compromise.  The market reportedly just wants a compromise -- any compromise.  That will presumably keep a worst-case recession scenario on ice and light a fire under the market.

The equity risk premium should come down with a worst-case scenario being avoided.  However, the sobering reality escaping the punch-drunk market right now is that a compromise involving higher taxes and/or lower spending of some kind is going to weigh on economic activity.

Mind the Gap

It has been widely reported that the Congressional Budget Office (CBO) is projecting a recession in the US if we go over the fiscal cliff.  What doesn't get mentioned as much is the CBO's alternative fiscal scenario.

The alternative scenario rests on an assumption that most tax cuts and other forms of tax relief set to expire get extended and that automatic spending cuts and other spending restraint are prevented from occurring.  Under that scenario, GDP is projected to increase a whopping 1.7% in 2013. 

If the Social Security payroll tax cut and emergency unemployment benefits are also extended, the CBO projects 2013 GDP growth to be 2.4%, which is still below potential.

The U.K. and eurozone countries know a thing or two about below-potential growth.  They have existed in that languid state of economic affairs for the last four years (oh, and so has the US). 

What is noteworthy today, and what is relevant for the US as it starts down its own path of fiscal austerity, is that unemployment rates went up and output gaps widened in the U.K. and the eurozone after fiscal austerity kicked in.   The output gap is a measure that reflects the percentage of economic labor and capital not being used (i.e. the slack in the economy). 

Three Unfavorable Scenarios

It is hopeful to think the U.S. will be spared a similar fate.  It could, but we struggle to believe companies will increase spending and hiring as earnestly as they say they will if they just have clarity on fiscal policy.

Three scenarios could unfold in the next month:

1. There is no compromise and we go over the fiscal cliff. 
2. A compromise is reached that includes higher taxes and/or lower spending.
3. Every hard choice is deferred and the can gets kicked down the road.

Not one of those scenarios is favorable for increased business investment. 

The first scenario would lead to a recession while the second scenario would lead to subpar economic growth just like we have today. 

It doesn't stand to reason that businesses will spend freely and hire more people if higher taxes and reduced government spending lower levels of disposable income and aggregate demand.  Businesses didn't do it with subpar growth in 2012.  Why should anyone believe things will be so different in 2013 when taxes are higher and government spending is lower?

The third scenario buys some time, but companies said this year they held back on investment and hiring because of uncertainty about fiscal policy.  Kicking the can down the road doesn't give businesses any more certainty about fiscal policy than they have today. 

We should point out, too, that the CBO has warned that the economy would remain below potential and the unemployment rate would remain higher than usual for some time even if all of the fiscal tightening was eliminated.  That's hardly the stuff increased business investment and hiring is made of.

Some Earnings Delusion

In turn, we struggle to see how analysts are forecasting double-digit earnings growth for the S&P 500 in 2013.  We said as much last week.

Earnings growth estimates will be lowered in the coming months to reflect the low growth/no growth reality for many of the world's largest economies.    

It would not be a surprise to see US multinationals with heavy exposure to Europe lead the downward revision to earnings growth estimates.

[Note: We screened for S&P 500 companies that derived at least 30% of their revenue from Europe last year.  45 companies were returned in the screen (we included companies that report an EMEA segment, assuming most of the revenue is generated in Europe).  If you'd like a copy of the list, please email me.]

What It All Means

Fiscal austerity is coming to the US.  The question of when and how much remains unanswered, but make no mistake, change is on the way.   That change is going to slow economic and earnings growth in the near term, not accelerate it.

That may be irrelevant in the near term, however, to a stock market that feeds at the trough of the news cycle and monetary stimulus. 

There will be a sense of relief in the capital markets if a compromise can be reached, but in due time the reality will be established that we're still stuck in a traffic circle of subpar growth that is going to make it difficult for the labor market to get right.

The experience of the eurozone makes it clear that economic growth in the US will get worse before it gets better.  And it may be years yet before growth isn't just better, but is actually at or above potential.

The eurozone, which is further along with fiscal austerity, is back in recession.  The US, which is just getting started, will be fortunate to avoid a similar fate.    

--Patrick J. O'Hare, Briefing.com