The strongest and weakest of the Euro zone had news on Friday. The Greek economy sank 1.5% in Q2, falling below the forecast for a 1.0% drop. Greece’s GDP was down 0.8% in Q1. Meanwhile, Germany’s GDP rose 2.2% in Q2, the best quarter since 1990. That topped expectations for a gain of 1.4%. It also helped the combined European Union’s Eurostat projections for combined growth of the 16 counties to 1.0%. Despite the solid Euro zone economy, all eyes were on the domestic news. Retail Sales for July were a little light of expectations, rising 0.4%. Expectations were for a gain of 0.5%. However, June was revised to a smaller decline of 0.3% versus an original report of 0.5%. Motor vehicles and gasoline provided much of the upside, rising 1.6% and 2.3% respectively. Food, clothing, and department store sales were the main drag, taking the core Retail Sales, ex-autos and gasoline, to -0.1%. A gain of 0.1% was anticipated. This obvious negative was offset by several very small positives. The Consumer Price Index rose 0.3% in July after falling 0.1%. Expectations were for an increase of 0.2%. Since we’re dealing with deflationary fears, not inflation, any uptick is a good thing. The University of Michigan preliminary Sentiment Survey rose to 69.6 from 67.8, topping estimates for 69.0. This is a mid-August survey, so it was nice to see sentiment inch higher. However, the enthusiasm should be somewhat muted, as the index was at 76.0 in June. Business inventories inched up 0.3% in June after rising 0.2% in May. May was an upward revision and June beat by a tick. Higher inventory levels add to GDP, so this may help offset some of the disappointment from the Trade Deficit figures released earlier last week. GDP for Q2 is still likely to be revised lower.

The weak economic news was part of the story, but only in as much as it fed the growing fears of investors that the “double dip” is back on. It is tough to be optimistic about an economy facing two enemies, slowing growth and deflation. The deflation hawks are seen in the action in bonds and the Dollar. The short end is getting squeezed by zero, the long end reflects investors desire for preservation of capital. In deflation, cash is king. Assets lose value over time. Therefore, cash with a small return should outperform any asset class. The 10-year treasury fell to its lowest level since April 2009. However, this low is not the typical “flight to safety”. The Financial crisis may not be over, but it is on the mend. A collapse of the Euro zone is far less likely than it was three months ago. This action is due in large part to rising fears of deflation. To that end, the strong comeback rally in the Dollar Index last week is also due to a resurgent fear of deflation. What provoked this move was that the FOMC only held the balance sheet steady, and did not do more to “re-inflate” the economy. We still have inflation hawks screaming about the $1.3 trillion the Fed injected after the financial crisis. Our argument is that this capital roughly equated to the capital lost by Financial institutions through deleveraging and investment losses. This will be a long and slow repair process, and the Fed would only damage the economy if it cut off this lifeline. The argument is over whether or not the Fed should do more, and while the market argues against quantitative easing, investors are telling us that they fear the Fed isn’t doing enough, rather than they fear they are doing too much.

In addition to the fundamental news indicating slower growth in Q2 and Q3, the fuel for the bull’s fire is all but gone. Earnings were the key to the market advance. Two major earnings reports out last week hurt more than they helped, mainly on the companies’ outlooks on the economy. Cisco Systems CSCO (0.0%) was out earlier in the week. Its forecast sent the stock down 10% on that day, despite the fact that it said it still sees its business improving through the economic weakness. J. C. Penney & Co. JCP (-4.7%) reported earnings in line with expectations at 6c, but the company forecast for 16c to 20c fell well shy of the Street consensus of 23c. Their reason for the downgrade of expectations was an “uncertain consumer climate”. After having seen the same-store sales data for July, it really shouldn’t be a surprise to hear the retailers take a cautious stance. However, it helped feed the fear that there was no longer any good news for which to look forward. The Dow fell 3.3% and the S & P gave up 3.8%. The real fear was felt through the wiping out of the “risk trade”. The NASDAQ gave up 5.0% and the Russell fell 6.3%. The leadership tells us a similar story of rushing to preservation of capital. Telecomm, Utilities, Non-durable Consumer Goods, and Healthcare sectors were lower, but by half that of the former bull leadership groups of Technology, Industrials, Financials, Basic Materials, and Energy.

It is quite clear that this is a wave of deflationary fear. Whether or not the economy dips under zero growth for a quarter shouldn’t be the question. The direction is clear. Q2 should end up closer to 2.0% growth or maybe even under. Q3 is most certainly destined for a low 1% handle. What matters to the long term are jobs, and the help is simply not on the way. Extending benefits amounts to a Band-Aid on the problem. To fix it, we need directed fiscal policy. I wish I could say that our politicians are fighting for our future, but right now they appear to be more concerned with only one job… theirs. The economic news train isn’t going to stop this week. There are some important indicators due out. The Empire State and Philly Fed Indices are August numbers on manufacturing. Housing Starts and Permits speak to the inventory issue of housing. Industrial Production and Capacity Utilization for July should provide some insight to whether or not the slowdown we see in the consumer is pressuring production. Finally, weekly claims on Thursday are a never-ending battleground for sentiment on jobs. Technically, the bulls ran out of gas when earnings season was mostly over. The bears have the upper hand and we suspect that will remain the case through September/October. There will be bounces along the way, but they will remain opportunities to sell. Since “deflation” is such a negative catalyst, keep an eye on the Dollar Index. It’s pop from 80 runs into a 50% retracement and its 10-week moving average at 84. It closed Friday near 83. This will be critical short to intermediate term resistance for the Dollar Index.