Commentary: 2012 Second Quarter Musing
by Franco Seguso,

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June 2012


Eurozone front and center: an incredibly complex crisis

First we were served an alphabet soup of acronyms (TARP, QE, SMP, ELA, TARGET-2, LTRO, EFSF, ESM) whereas now we are treated to verbal contortions: Eurobond stands for Eurobund, austerity in French means “spending a lesser amount of of other people money”, structural reform in Italian stands for ‘tomorrow’, growth in southern Europe means ‘Angela treat’, voluntary restructuring in Greek means ‘subordination of private investors’  while in Spanish ‘cooking bank books’ is called dynamic provisioning and limited financial support for banks stands in lieu and place of ‘country bailout’. All this would be farcical if not for the dreadful economic reality.

The Eurozone financial crisis is a big mess getting bigger as the recession is broadening and deepening from the periphery towards its core, with negative implications on all debt ratios. This is a very complex crisis involving balances of payments and productivity divergences, public deficits and private debts, banking leverage and sovereign guarantees, social compacts and cultural divergences, and lots and lots of denials. Such embedded complexity makes a collapse all the more unimaginable, yet here we are with open discussions on exit strategies. But make no mistake: an unraveling of the Euro would be the equivalent of painstakingly unscrambling an omelet of 17 eggs.

In a matter of just 3 short years the Eurozone yield convergence has all but reversed, with credit markets now pricing-in the end of the Euro experiment and placing unsustainable risk premiums on its weakest sovereigns (UK interest rates are a quarter of those of Italy).

Five countries (Ireland, Greece, Portugal, Spain and Cyprus) are now receiving bailout assistance. Italy is teetering on the hedge, France in its shadow, Hungary and Slovenia not far from the brink. In Spain, the math to balance a 9% annual deficit, a 4% trade deficit, an 80% debt-to-GDP and a 6.8% interest rate with 0% nominal growth is simply daunting.

With Spain entering the eye of the storm, even the European Commission has joined the rest of the chorus in calling for Eurobunds to contain the contagion of the sovereign-banking crisis, together with a pan-European guarantee on bank deposits to stem bank runs in the periphery whilst allowing the ESM (European Stability Mechanism) to directly recapitalize banks in the Eurozone.

Lost in translation are all the laws, treaties and constitutions that would need to be respectively ratified, modified and amended by 17 different countries. Not to mention the sheer size of liabilities that require back-stopping (EUR 23 trillion of deposits, 10 trillion public debts of which 3 trillion in Spain and Italy alone) by the Euro 0.5 trillion ESM (that’s a tiny 1,5% of total liabilities) that so far has been approved by only 3 of the 17 Eurozone members. In the meantime the fiscal compact agreed at an EU summit last March has been approved so far by 2 of the 27 EU member states, giving an all new meaning to the sense of urgency when it come to homework …

If only the Germans could write blank checks no string attached, all these Euro-summits would not be necessary! So, expect a lot of German-bashing in coming weeks as their taxpayers are not easily going to guarantee, and in the end materially subsidize, the entire European sovereign/banking train-wreck; at least not until they will stare into the abyss of a financial meltdown. Million

Club-Med: denial seems a strategy

In the meantime you would expect the Club-Med debt-stricken countries to undergo significant adjustments to contain the crisis, from structural reforms to entitlement and welfare cutbacks, but little of this is on the horizon if not outright the opposite.

There is this astonishing mood of denial from the French insistence on a 35hrs workweek and retirement at 60 to the Italians watering down labor reform, from the Spanish ‘no bailout’ to the Greeks calls for renegotiating their bailout memorandum. Structural reforms have been reversed (France), diluted (Italy), hidden (Spain) or avoided altogether (Greece).

Outside tiny Ireland (not a Club-Med anyway) not a single Government has announced plans to shrink its own footprint in the economy. Spain with its running 9% deficit is characterized as ‘virtuous’. You realize how far we have come into this crisis when Europe celebrates an election ‘victory’ in Greece by none other than the very same coalition that cooked the books to enter and overstay the Euro in the first place: if this is not denial !

Spain 100bn bank bailout directly on the footsteps of Dexia and Banxia collapses are also testament to the total lack of credibility of the Euro Banking Association stress-test. No wonder Ms. Merkel is resisting direct recapitalization of banks.

And then there is this circular absurdity of a bankrupt banking system guaranteed by broke sovereigns backstopped by supra-national firewalls (EFSF, ESM) themselves underwritten by the same banking systems with the same sovereign guarantees. This circular logic in all its magnificence was on full display with Italy borrowing at 6% to fund its 20% share of the Spanish bailout at 4% ....

Austerity?

Professed austerity is under siege across Europe as it is now identified as the cause, rather than the consequence, of the debt crisis. Few seem to question the unsustainable and unfunded social entitlements or the incontinent welfare spending, or willing to abdicate fiscal sovereignty in exchange for mutualizing obligations.

The Mediterraneans are demanding ‘growth’ strategies to escape their quandary of austerity, excessive leverage, debt sustainability and lack of productivity. The problem is to find someone, somewhere, to finance this growth as all domestic engines of growth have stalled.

With no painless way out of this mess, the tactic seems to corner the Teutonic north into agreeing new deficits spending, monetary financing of Governments, socialization of debts and bank liabilities, and mutualization of unfunded social entitlements. Politicians will always try to piggy-bank their way to prosperity on someone else checkbook; this time around is on Germany and on the ECB. In this Nash equilibrium, everyone expect the ECB to be the first to blink when facing the abyss.

Yet, asking the Germans to work 5 or 7 year more than their French counterparts to ‘save’ the Euro is not going to fly easily with the electorate; nor is printing the way out going to fly with the Bundesbank or the German Constitutional Court (remember the no-bail-out clause of the Maastricht treaty?). Conundrum acquires a lot of meaning here!

You cannot have a monetary union without full fiscal and political union, but also you cannot expect a fiscal union without some uniformity in entitlements (the largest fiscal liability) across the union. This would require the current Eurozone organization to evolve into an integrated federal union, a process that is as much geo-political as it is cultural. Time is thus a major issue here and we are clearly running out of it.

Germany in an untenable position and no good choices to boot

Europe is reaching an existential crossroad between a fully fledged federalism and a sizeable downsizing (either through economic depression or through countries exiting the Eurozone). Soon Germany will have to make a hard and difficult call: try to save the Euro and with it the European Union project or risk an almost certain break-up of the Eurozone and its own legacy. Both options are fraught with huge risks, both come at immense costs to the Germans and both carry pain to social cohesion.

This is an unforgiving choice between an unpalatable open-ended transfer union now in exchange of a political-fiscal union in a distant future or a political revulsion in the periphery leading to an unpredictable financial and economic depression across the Eurozone. With a non-trivial quarter of its GDP already tied up into rescuing the Eurozone, Germans greatest fear may increasingly become the unlimited liability of a fiscal union that does not solve by itself the structural causes of the crisis rather than a scary but difficult-to-phantom reversion to national currencies. There is a limit also on how much Germany can afford as its own debt-to-GDP over 80%.

As the core engine of Europe and the main economic beneficiary of the accumulated imbalances, Germany is increasingly isolated as France has now joined the reflationary or die camp following the populist election of a socialist candidate.

The Chancellor strategy will most likely be one of muddle-through until someone else breaks this Nash equilibrium and trigger a forceful chain reaction. In the meantime we expect more of the same, summits followed by grand declarations but narrow concessions, a few new financial resources but more leverage of the existing ones, no structural resolution to the crisis but some more time until the next emergency summit. Outside markets imagination, the are no more magic bullets!

Euro-crisis remains a side show of the global deleveraging process

While Greece, Spain and Italy steal the daily headlines, the Euro-crisis remains a side-show (albeit one that could trigger a tipping point) to a much bigger and global crisis, namely the compounding $300 trillion stock of debt and leverage embedded in the balance sheets of the industrialized world.

This inverted pyramid of debt is sustained by a dwindling amount of productive cash flow and is over-layered by a gigantic 600 trillion debt derivative super-structure. These numbers are simply mind-blogging to be comprehended rationally, but give the magnitude of the monster debt-deleveraging the world is facing.

Policy makers continue to fight this structural debt deleveraging process by piling new layers of unproductive public debt upon this already unsustainable stock of debt. With nominal growth way too low to service the stock of debt (interest cost) and in the absence of some sort of debt moratorium or outright default, a debt-spiral dynamic remains in motion as new debt is required just to service old debts. At such advanced stage, the powerful law of interest compounding squeezes the productive economy with crushing debt-servicing costs, until a country loses access to the debt markets. Default or the printing presses are the only choices left: choose your poison!

Debt crisis happen slowly at first, then all of a sudden. They also tend to hit first the weakest links in a debt chain (US subprime, Iceland, Ireland, Greece, Cyprus, Portugal, Spain, Italy – see the trend?), then move inexorably toward the core as each link breaks down once at a time.

Since the start of this crisis bad debts have been restructured at a snail pace and almost exclusively through default (financed so far by starving depositors of any yield). Until bad debts aren’t broadly and convincingly restructured, sustainable and durable growth will remain elusive. From this perspective, only a printing press and time stands between the fate of Greece, Spain or Italy and the like of the UK, the US or Japan.

The Euro saga is also deflecting attention from other major problems worldwide, from the Middle East turmoil (Syria sliding into civil war, Egypt taken over by the Muslim Brotherhood, Iran nuclear impasse, Turkey pulled into the Syrian conflict and Israel in the middle of this powder keg) to the fiscal cliff in the USA, from Japan tentative fiscal consolidation (don’t hold your breath) to the BRIC abrupt slowdown, from the return of a global recession to the relentless progression of unemployment.

If you are still reading here, you may know that I am not overly optimistic …

 

Portfolio

From my goggles the world looks surrounded by black swans floating on a stormy ocean of debt, not exactly your archetypal investor-friendly environment. Volatility remains at severe levels, while each large market drawdown wrong-foots investors and portfolio managers alike. We maintain our defensive capital-preservation and income-generation approach even though we have to acknowledge that uncovering value with such a financial backdrop is a big challenge.

We continue to favor gold and gold mines as the ultimate systemic insurance against the financial folly of believing in free lunches that is so pervasive in many quarters.

Bank retrenchments are creating opportunities for holders of capital as corporations replace contracting bank lending with debt issuance. With bond markets still flashing recession and deflation, we add to our exposure to the higher level of the capital structure and away from the leveraged and increasingly subordinated segments (financial, construction, sovereign). Local currency bonds in emerging markets offer some of the best risk-adjusted returns in the fixed income universe.

European shares, particularly in the periphery, are already pricing a lot of economic pain and are at (an early) accumulation level based on trailing and forward price/earnings (the Eurozone cyclically adjusted price/earnings is at 11x and dividend at 4%). Historically, when equities become extremely cheap in term of CAPE (around 7x) and book value (below 1x), the macro-economic environment turns out to be less relevant than the underlying equity metrics. Accumulate selectively!

 

All the best
Franco

Bangkok, June 29th, 2012

 

You know that something is really, really wrong when the best rapper is a white guy, the best golfer is a black guy, the tallest guy in the NBA is a Chinese, a Swiss hold the America's Cup, the Pope is a German, Europe's central banker is an Italian, Cyprus holds the European Presidency, France is accusing the U.S. of arrogance and Germany doesn't want to go to war (extract from Zerohedge).