Stocks and the euro rose after Merkel and Sarkozy said that Europe’s two biggest economies were aligned on backing automatic penalties for deficit violators and locking limits on debt into euro states’ constitutions. The French leader said they aimed to reach consensus on the changes required by March.
It looks like Merkel got everything she wanted and the French went along (see the analysis from FT Alphaville). The French and Germans agreed to a Brussels-on-the-Rhine, with hard constraints and penalties for member countries who deviate from the True Path.
The devil is in the details
As I wrote before, the devil is in the details of any Grand Plan. Here are a few questions before we get into a frenzy of celebration:
- How do they get all the other countries (i.e. the Dutch, Finns, Irish, Belgians, etc.) to agree to permanently giving up a this level of fiscal sovereignty?
- What countries have to agree? All 27 EU countries or just the 17 eurozone countries?
- If we just needed agreement among the eurozone members, do they all have to agree, i.e. can we see a two-speed eurozone where you have countries inside and outside this stability pact? Answer: While technically possible, it is not practical. Consider what John Hussman wrote this week about the fallouot from a Greek default [emphasis added]:
Haven't we moved past Greece already? Well, no. Based on reported holdings of Greek debt in the European banking system, the implied losses on Greek debt alone are now enough to put many European banks into capital shortage. Europe could solve Italy's issues tomorrow and European banks would still face a banking crisis.
- Who will get to be the monitor for transgressor countries? The European Court of Justice only gets to decide if a country is in breach of its targets, but will not monitor compliance. Who gets that lovely job?
- Will this agreement be enough for Mario Draghi and the ECB to start printing? Recall that last week Draghi said, in essence, that he needs a binding compact with hard and fast rules [emphasis added]:
What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.
Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.
We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.
- Will Merkel et al agree to the ECB printing?
- Lastly, who takes the hit to eurozone sovereign bad debt? One of the details of the latest Grand Plan is that bondholders they would be safe in any future debt restructuring. Hussman summarized the problem quite succinctly:
There are still many moving parts to this Grand Plan that have to come into place before we can all celebrate. Are we destined for a repeat of the October experience where as we approached the G20 summit, the market rallied on leaks of the details of that Grand Plan for the EFSF?Europe doesn't face a liquidity problem. It faces a solvency problem. What investors really want isn't just for someone to buy distressed European debt, but for someone to buy that debt and willingly take a loss on it so the money doesn't ever actually have to be repaid. That isn't going to happen easily. Short of major fiscal improvements in Europe (which appear increasingly hopeless in the face of an oncoming recession) any solution will have to explicitly or implicitly impose losses on someone. In my view, the best "someone" is the investors who willingly made the loans in expectation of earning a spread, and who knowingly took a risk.
The worldwide hope among these investors is that the "someone" taking the hit will instead be the German people, but Germany remains resolutely against printing permanent new euros in order to effectively redeem the debt of Italy and other countries. Despite hopes that the ECB will suddenly shift its policy on this, I continue to expect that any ECB purchases of distressed European debt will follow an agreement on European fiscal union, and that even if initiated, will be on a smaller scale than investors seem to hope. Without airtight fiscal credibility among distressed Euro-area countries, whatever debt purchases the ECB makes will be almost impossible to reverse.
By the way, where is the state of the EFSF today?
The emperor has no clothes
Barry Ritholz wrote the following early yesterday morning as ES futures were rallying hard [emphasis added]:
Hence, some caution is warranted. Last week, my client accounts were at 60-65% equity exposure. But on December 1, the tactical component of our portfolios flipped from 100% equity to 100% bonds. It might be bit early to become to defensive, as the year end rally shows no signs of letting up just yet. However, in secular bear markets, capital preservation and risk management should be every investors first priority.I agree 100%.
Hence, Investors are advised to watch the quality of this rally — the volume, the market internals, the reaction to news events — and position themselves accordingly.
We may be in a situation reminiscent of 2008, as described by Kyle Bass, where the markets do not respond until it actually goes over the cliff. See this rather long video here, where he described the situation in 2008 where senior Lehman bonds were trading at roughly 400 bps over Treasuries a week the firm imploded, when the Treasury Secretary stated emphatically that Lehman was not getting bailed out. One day before the firm went under, senior Lehman bonds were trading at only 700 bps over Treasuries.
Don't get overly distracted by the eurocrat discussion about how the longer problems are getting solved (which they don't appear to be). Hussman wrote this week that a Greek default alone is enough to sink the European banking system and the story about the potential Standard and Poor's downgrade of European sovereigns is just a shot over the bow.
Pay attention to both the short and long term issues facing Europe.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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