Thursday, March 28, 2013

You just don't understand Europe...

In the wake of the disappointing market reaction to the Cyprus deal, I just want to repeat the comment I hear from some of my European contacts: "You just don't understand Europe."

Don't be fooled by the theatre
Europeans elites do their deals behind closed doors and what we see in the headlines is mostly theatre. By contrast, Americans focus much more on process and headlines - and that's where they go off the tracks when analyzing the eurozone crisis. That's why we get alarmist comments, like John Mauldin's Thoughts from the Frontline: You can't be serious in which he worried about the precedences set by the Cyprus deal and the effects on European banks:

Basel III standards require European banks to increase their deposit ratios. This European response to Cyprus is going to make that harder for banks in smaller European countries to accomplish. Very tiny Luxembourg has banking assets 13 times the country’s GDP. Yes, I know that Luxembourg’s banks are the very epitome of solid banking and that the majority of those assets are loans to central banks and other credit institutions, but there is no way on God’s green earth that Luxembourg as a country could even begin to think about backing its banks. Of course, everyone knew that before this crisis, but if you are the treasurer of a large corporation, how soundly do you sleep at night after Cyprus? And God forbid you have an account in one of the peripheral countries. In the case of Ireland, the lesson was that the money would be found to back the banks, even if taxpayers suffered. But now? New rules for new times. And then you open The Financial Tim es this weekend and read (emphasis mine):

The chairman of the group of eurozone finance ministers warned that the bailout marked a watershed in how the eurozone dealt with failing banks, with European leaders now committed to “pushing back the risks” of paying for bank bailouts from taxpayers to private investors.

Jeroen Dijsselbloem, president of the eurogroup, was speaking after Cyprus reached its 11th-hour bailout deal with international lenders that avoids a controversial levy on bank accounts but will force large losses on big deposits in the island’s top two lenders.
By contrast, I was recently relatively sanguine about Cyprus (see Don't get too excited about Cyprus and More of the usual Eurocrisis drama). I wrote that a Cypriot solution is specific to Cyprus:
I believe that bailouts of other eurozone countries, should they be necessary, will conform to a different template of conditionality other than the imposition of a tax on bank deposits. For example, the ECB has made it clear that it will backstop Spain, but on condition that the government undertake structural reforms and austerity. In the case of Spain, Rajoy has yet to swallow the bitter pill that comes with an OMT bailout.

Don't forget Draghi's Grand Plan
To explain, the real agenda of the European elites consists of three components:
  1. Push for structural reform long term;
  2. Austerity in the short-term; and
  3. The ECB stands by to hold everything together if the above two steps are taken.
Mario Draghi revealed this Grand Plan in February 2012 (see Mario Draghi reveals the Grand Plan) in a WSJ interview. Here are the key quotes from that interview [emphasis added]:
WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.
He went on to say that the European social model was dead:

WSJ: Do you think Europe will become less of the social model that has defined it?

Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.

WSJ: Job for life…

Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.
Unlike Dijsselbloem, who is a rookie, Draghi is an experienced central banker who chooses his words carefully and he reveal his agenda in February 2012. Investors looking at Europe should remember that.

If you understand the Draghi Grand Plan, then you will understand how the eurocrats are likely to react when the next sovereign crisis occurs. First, the ECB will "do whatever it takes" to save the eurozone, but help from Frankfurt (the ECB) and Brussels (EU) comes with strings. In all likelihood, the eurocrats will believe that the country seeking help needs austerity and structural reform. In such a case, be the price to be paid will be paid is austerity and structural reform and the solution will not to stiff bank depositors (think Spain as an example as Rajoy's reluctance to embrace Draghi's "conditionality").

The kind of "conditionality" demanded by the ECB and is therefore highly situation specific. Cyprus was truly a unique case. Don't expect the same template to be used for Spain or Portugal. That's where outsiders make the mistake.

Investment implicationsLast week, I wrote that I was watching the relative returns of Greek stocks to eurozone stocks as a barometer of the level of stress in Europe, largely because of the Greek-Cypriot link and because Greece is the high beta play in Europe. When I looked last night, GREK had tanked relative to FEZ and had violated an important level of relative support.

The Athens Index had also dived relative to eurozone stocks. Though the degree of relative performance was not as bad, it is nevertheless a cautionary signal for the risk trade in Europe.

The French elephant in the room
The negative market reaction over Cyprus suggests to me that we are going to go through a "the glass is half empty" cycle in Europe and traders should be prepared accordingly. The key indicators to watch is the performance of France. France is the elephant in the room. The French economy is suffering a negative divergence with Germany. Consider this graph of French and German PMI (via Business Insider).

The eurocrats can deal with Italy, Spain and Ireland, but France is at the core of the EU and impossible to save. The Economist described France as the time bomb at the heart of Europe:

European governments that have undertaken big reforms have done so because there was a deep sense of crisis, because voters believed there was no alternative and because political leaders had the conviction that change was unavoidable. None of this describes Mr Hollande or France. During the election campaign, Mr Hollande barely mentioned the need for business-friendly reform, focusing instead on ending austerity. His Socialist Party remains unmodernised and hostile to capitalism: since he began to warn about France’s competitiveness, his approval rating has plunged. Worse, France is aiming at a moving target. All euro-zone countries are making structural reforms, and mostly faster and more extensively than France is doing (see article). The IMF recently warned that France risks being left behind by Italy and Spain.

At stake is not just the future of France, but that of the euro. Mr Hollande has correctly badgered Angela Merkel for pushing austerity too hard. But he has hidden behind his napkin when it comes to the political integration needed to solve the euro crisis. There has to be greater European-level control over national economic policies. France has reluctantly ratified the recent fiscal compact, which gives Brussels extra budgetary powers. But neither the elite nor the voters are yet prepared to transfer more sovereignty, just as they are unprepared for deep structural reforms. While most countries discuss how much sovereignty they will have to give up, France is resolutely avoiding any debate on the future of Europe. Mr Hollande was badly burned in 2005 when voters rejected the EU constitutional treaty after his party split down the middle. A repeat of that would pitch the single currency into chaos.
The lines in the sand
I am watching closely this ratio of the CAC 40 to Euro STOXX 60 to see which way it breaks out of the relative consolidation range.

If it rallies through upside relative resistance, then any crisis is just more theatre and can be regarded as a buying. On the other hand, if it breaks to the downside, there's going to be trouble.

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.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


jjauregui said...

"Don't expect the same template to be used for Spain or Portugal. That's where outsiders make the mistake." Ya, right.

keithpiccirillo said...

I don't know why you are singling out France. Smaller countries to the East like Lichtenstein are the next dominos from what I'm reading, and how is France in a more precarious position then both Italy and France?

Humble Student of the Markets said...

Keith - Smaller countries can be dealt with. France is much too big to save and much too big to leave the eurozone.

P.K. said...

It's my understanding that Cypriot banks were loaded up with Greek debt. One question that I never ONCE hear asked: If banks are so vital to a nation's (or the global) economy, why are they allowed to roll the dice in risky bets that, if they go bad, put taxpayers and depositors on the hook for the losses, while bondholders come away mostly unscathed?
However one wants to describe this system, it is definitely NOT a "free market" system.

Laspeyres said...

Yes, the likes of Maudlin have been very lazily extrapolating. However, I fear that markets have missed the impact of Dragi's clarification of OMT elegibility in his 7th March speech. He said that eligibility requires that a country is comfortably issuing debt at a range of maturities to a wide range of investors. This implies you can only access OMT if you don't need it. Bit by bit, banking union and OMT, the two new bits of the crisis resolution infrastructure that markets welcomed last summer have faded into nothingness.

raul said...

Cam you were wrong about Europe outperformance relative to US in your prediction for 2013.I am European I know Europe. Don't make mistake of doubling up on your losses.However, for the next short period only $indu overextended compared to $ dax but $dax has max 8150 upside and lot of downside There are some facts. You believe Europe bank stress tests ? You know Cyprus banks passed these? Do you know Allied Irish Banks has got lots of bad debt not accounted for on their books. Their depositors money is at risk .So a Cyprus euro or an Irish euro no longer as valuable as german euro . Think about that . The only thing that has saved Euro is China's need to dump their exports, so they will do everything in their power to save euro and this charade will continue The only thing you need to understand about Europe is that the politicians and the banks will lie and lie to save their skins.