The bull case for stocks

I have been quite bearish in these pages lately. As an antidote and to help me think critically, I outline what could go right for the markets in 2012, along with the risks:

• The coordinated central bank liquidity injection of November 30 has taken a Lehman-like event off the table.
• In the US, the Fed does QE3 in the 1H, which would send asset prices flying.
• In Europe, the ECB is already engaged in a form of QE though the back door using LTRO, which should heal banking balance sheets over time.

Global central bankers are worried
The coordinated central bank actions of November 30 to inject liquidity into the global banking system shows that central bankers are worried. No doubt, they learned from 2008. In the short term, liquidity ensures that a major bank failure or Lehman-like failure in the shadow banking systems is off the table and will not bring the global financial system down in a market crash.

Key Risk: The system isn't totally healed. These actions just bought some time for the politicians to act. Indeed, Bloomberg reported that Ben Bernanke, in a closed-door briefing to Republican senators, made it clear that there are limits to Fed policy and it doesn't intend to bail out European banks.

In addition, Bank of Canada head Mark Carney said in an unusually frank speech that the world is in a period of deleveraging. The road ahead is hard and the risks are still high:

The Global Minsky Moment Has Arrived
Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it.

Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on time and in full.

While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unravelled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter.

Hard experience has made it clear that financial markets are inherently subject to cycles of boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the rationale for micro- and macroprudential regulation.

It follows that backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage—the situation that got us into this mess in the first place.

The Fed does QE3
Could the Fed still save the equity markets in 2012? Cardiff Garcia of FT Alphaville pointed out this analysis from SocGen showing that the composition of the FOMC is going to turn far more dovish in January 2012.

On that same point, Bloomberg reported on November 29 that vice-chair Janet Yellen that the Fed has the scope for additional asset purchases (read: QE3):

“The Federal Reserve has some scope for action,” Yellen said today. “We are actively considering methods that we could use to provide greater clarity” on the central bank’s pledge to keep rates low through at least mid-2013, and new purchases have the potential to “flatten the yield curve.”

Central banker statements are very measured. Yellen's speech about additional purchases is a definitely signal that QE3 is coming.

Key Risks: We are now in a world of bad news is good news for the markets and good news is bad news. Economic growth has to show that it is indeed deteriorating before the Fed can act. The calls by the likes of ECRI and John Hussman for a recession have to be wrong. The high frequency data is showing the economy is definitely not keeling over. Assuming that ECRI is right, when will the data be convincing for the Fed to act? Would a two month extension of the payroll tax cut for two months just extend the pain?

Moreover, this chart from Scott Grannis shows inflationary expectations are still stubbornly high and rising. The Fed is unlikely to undertake QE3 unless inflationary expectations (and not just inflation) remain elevated.

The Sarko carry trade saves Europe?
Students of market history will recall the policy of forebearance that saved the US banking system during the LDC (Less Developed Country) loan crisis of the early 1980's. After the banks lent to all manner of LDCs that went bust, the authorities pretended that the loans that were on the banks' books remained good for 100 cents on the dollar. At the same time, the Fed began to lower rates in August 1982 and signaled to the banks that they would continue to stay low or continue to fall. Thus, the banks could borrow short and lend long, which repaired their balance sheets over time.
 
The ECB's long term repo operation (LTRO) announced on December 8 did just that. The ECB announced that it would provide unlimited amounts of liquidity via LTRO and relaxed the collateral requirement for LTRO all the way down to anything rated single-A. Nudge-nudge-wink-wink. If you are a troubled bank, you can bring your *cough* junk, borrow from the ECB for up to three years at 1%, put it into Spanish or Italian debt at 5-6% and earn the spread. If you used leverage, it wouldn't take long for you to repair your balance sheet.
 
This prompted Nicolas Sarkozy to say that banks could then finance their own country's debt, which prompted some observers to dub this forebearance trade the "Sarko trade":

French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds. “This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.

The ECB is precluded by mandate from lending directly to sovereigns. LTRO is a backdoor way of doing QE by lending to the banks which then lend to the sovereigns - and the amount is unlimited! It kills two birds with one stone. It repairs banking balance sheets and addresses the solvency problem and it allows sovereigns access to the markets.
 
Key risks: This is another one of those European plans that sound good in theory but the devil is in the details. First of all, Simone Foxman reports that even though the ECB will take single-A paper as collateral for LTRO, it will require a haircut for lower grade paper inasmuch as it will not lend 100 cents on the euro for lower grade debt:

The details of how the ECB means to relax collateral have not yet been released. The Bank currently accepts collateral rated as low as A-, although debtors must pay a penalty based on asset risk. Were even riskier assets allowed to be used as collateral or if the penalty were dropped, this would provide significant incentive for banks to purchase sovereign debt, particularly given currently high yields on bonds. If it worked, it would be the ultimate carry trade—borrowing from the ECB is now a cheap 1%, so banks could see huge returns on sovereign debts with high yields.

Supposing that a bank uses the LTRO facility and puts up Spanish paper as collateral. Soon afterwards, Spain is downgraded by the rating agencies. Under the terms of the facility, the ECB would ask the bank to put up additional collateral as a "margin call" because of the credit downgrade.

Second, one of the legs of the policy of forebearance is to allow banks to carry doubtful debt at book value and market it to market. If they were the required to mark-to-market, then the bank could be deemed insolvent and would either need to be liquidated, merged with a stronger partner or nationalized. The European Banking Authority (EBA) has recently become progressive tougher on European banks in its stress tests and began to raise its standards from a ridiculously low level (recall that Dexia was declared healthy with a Tier 1 capital ratio of 12% just before it imploded).

The EBA stands in the way of this forebearnce trade. Will the EBA play ball? Can Berlin and Paris twist enough arms at the EBA to get them to come onside?

Third, there is the matter of prudence for bank management, a point that Felix Salmon raised when he wrote that it wouldn't work. This is an all-in bet-the-farm trade for any bank who wishes to undertake the carry trade of tapping LTRO to buy sovereign debt. If this works, you make a ton of money and your bank is fine. If it doesn't, your bank is bankrupt. Here are some key quotes from European bankers:

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

From my viewpoint, the most important technical consideration for the "Sarko trade" to work is the cooperation of the EBA. It will have to happen in very large scale for it to have an impact. I wrote last week that if you put "all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP." That's a lot of money.

Moreover, the "Sarko trade" will only work if there are no accidents along the way. There are some key elections coming up in 2012, namely Greece, Italy, Finland and France. In particular, will the new governments in Greece and Italy cooperate with the EU? How badly will austerity bite in eurozone? Can they prevent a European bank failure despite their best efforts? If not, would its effects cascade through the banking system? What about China, will it avoid a hard landing?

That's the trouble with the all-in bet-the-farm trade, if it goes wrong (and plenty of things can go wrong), you're dead.


Many moving parts to the bull case
In conclusion, there are many moving parts to the bull case. For stocks to stage a significant rally, I believe that two material things have to happen:

• The US economy and inflationary expectaions have to weaken sufficiently for the Fed to underatke QE3.
• The EBA has turn a blind eye and moderate its mark to market rules for bank debt.

Market analysis isn't just about having a single view, but about scenario analysis and the assessment of the probability of those scenarios. How you decide about the likelihood of these events will determine whether you are a bull or a bear.



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.

Are Treasury bonds a crowded long?

How crowded is the long Treasury trade? Anecdotal evidence suggests that the trade is becoming a crowded long. Ed Yardeni recently wrote:

Last week in Kansas City, one of our long-only accounts was especially concerned that the Endgame scenario is upon us. We discussed the best way to preserve capital in such a calamitous environment. The conclusion was to load up on the US dollar and US Treasury bonds, the scenario that seems to be working so far this week.

What does the data show?
Let's go to the data. Global Macro Monitor showed this chart of who is funding the US deficit. While the latest data shows that there are certain a lot of fund flows into US Treasuries from domestic and international investors, levels are similar to levels seen in 1Q 2010 and below the panic levels seen in the 3Q and 4Q of 2008.

What about hedge funds? These charts from Mary Ann Bartels of BoA/Merrill Lynch shows that large speculators, or hedge funds, are nowhere near a crowded long in the long bond.

What about the 10-year note? This chart shows that while large speculators have been buying the 10-year note, they are also nowhere near a crowded long.

This chart below shows the relative performance of the 30-year Treasury ETF against SPY. Again, it shows that while long bond returns are somewhat stretched relative to equities, relative performance levels are similar to the levels seen during the Summer of 2010 and far below the end-of-the-world levels of the Lehman Crisis.

Conclusion: While investors may be rushing into US Treasuries, the safety trade is nowhere near a crowded long, which indicates that risk-off trade has more room run.


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.

A "China is slowing" scare?

It's been a while since we've had a "China is slowing" scare, but we may be due for one. The chart of the Shanghai Composite shows that the index violated a key support level last night, which is an indicator of heightened stress.

The chart of the Hang Seng Index also shows that it violated a key support level in September and attempted a failed rally above the support-turned-resistance line. The index is now testing the bottom of a triangle formation, while investors wait for either an upside or downside breakout as an indicator of near-term direction.

China's deflating property bubble
Much of the stress comes from the faltering property market in China. The Los Angeles Times reports that China's housing bubble is losing air:

Home prices nationwide declined in November for the third straight month, according to an index of values in 100 major cities compiled by the China Index Academy, an independent real estate firm. Average prices in the Shanghai area are down about 40% from their peak in mid-2009, to about $176,000 for a 1,000-square-foot home.

Sales have plummeted. In Beijing, nearly two years' worth of inventory is clogging the market, and more than 1,000 real estate agencies have closed this year. Developers who once pre-sold housing projects within hours are growing desperate. A real estate company in the eastern city of Wenzhou is offering to throw in a new BMW with a home purchase.

Patrick Chovanec, professor at Tsinghua University's School of Economics and Management in Beijing, echoed the accounts about deflating housing bubble:

According to the China Real Estate Index, published by Soufun.com, the average primary market housing price across China’s top 100 cities dropped for the third month in a row in November, by 0.3% month-on-month, with prices in 43 cities still rising and 57 cities falling. However, other real estate agencies reported steeper drops in specific locations. Homelink said that in November alone, primary market prices in Beijing dropped 35% month-on-month, and industry sources told the Legal Evening Post they dropped 16.8% week-on-week in the last week of November, down 29% year-on-year. According to Caijing magazine, Beijing home sales volume (by area) in the first 11 months of 2011 was down 27% year-on-year, to a 10-year record low. A similar fall-off was evident in commercial as well as residential real estate. According to the Beijing Morning Post, sales volume for retail and office space in the capital dropped 18% and 7.4% respectively in October, month-on-month. Homelink’s chief Beijing analyst, Zhang Yue, told the paper he saw a growing supply glut developing.

The downturn was not limited to Beijing. Dooioo, another agency, said that primary housing sales volumes in Shanghai are the worst since 2006, while Chinese Business News reported that in Shenzhen, primary prices were down 10.7% and transactions down 11.3% week-on-week in the last week of November. Business China also reported a drastic drop in sales, despite generous discounting.

Chovanec writes that how the market behaves from now on will be a test of Chinese investor confidence in the property market, largely because property purchases are often fully paid for in cash with no leverage and represent a source of savings for individuals [emphasis added]:

How investors in the secondary market will react to the collapse in primary market prices is the biggest question of all. As I’ve mentioned many times, many people in China buy multiple units of housing in order to hold them empty indefinitely, as a form of savings. They do this because they have few attractive alternatives and because they have faith that housing prices will go up. Since many have paid cash, they aren’t under the same immediate pressure to sell as developers. But they do tend to look to rising primary market prices for assurance that their investments are profitable and safe, and now those prices are now plummeting. A great deal depends on whether they hunker down to weather the storm, or join the fire sale.

He does caution, however, that even though many apartments are paid for in cash, there may be other forms of leverage in property purchases. Depending on how pervasive the level of financial leverage, sales could create a cascade of falling Chinese property prices.

Beijing-based blogger Bill Bishop recently related the story of an email he received, which makes equally interesting reading. It came from a real estate agent representing a condo owner in one of the city’s top apartment buildings, in the Central Business District (CBD). Although he had no mortgage, and owned the unit outright, he was desperate to sell in order to raise RMB 20 million for his business. So it’s worth keeping in mind that, while many Chinese investors may not be directly leveraged on their real estate investments, given the credit explosion that has driven the Chinese economy these past few years, they may be highly leveraged in their business or other ways that could turn them into distressed sellers.

Watch for "China is slowing" stories
As the world has focused primarily on Europe and secondarily on the United States, my sense is that the consensus is that China will escape a hard landing. While I am of the belief that China should survive the next economic downturn in relatively good shape, stories like these will serve to heighten investors' sense of emerging market risk. In addition, we are seeing stories about India slowing as well.
Should European or American economies get into serious trouble in the months to come, there may not be any place to hide.



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.

Will S&P downgrade Europe?

Last week, Standard and Poor's warned the 15 EMU sovereigns that they may be downgraded. They expected "review of eurozone sovereign ratings as soon as possible following the EU summit scheduled for Dec. 8 and 9, 2011". They went on to state:

Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.

Now that the EU Summit has come and gone, what now?


The effects of the "fiscal compact"
I did some projections and assumed a number of problems of the latest "fiscal compact" away, such as the difficulties of treaty ratification, specification of enforcement mechanisms, etc. Using this handy tool from the Economist, I projected a probable path for selected eurozone countries. The blue line represents the base case estimates from the IMF and the red line are my revised assumptions. Since the latest "fiscal compact" amounts to nothing less than an austerity club, I made the following rather conservative changes to IMF assumptions to account for the more immediate fiscal tightening effects of austerity programs:

• Growth slows by 0.5%
• Inflation slows by 0.5%
• Primary budget balance is reduced by 0.2%, which is also a side effect of austerity measures
• Interest rate is the average of the current 5 and 10 year bond yield for that country

The results aren't pretty. Consider Spain, a Club Med country. Debt to GDP is project to spiral upwards, worse than the base case estimate from the IMF (blue=oringal IMF assumptions, red="fiscal compact"):

What about Portugal? The only silver lining is that things don't deteriorate as badly as Spain under these assumptions.

Italy, the biggest Club Med country of all, doesn't fare all that well either as its debt to GDP gets out of control rather quickly. The problem of Italy lays the groundwork for another eurozone crisis in the near future.

What about France? Oh, dear! It looks like Sarkozy is likely to lose his precious AAA credit rating.

The only question at this point is whether it will be one or two notches. This chart below compares the France under my new projections with the United States under IMF's base case projections. At least the French are outperforming the Americans...

The only country that fares reasonably well under these revised assumptions is Germany, whose debt to GDP ratio continues to contract. Even then, its deficit to GDP measure won't be below the magic 60% target, which would suggest further fiscal tightening under the terms of the "fiscal compact".

This analysis indicates that the fiscal balance of major eurozone countries will deteriorate under the terms of the new "fiscal compact", which leads to the conclusion that a wholesale downgrade of many eurozone sovereigns is very likely.


Setting the stage for another debt crisis
The next question for me was, "How much more risk would a credit downgrade introduce to the eurozone?"

Using this data from Jason Voss of the CFA Institute, I constructed a spreadsheet for the likely rollover of debt in 2012 of selected eurozone countries as a measure of the degree of funding stress they may have to undergo. (All amounts are in billions of euros.)

In his article, Voss showed the likely rollover of debt as a percentage of GDP for all eurozone countries. I then went to the IMF website and looked up the projected 2012 GDP by country to calculate the projected rollover figure for 2012. Italy is one of the more problematical as it is scheduled to rollover over €300 billion in 2012 (even this estimate may be low as others have cited a figure of €440 billion). Surprisingly, France will need to come to market with nearly €400 billion and the German rollover comes close to €600 billion.

If you include all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP. Supposing that we assume that Germany will have no trouble rolling its debt and excluded her from 2012 financing needs, then the eurozone debt market will see roughly €1.2 trillion in sovereign debt issues - an astoundingly large number. The PIIGS alone will need to finance about €700 billion next year.

These are very large numbers. Given that European banks are in the process of shrinking their balance sheets, which will reduce their appetite for sovereign paper, where will the money come from? The combination of EFSF and ESM? But the funding for the EFSF and ESM come from the eurozone sovereigns. Can they loan money to themselves?

What about the IMF? There was some discussion that some sovereigns, e.g. Germany, could lend to the IMF, which when then lend it back to troubled European country, e.g. Italy. However, the total amount of that facility amounted to €200 billion.

The size of the ESM, EFSF and new IMF facility is simply not enough. It's like sending out a riot squad of 10 police officers with helmets and batons to face an angry mob of a thousand people. If the mob stampedes, the results won't be pretty.

What about the ECB? Mario Draghi made it clear that the ECB would cap bond purchases to €2 billion a week (when actual recent purchases have amounted to roughly €1 billion a week). The total cap adds to about €1 trillion a year, which could be a big bazooka if it was un-sterilized. However, such intervention would be sterilized, which begs the question of where the money to buy the ECB's sterilized paper would come from.

This analysis tells me to be prepared for more volatility and crisis summits in 2012, if not before.




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.

Is the eurozone banking system about to collapse?

The Telegraph sounded alarm bells late Friday that the Eurozone banking system [is] on the edge of collapse. Specifically, the problem is related to a lack of acceptable collateral, or "collateral crunch", for overnight and other short-term bank funding [emphasis added]:

Senior analysts and traders warned of impending bank failures as a summit intended to solve the European crisis failed to deliver a solution that eased concerns over bank funding.
 
The European Central Bank admitted it had held meetings about providing emergency funding to the region's struggling banks, however City figures said a "collateral crunch" was looming.

"If anyone thinks things are getting better then they simply don't understand how severe the problems are. I think a major bank could fail within weeks," said one London-based executive at a major global bank.

Many banks, including some French, Italian and Spanish lenders, have already run out of many of the acceptable forms of collateral such as US Treasuries and other liquid securities used to finance short-term loans and have been forced to resort to lending out their gold reserves to maintain access to dollar funding.

The eurozone banking system is paralyzed by counterparty fears risk, where banks would rather park their excess funds with the ECB instead of lending to each other:

Bank deposits with the ECB now stand at their highest level since June 2010 at €905bn (£772bn) as lenders withdraw deposits held with their peers and put them into the central bank. At the same time, banks in major eurozone countries such as France and Italy have become increasingly reliant on central bank funding. This follows the trend seen in smaller countries like Ireland where lenders have effectively becomes taxpayer-funded "zombie" banks.

The Bundesbank is running out of money
Izabella Kaminska at FT Alphaville has was on this story early and she has covered it well. She wrote that the problem is becoming so acute that even the Bundesbank is running out of money. She explains that the ECB isn't a single central bank, but a collection of central banks [emphasis added]:

While policy is decided centrally, actual enforcement and implementation of that policy is conducted on a national central bank (NCB) level.

That means every NCB is in charge of providing liquidity to its own particular market. The Irish NCB’s routine distribution of emergency liquidity assistance (ELAs) on a near enough unilateral basis (there’s only the need to notify central command in Frankfurt) is a good example of how the system works.

All payment surpluses and deficits created as a result of these unilateral NCB processes are then balanced out via the so-called Target2 system (Trans-European Automated Real-time Gross settlement Express Transfer system).

Generally speaking, the system ensures that all NCBs carrying surpluses channel them over to NCBs carrying deficits.

The problem is that since the crisis unfolded, the number of NCBs handling deficits has started to outnumber the number of NCBs holding surpluses. One particular NCB — the Bundesbank — has become the key provider of funds to the whole eurosystem.

She pointed to a blog post at VoxEU which summarized Bundesbank's problem [emphasis added]:

In order to fund these loans, the Bundesbank sold its holdings of German assets. Asshown in Figure 1, between December 2007 and September 2011 the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion. In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history.

The ominous sign – which might set the stage for Act Two in the unfolding Eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem. At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action.

The Bundesbank having to sell its gold to fund banking liquidity??? That will make Merkel sit up and take notice.


An acute collateral crunch
Kaminska explained the collateral crunch problem in ECB as Pawnbroker of Last Resort:

While soaring Libor rates were a key indicator of market stress during the credit crunch, the best indicator of collateral crunch intensity is instead the repo rate. The lower the rate, the greater the crunch.

The wider the spread between Libor and the secured (repo) rate, the greater the general distress in the market. The following chart reveals just how good an indicator of general market stress it is:

 
Also see What the repo markets *want* the ECB to do, specifically the ECB's policy of requiring different levels of haircut for different kinds of collateral:

[W]hile the ECB’s haircut policy might have been seen as prudent at the time, in a single monetary union — where markets are already reflecting preferences for certain types of Eurozone debt — having the ECB treat government collateral differently only intensifes the phenomenon.

The ECB should, by all definitions, treat all government debt the same.

While some of the technical steps the ECB took last week took some pressure of the money markets, they weren't enough. See Nomura on Draghi’s failure to address the collateral problem. Kaminska wrote that bank funding has a greater effect on the perception of the European sovereign solvency [emphasis added]:

[T]here are many reasons to think that the trend towards ‘quality’ collateralised funding is having as much of an impact on the valuation of bonds in both private and central bank funding markets, as the perception that European sovereigns might be insolvent.

This has the makings of a Lehman moment for the European banking system. Here are some of the signs of a imminent bank collapse. First, I would continue to watch for signs of stress in the money market, such as the LIBOR vs. the secured (repo) spread. For investors without access to Bloomberg and other services with money market data, here is a quick and dirty way of watching for signs of rising stress in the banking system.
 
 
The Four Horsemen of the Euro Banking Apocalypse
Watch the stocks of stressed banks. There are four that appear to be under severe stress from a list that I detailed previously here. The first is Commerzbank, which has already undercut its Lehman Crisis 2009 lows and is in the prospect of testing its recent lows as another support level. If that low doesn't hold, then that may be one of the first Signs of the European Banking Apocalypse.
 

 
I would also watch the shares of Credit Agricole, which has also been subject to rumors of severe banking problems.
 

 
Societe Generale, another French bank, has also been the subject of insolvency rumors. In all cases, these banks have undercut their 2009 lows in 2011, but SocGen shares have managed to rally above that level.
 

 
The last one to watch is the shares of Intesa, the Italian bank:
 

 
In all these cases, the shares have fallen below their 2009 Lehman Crisis lows in 2011. In all but one, they are in the process of testing the 2011 lows as the final support - a sort of final trip-wire to a European banking crisis. As many of these stocks trade in ADR form in the US, many of my American may be tempted to monitor the performance of the ADR instead. I would recommend that you watch the euro-denominated price as that is more liquid and I have provided the Yahoo finance link to those prices.
 
There are a number of other troubled bank stocks to watch, but these have not undercut their 2009 lows. In no particular order, these include the Royal Bank of Scotland, KBC, Unicredit, BNP Paribas and Banco Santander.
 
 
 
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.

Forcing the heart attack victim on the treadmill

In a previous post*, I used the analogy of Europe as a heart attack patient:

Imagine that a man (the "eurozone") experiences severe chest pains and looks like he is headed for a heart attack ("Lehman moment"). The protocol is well defined in these circumstances. Take steps to stabilize him ("inject liquidity via the ECB") and then address the causes with a program of diet, exercise and medical treatment ("longer term solutions such as balanced budgets, pro-growth policies, possibly closer fiscal integration, two-speed eurozone, etc."). Berating him about being lazy and overeating ("you lazy Greeks, Italians...") and making him get on the treadmill to work off his Thanksgiving feast ("more austerity and IMF monitors") while he is on the verge of a heart attack ("Lehman like financial crisis") is less than helpful under the circumstances.

If the ECB was supposed to be the Emergency Room doctor, then yesterday's decision by Mario Draghi to rule out further bond purchases was like throwing the patient out on the street with instructions of "take an aspirin and call me in the morning."
 
What's more, the patient's family then gathered around to berate him for his bad habits over the years and forced him to get on the treadmill (the latest Grand Plan for greater fiscal integration) in order to lose weight and improve his health.
 
 
Heart attack time?
The markets promptly responded and Italian 10 year yields shot up an astounding 47 bps.
 

 
European stocks took a similar pounding in the wake of the news:
 

Euro STOXX 50

 
 
Fiscal policy does the heavy lifting
Instead of a combination of fiscal and monetary policy to save the eurozone, we now have to rely purely on fiscal policy. Will a new Brussels-on-the-Rhine, even if it were to be ratified by the eurozone governments, be able to do such heavy lifting without plunging Europe and the rest of the world into a deep recession?
 
There is a tool from The Economist that allows a user to specify economic assumptions, i.e. GDP growth, budget balance, interest rates and inflation, for a country's to see what is needed to stabilize national debt-to-GDP ratios. When I played around with it, getting from A to B looks a tough task once you assume the recessionary effects the combination of an austerity program and credit crunch. (If the tool below doesn't work, try this link instead).
 


The markets had been focused on ECB action to buy the eurocrats some time to fix the long-term problems. Now, we have a credit and liquidity squeeze occurring in the European banking system that is technically insolvent. These issues need to get addressed now.

As I write these words late Thursday night, it appears that the latest Grand Plan is already falling apart. Maybe Merkozy and the eurocrats can pull a rabbit out of the hat, but I am not optimistic.
The markets are going to take this very, very badly.




* In the past, I mistakenly referred to the December 9 EU Summit as the Marseilles summit. It is being held in Brussels. I apologize for the error.


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.

Immigration: The double-edged sword for America

Lately, this blog has been focusing on all Europe, all the time. I wanted to step back and write about something else.

With an election year coming up in the United States, immigration is one of those hot-button issues that has been dividing people. But the electorate has to remember that the immigrant experience is part of the American Dream of rags to riches. The trend toward rising barriers to immigration, legal and otherwise, is also raising barriers to job creation and, longer term, barriers to the nurturing of human capital in America.

Consider this story about the blowback in Alabama's tough stance on illegal aliens without proper documentation:

[T]wo foreign workers with the Mercedes-Benz and Honda auto assembly plants in Alabama have run into problems.

To wit, they were caught without proper drivers' licenses and arrested under Alabama's anti-immigration laws:

On Nov. 16, a German manager with Mercedes-Benz was arrested under the law in Tuscaloosa for not having a driver's license with him while driving a rental car.

First Mercedes, then Honda:

Last week, a Honda employee from Japan was detained under the law in Leeds.

Police at a roadblock found him carrying an international driver's license and passport, but not an Alabama license or Japanese license as required by the law.

Great way to attract employers to locate in your state, guys! Auto assembly plants produce jobs - good paying jobs. Stunts like that give locales a reputation for being difficult to do business.


Where does "American" brain power come from?
One of the sources of American competitiveness has been its human capital, but increasing barriers against immigration is drying up foreign sources of human capital to migrate to its shores. Richard Florida recently wrote:

Since September 11, America’s increased concern with security has threatened to undermine its ability to attract global talent. Foreign-born scientists and engineers provide a critical element of America’s talent base: in the last decade, more than half of all Silicon Valley start-ups were launched by immigrants. In 2007, I warned that by making itself less hospitable to immigrant students, scientists, and entrepreneurs, the United States was undermining its own interests. "What if," I asked, "Vinod Khosla, the co-founder of Sun Microsystems and venture-capital luminary who has backed so many blockbuster companies, had stayed in India? Or if Google’s Sergey Brin had decided to apply his entrepreneurial talents in Europe?"

Many startups, such as Intel and Sun Microsystems, were co-founded by foreigners. True, universities like Stanford and Harvard are still the envy of the world, but as top students find it difficult to go to America to study and to work afterwards, how long before their rankings start to slip. Florida wrote that things are getting so bad that some entrpreneurs are trying to find ways around the system by building a "floating offshore Silicon Valley":

Blueseed, a Silicon Valley start-up, is trying to do an end run around the broken immigration systems by dreaming up a "floating startup incubator." It would circumvent immigration laws the same way that gaming businesses once avoided gambling restrictions, by parking their clients on a ship in international waters.

Has it come to this? Trying to figure out ways to game regulations is not a path to long-term sustainable competitiveness. The New York Times recently reported that Despite Economic Slump, Europe Gets More Tech Start-Ups (h/t FT Alphaville). Is this a tipping point?

Is the American electorate being penny wise and pound foolish when it comes to immigration? Is this another American step towards being Argentina? We shall find out after this electoral cycle.
 
 
 
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.

Many moving parts to this Grand Plan

We have a deal! Bloomberg reports that EU Treaty Rewrite Sought in United Franco-German Crisis Push:

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:

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.

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?
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.

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.

I agree 100%.

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.
 
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.

An upside-down perspective

For a different perspective, it's always useful to look at a stock chart differently. Consider the following chart whose identifying labels have been removed, would you buy this stock?

The pattern certainly looks constructive. The "stock" has certainly been forming a wide saucer base and undergoing an uptrend. Would you buy it?
What about this next one?

This chart of this second "stock" is similar to the first one, except that the pattern is a little better developed inasmuch as it has broken out of resistance and undergoing a classic bullish cup and handle formation.

I don't want to keep everyone in suspense. The first chart is the Euro STOXX 50 viewed upside-down, which is the market's signal of the ongoing problems in the eurozone, and the second is the upside-down chart of the yield on 10-year Treasury Note (TNX), an indicator of the risk-off safety trade. Here I present the original charts, without further comments or annotations.

These charts have mixed messages as to the timing of a break. The inverted chart of TNX suggests that the time to tactically get defensive is now, while the chart of the Euro STOXX 50 indicates a breakdown is more likely in 1Q. Much could happen next week as we approach the Marseilles summit, but many obstacles remain.

My inner investor tells me to be afraid, very afraid. My inner trader tells me to be prepared for volatility in the next two weeks, which will see an ECB meeting, an EU summit and an FOMC meeting. Anything can happen in the short-term.




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.

Here is the contagion!

Despite the liquidity surge engineered by global central banks last week, the problems in the eurozone haven't gone away. In fact, last week the Economist article entitled "Contagion? What contagion? American banks have been strangely immune to Europe’s crisis" rhetorically asked if American banks are insulated from the crisis in Europe:

America’s banks are reasonably healthy. They have significantly bolstered capital since 2008 and now boast core capital of 9% of assets, well above regulatory requirements. While many European banks held dangerous quantities of American mortgages in 2008, American banks today have relatively little exposure to Europe’s troubled sovereigns. For the five biggest, total exposure to Greece, Ireland, Italy, Portugal and Spain (net of hedges) ranges from $16 billion at Citigroup, or 14% of core capital, to $2.5 billion at Goldman Sachs, or less than 5%, according to Peter Nerby of Moody’s, a credit-rating agency. (But if France gets into trouble, that would be a far bigger problem.)

The markets, however, are telling a different story. The relative performance of the BKX, or banking index, shows that the banks remain in a relative downtrend compared to the stock market. Despite last week's uptick, the major relative downtrend is still intact. I wrote back in May 2011 (see On the fence, watching for an Apocalypse) that a violation of relative support (the green line) has been a signal of "rising systemic risk in the financial system that ultimately culminated in market meltdowns". The two previous occasions were the Russia Crisis in 1998 and the Subprime Crisis in 2007.

In addition to the banks, market stresses are also showing up in the broker-dealer stocks and the group has been in a well-defined relative downtrend since the start of 2011.

In a way, the analysis from the Economist is correct. The BKX is highly weighted with the large Too-Big-To-Fail banks, which have greater European exposure through their investment banking arms. By contrast, the regional banks are less exposed to Europe and the relative performance of the regionals have recovered from the banking scare in the Fall.

In the end, there will be few places to hide should the eurozone implode. The article in the Economist closed with the following paragraph [emphasis added]:

On November 30th the Fed, ECB and other central banks sought to rectify this by lowering the spread to 50 basis points. Stockmarkets soared but the euphoria may not last: illiquidity is a symptom of Europe’s crisis, not the cause. As long as sovereigns are at risk of insolvency, their banks are, too. If the euro collapses, the resulting chaos will not spare America’s economy, despite the health of its banks.

Commerzbank the first domino?
Indeed, cracks are appearing again in the European banking system. Mish reported that Germany is considering the nationalization of Commerzbank. Readers may recall that last week, I identified Commerzbank as one of the "canaries in the coalmine" of European stress (see Tripwires to a market crash):

While the shares of the Commerzbank rallied last week, they remain in a downtrend that began in April 2011 and the stock price has descended below the lows of 2009 - which is another indication of imminent market stress.

The failure of a bank like Commerzbank will be as big as Dexia. The latest interim report from the bank shows their balance sheet to have €738.2 billion in size and €244.2 billion in risk-weighted assets. By comparison, the August 2011 (pre-collapse) report from Dexia showed risk-weighted assets at €127.0 billion. As I also pointed out in my post, other major banks are at risk to follow, namely Credit Agricole, Societe Generale, KBC, RBS, Intesa, Unicredit and Santander.

Merkozy better unveil an immediate solution at the Dec 9 Marseilles summit, instead of a plan to have a plan (e.g. rewriting treaties will be a long involved process, etc.) Events like a Commerzbank failure may catch up with them quicker than anyone thinks.




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.

Can the ECB and IMF save Italy?

The markets have been reacting this morning to the news of a joint ECB and IMF plan to save the eurozone. According to Bloomberg:

A European proposal to channel central bank loans through the International Monetary Fund may deliver as much as 200 billion euros ($270 billion) to fight the debt crisis, two people familiar with the negotiations said.

Here's how the plan would work:

Under the proposal, national central banks would recycle funds through the IMF, potentially to underwrite precautionary lending programs for Italy or Spain, the two countries judged to be the most vulnerable now, the people said.

“We’re looking for a maximum reinforcement with the IMF and the central bank,” Belgian Finance Ministers Didier Reynders told reporters Nov. 30.

I was hopeful that such a plan might work, but recently STRATFOR (subscription required) poured cold water on the idea of an IMF rescue of Italy [emphasis added]:

The IMF normally operates by a tranche-and-reform model. The bailout money is provided in chunks, and each chunk is given only after specific defined and monitored reforms are implemented. This grants the IMF leverage over the state in question to ensure that the agreed-upon reforms are not only crafted, but implemented and stuck with for the duration. Otherwise the ward is cut off, as Belarus has recently been.

Italy’s problem is more than just simply needing cash. Italy isn’t just facing an immediate funding crunch like most IMF wards. It has a preexisting debt stock that’s about 120 percent of GDP — it’s unserviceable, and Italy faces billions in maturing debt that must be refinanced on a monthly, and sometimes even a weekly, basis — 300 billion in refinancing needs in the first half of 2012 alone.

Were the Fund to become involved, it would have to intervene regularly in the bond markets to keep Italian yields down. Such proactive activity is not only not within the existing skill sets of IMF staff, it would deny the Fund the leverage over Rome that it needs to make the reforms stick.

Bruce Krasting, in response to the now denied rumor of the IMF rescue of Italy, wrote that the credit markets might not react well to such an outcome:

In the real world of global finance the reality is that any country that is forced to accept an IMF bailout is also blocked from issuing debt in the public markets. IMF (or other supranational debt) is ALWAYS senior to other indebtedness of the country. That’s just the way it works. When Italy borrows money from the IMF it automatically subordinates the existing creditors. Lenders hate this. They will vote with their feet and take a pass at Italian new debt issuance for a long time to come. Once the process starts, it will not end. There will be a snow ball of other creditors. That's exactly what happened in the 80's when Mexico failed; within a year two dozen other countries were forced to their debt knees. (I had a front row seat.)

There are no doubt many versions of the Grand Plans. If a resolution to the eurozone crisis was easy and relatively painless, it would have been done by now.

The devil is in the details.



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.

All eyes on the Marseilles summit

Eurocrats seem to be in a cycle of crisis, followed by a summit that produces a half-baked plan, only to be followed by a crisis later. The next EU summit occurs on December 9 in Marseilles and the world will be watching to see what kind of solutions the eurocrats have cooked up next.

I previously used the medical analogy of the pending heart attack:

Imagine that a man (the "eurozone") experiences severe chest pains and looks like he is headed for a heart attack ("Lehman moment"). The protocol is well defined in these circumstances. Take steps to stabilize him ("inject liquidity via the ECB") and then address the causes with a program of diet, exercise and medical treatment ("longer term solutions such as balanced budgets, pro-growth policies, possibly closer fiscal integration, two-speed eurozone, etc."). Berating him about being lazy and overeating ("you lazy Greeks, Italians...") and making him get on the treadmill to work off his Thanksgiving feast ("more austerity and IMF monitors") while he is on the verge of a heart attack ("Lehman like financial crisis") is less than helpful under the circumstances.

Coordinated global central bank intervention has stabilized the patient for now, but the longer term problems still need to be solved.



The ECB lays down the law
The outlines of the Grand Plan (what version are we on now?) came from Mario Draghi yesterday, when he gave a speech to the European Parliament. First, he held out the carrot of intervention using "non-standard measures" [emphasis added]:

As you know, the ECB’s monetary policy is constantly guided by the goal of maintaining price stability in the euro area over the medium term. And when I say this, I mean price stability in either direction. This applies to both the setting of official interest rates and the implementation of non-standard measures.

By "either direction", he meant that the ECB is aware of the risks of undershoot, as well as overshoot to the inflation rate. Should deflation set in, Draghi signaled that the Bank is willing to act. He then laid out the preconditions for the ECB to act:, namely closer fiscal integration within the eurozone:

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.

Draghi wants rules to be enforceable:

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.

In return, he hinted that the ECB is willing to act to stabilize markets, but "sequencing matter":

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

This speech should not be a surprise. I pointed out on October 17 (see A framework for assessing a eurozone rescue) that the ECB is politically untouchable and had its own agenda. This analysis showed the top of ECB's wish list is a set of "bulletproof fiscal constraints on euro area members":

The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.

Brussels-on-the-Rhine: The devil in the details
In recent days, the news has been full of stories of how the Germans and French are working for a plan for closer fiscal integration, or a set of "bulletproof fiscal constraints on euro area members" (see one example here). As usual, the devil is in the details.
 
There are several ways of tackling the problem. One way is to agree to some form of fiscal integration within the 17 eurozone countries, with the carrot of some form of eurobond that can be issued by this Brussels-on-the-Rhine. The stick would be a form of supervisory control, or receivership, should a member state miss its targets.

Imagine the kind of reaction that would set off in the streets of Athens, Lisbon, Dublin, Madrid, etc. (Maybe they should sign the papers inaugurating the new Brussels-in-the-Rhine agency in the little railway car at Versailles?) Such a move would require treaty re-negotiations and likely constitutional change at the member state level as individual countries would be ceding fiscal authority to some supra-national agency. Negotiations are going to be ugly. Already, Ireland has demanded debt relief as the quid pro quo for treaty changes. What would the other countries like? Perhaps a pony too?

If the eurocrats were to choose to go this route of fiscal integration with all of the 17 eurozone countries, then watch for some language in the proposal for exit from the eurozone to be used as a stick to beat the non-compliant countries. The risk is the blowback from a possible bank run should a member state leave the eurozone and devalue its new currency. John Hempton describes what might happen if Greece pulled an Argentina:

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.


And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.

Within a week, they will have nuked the banking system in the peripheral countries.


A two-speed eurozone?
What about a two-speed eurozone with "voluntary" participation in fiscal integration. While that may stabilize the "in" countries, what about the "out" countries? Supposing that Athens refuses to submit to monitors from the Wehrmacht new Brussels-on-the-Rhine, what then? If Greece was to find its debt unsustainable and default, aren't we back to where we started?

OK, let's go back to the drawing board.

For now, all eyes are on the Marseilles summit. Angela Merkel appears to have dug in her heels and is adamantly against ECB intervention, preferring to see a Brussels-on-the-Rhine solution. We will have to see if the eurocrats can put together something better than another half-baked plan. Given the obstacles involved, I am not optimistic.



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.