Monday, October 31, 2011

Defying gravity

Something has changed within me
Something is not the same
I'm through with playing by the rules
Of someone else's game

Too late for second-guessing
Too late to go back to sleep
It's time to trust my instincts
Close my eyes: and leap!

It's time to try defying gravity
I think I'll try defying gravity
And you can't pull me down!

- Defying Gravity lyrics, from Wicked

The rally in risky assets in reaction to the EU Grand Rescue Plan was awesome to behold as the risky assets seemed to defy gravity despite grave concerns expressed by analysts over the details of the plan. The rally has unleashed a tsuanmi of positive price momentum. However, medium term concerns from cyclical indicators, measures of risk aversion and macro concerns over the sustainability of the eurozone "fix" leaves me to believe that we are undergoing a consolidation phase with an upward bias in the next few months.

I would be inclined to become more cautious about the outlook for equities and other risky assets in the 1Q and 2Q of 2012. My Inflation-Deflation Timer Model agrees with this assessment and has moved to a "neutral" from a "deflation" reading, which would orient the model portfolio from a bond heavy tilt to a more balanced weighting between stocks and bonds.

In the meantime, enjoy the spectacle of stocks defying macro-risk gravity.


Powerful momentum
To see how powerful the momentum is, you just have to look at the chart of the SPX. It shows that the index not only rallied through a downtrend line, but through resistance at the 1260 level and the 200 day moving average. Does this mean that the tide has turned and it's now up, up and away from now on?


Charts from a number of major equity averages around the world seem to suggest that bullish view. The FTSE 100 shows a similar pattern of a rally to test the 200 day moving average.


Even the Euro STOXX 50 shows a pattern of a turnaround. It broke through a downtrend line and the index is now in a minor uptrend, though the rally hasn't quite reached the 200 day moving average yet.


Moving eastward, even the Hang Seng Index has shown a pattern of strength by rallying through an important multi-year resistance zone.



Cyclical red flags
While the short-term momentum has been impressive, cyclical indicators are not sounding the all clear signal just yet. The resource-heavy and cyclically oriented Canadian equity market is showing a pattern of a rally through a short-term downtrend, but the longer term downtrend remains intact.


Commodities are also telling a similar story of a counter-trend rally within a longer term downtrend.


The Shanghai Composite isn't looking as healthy as Hong Kong or the other major equity averages around the world as it is struggling at the site of the 50 day moving average as well as a major resistance zone.


Inter-market analysis confirms my cyclical concerns. The relative performance of the Morgan Stanley Cyclical Index against the market also shows a pattern of a counter-trend rally within the context of a longer term relative downtrend.



Risk appetite returns, but...
Measures of risk appetite are also telling a similar story of a retracement within a longer term downtrend. Consider, for example, the performance of the NASDAQ Composite against the large cap NASDAQ 100. The ratio rallied through a relative downtrend line, but it has barely retraced much of the technical damage done when the risk aversion trade began in July. This chart suggest to me that the current rally has further to go, but a more realistic expectation would be a period of sideways consolidation with an upward bias. Longer term, this trade has the potential to go down further.


The relative performance of JNK (junk bonds) against IEF (7-10 year Treasuries) also show a similar pattern of rally through a short-term downtrend, but the longer term downtrend remains intact.



Macro concerns
On the macro-economic front, grave concerns remain. I detailed in my last post some of the concerns over weakness of the eurozone rescue plan (with new comments in brackets):
  • European banks could send Europe into a deep recession. I wrote before that banks are asked to recapitalize to the tune of €100 billion, but the total market float of these banks is about €200 billion. Any plan that raises that much equity in such a short time will crater bank stocks. Bank CEOs have the alternative of getting to their 9% target by calling in loans, which would create a credit crunch that sends Europe into a deep recession.
  • How good is the EFSF monocline insurance guarantee? Individual EU states are only guaranteeing their contribution the EFSF and have not actually funded their portion of the contribution. So when the EFSF insurance scheme “guarantees” the first 20% of a Spanish bond, part of the guarantee comes from Spain. If Spain were to get into trouble, can investors depend on the Spanish guarantee? In that light, how big is the real size of the EFSF monoline insurance scheme? [In addition, the WSJ also asked a very good question about regulatory risk surrounding the EFSF: "If Greek CDS don't trigger, why would EFSF?"]
  • EFSF insured bonds create a two-tiered bond market in Europe. What will happen to currently outstanding bonds of troubled countries should there another credit event with, say, Portuguese bonds? [That appears to be less of a concern as the EFSF has indicated that credit protection will be detachable from the new bonds issued with such protection.]
  • Greece is still struggling under the burden of an enormous debt. Even with the “voluntary” haircut, Greek debt will be 120% of GDP, which is above the 100% 90% of GDP benchmark that most analysts Rogoff and Reinhart consider to be a sustainable level for sovereign debt. Will Greece have to come to the table again for relief in the future?
  • Could Portugal be the next Greece? The Portuguese debt burden does not appear to be sustainable and many analysts believe that Portugal is the next Greece. This deal only grants relief to Greece and does not put a sufficient ring-fence around the other peripheral countries. The current prescription of more austerity is only likely, in the short-run, to exacerbate budget deficits and send fragile EU member state budgets like Portugal and Italy over the edge. [Already, Portugal is showing signs of unraveling and going down the Grecian path.]
  • What does the EU do when Portugal or Ireland asks for debt relief? When they rescued their banks in 2008-9, the Irish understood that they would be offered the same deal as Greece if there was a deal to be done on debt relief. Already, the Irish are seeking some form of debt relief. How will the EU respond?
Add these concerns to the European worry list:
  • Pressures are showing up again in the bond market. The Italian bond auction on Friday did not go well. 10-year yields surged to new highs at 6.06% and they sold only €7.93 billion of bonds, which was under the €8.5 billion maximum.
  • The EFSF's AAA credit rating depends on the French AAA. The WSJ reported that Standard and Poors has affirmed the EFSF AAA rating, but that rating depends on the credit rating of contributing member states, several of which have been downgraded recently. This puts incredible pressure on France to retain its AAA rating.
  • Will ISDA declare the *cough* "voluntary" haircut to be a credit event? The beleaguered ISDA has a hard decision to make. It certainly walks like like a duck and quacks like a duck, but will it declare the "voluntary" haircut to be a default credit event and trigger all the credit default swaps sold on Greek debt and throw the global financial system into turmoil? Fitch has already weighed in stated that they believe that the "voluntary" 50% haircut and debt exchange would constitute a default. Macro Man has likened the discussion with the ISDA to the Monty Python dead parrot. Here is an excerpt (for full details click on Macro Man link above):
"I wish to complain about this CDS what I purchased not half a year ago from this very investment bank"
"Oh yes, the Hellenic Republic... What's wrong with it?"
"It's not paid out, that's what's wrong with it."
"No, no, it's just voluntary, look."
"Look my lad, I know a dead product when I see one, and I'm looking at one right now"
"No, no, it's not dead, it's just voluntary."
"Voluntary?!"
"Yeah... remarkable product, Sovereign CDS... beautiful name, innit?"
"The name don't enter into it. It's not paid out."
"Nah, nah... it's voluntary"
To put it all into context, here is what STRATFOR, writing before the Grand Rescue Plan was announced, thought about how Europe would resolve its Greek problem:



All roads lead to *ahem* Rome. I guess that's why George Soros thinks that the current rescue plan will hold together between "one day and three months".


The trouble doesn't stop in Europe
Meanwhile, there are signs of trouble in China. Consider:
Last but not least, we have a looming recession in the US. In addition, the Super Committee to reduce the budget deficit appears to be deadlocked, and Merrill Lynch analyst Ethan Harris believes that inaction may prompt a credit rating downgrade of US debt by either Fitch or Moody's.

Ouch!


Don't forget the policy response
To investors who see these macro risks as dire warnings of a calamity, I would say, "Don't forget to think about the policy response."

I wrote that central bankers are planning a party and I believe that's what the markets are beginning to discount. Elements of the Federal Reserve are pushing for QE3 in the form of MBS purchases and there appear to be good reasons to undertake such a step.

Incoming ECB head Mario Draghi also signaled a subtle change in ECB policy last Wednesday by supporting the continuation the program of sovereign debt purchases, which was supposed to be temporary and discontinued when the EFSF comes into being. This represents the first step in a slippery slope to ECB quantitative easing, and even permabear Albert Edwards believes that ECB will eventually be forced to embrace QE. One key test of the direction of the Draghi ECB is its interest rate decision this Thursday.

In China, the authorities are getting ready for a policy of selective stimulus by cutting reserve requirements. The Chinese have maintained a policy of either stomping on the accelerator or stomping on the brakes. This latest move is a signal that they may be taking the foot off the brake and they are starting to step on the accelerator again.

While I recognize that the macro risks are enormous, but do you want to take the chance and step in front of a trillion or two of central bank stimulus?


Sideways consolidation with an upward bias
If asked to give an opinion as to future market direction, I would have to say that your stance would depend on your time horizon. Given the tremendous bullish momentum shown by equities last week and the technical damage done to the bearish case, my inner trader would say that in the short-term, his best guess is a sideways consolidation with an upward bias. The bull case is underpinned by the fact that we are moving into a period of positive seasonality and the likelihood that the markets start to discount the possibility of Fed and ECB intervention.

Watch the FOMC statement and Bernanke press conference this week for language that tilts towards another form of QE, or under what circumstances they would become more stimulative. Also watch the ECB decision Thursday. If either central bank shows signs of further accommodation, then the news could spark off another melt-up in equity prices.

My inner investor, on the other hand, believes that in the medium term, the eurozone Grand Rescue Plan is deeply flawed at many levels. Moreover, if the Fed does not signal that it is tilting towards greater accommodation by its December meeting, then the markets could be in for a rude shock should the economy start to slide into a recession. Early next year, Portugal could blow up and become the next Greece. Ireland may kick up a fuss and demand debt relief. There is also the dynamics of the French presidential election in the spring, which could create further volatility in the markets.

Those are things to worry about in 1Q or 2Q. Meanwhile, enjoy the rally.


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.

Friday, October 28, 2011

Central bankers plan a party

So now we have the EU Grand Rescue Plan. I wrote before that the success of any short-term rescue plan depend on the cooperation of the EU, the ECB and the Greek Street. (Also see Ambrose Evans-Pritchard's comment: Europe's grand gamble risks failure without ECB). I believe that the plan is deeply flawed for many reasons and only kicks the can down the road for a few months, but the key its short-term success is the cooperation of the European Central Bank.

In a "separate" statement yesterday, Mario Draghi said that he would support continuing the ECB's program to buy the sovereign bonds of periphery countries. This program was supposed to be temporary and end when the EFSF came into being. Such a statement is an important signal that a Draghi ECB is more pragmatic and more likely to print money if conditions warranted. Even permabear Albert Edwards believes that ECB will eventually be forced to engage in quantitative easing.

Great, so the ECB is on board, which should alleviate short-term pressures. There are, nevertheless, some major problems with the Grand Rescue Plan:
  • European banks could send Europe into a deep recession. I wrote before that banks are asked to recapitalize to the tune of €100 billion, but the total market float of these banks is about €200 billion. Any plan that raises that much equity in such a short time will crater bank stocks. Bank CEOs have the alternative of getting to their 9% target by calling in loans, which would create a credit crunch that sends Europe into a deep recession.
  • How good is the EFSF monocline insurance guarantee? Individual EU states are only guaranteeing their contribution the EFSF and have not actually funded their portion of the contribution. So when the EFSF insurance scheme “guarantees” the first 20% of a Spanish bond, part of the guarantee comes from Spain. If Spain were to get into trouble, can investors depend on the Spanish guarantee? In that light, how big is the real size of the EFSF monoline insurance scheme?
  • EFSF insured bonds create a two-tiered bond market in Europe. What will happen to currently outstanding bonds of troubled countries should there another credit event with, say, Portuguese bonds?
  • Greece is still struggling under the burden of an enormous debt. Even with the “voluntary” haircut, Greek debt will be 120% of GDP, which is above the 100% of GDP benchmark that most analysts consider to be a sustainable level for sovereign debt. Will Greece have to come to the table again for relief in the future?
  • Could Portugal be the next Greece? The Portuguese debt burden does not appear to be sustainable and many analysts believe that Portugal is the next Greece. This deal only grants relief to Greece and does not put a sufficient ring-fence around the other peripheral countries. The current prescription of more austerity is only likely, in the short-run, to exacerbate budget deficits and send fragile EU member state budgets like Portugal and Italy over the edge.
  • What does the EU do when Portugal or Ireland asks for debt relief? When they rescued their banks in 2008-9, the Irish understood that they would be offered the same deal as Greece if there was a deal to be done on debt relief. Already, the Irish are seeking some form of debt relief. How will the EU respond?
In brief, the participation of the ECB in the Grand Rescue Plan has put the immediate fear of a calamity on hold and kicked the can down the road. That road has many land mines, which I have outlined, and one of those land mines is likely to blow up in faces in the next few months.


Let's party like it's 2009!
In the meantime, the ECB appears to be planning a party. In addition, elements within the Federal Reserve have indicated that they support a form of QE3 in the form of large MBS purchases. As well, China also signaled that they are getting ready with selective forms of stimulus by cutting bank reserve requirements.

My inner trader is positively giddy at the prospect of central bank parties. He agrees with the sentiments of Cullen Roche of Pragmatic Capitalism, "Don't fade government intervention." Just look at the last party that was sparked by QE2. These parties tend to push the price of stocks and other risky assets to significantly higher levels. He says, "Don't worry, be happy."

My inner investors is prepared to show his face at the party, just to be friendly, but he is wary of the cops who are prepared to raid the party and he knows that they are lurking on the next block. This party may last for 2-4 months, but the downside risk is considerable should we see another policy mistake or market accident. He agrees with the analysis of Barry Ritholz, who wrote these words before the melt-up rally yesterday:
[Y]our posture is dramatically impacted by your time frame. If you are looking out 1-3 months, you are probably bullish. If your outlook is measured in 6-12 months, you might be less sanguine. And the time between is anyone’s guess . . .





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.

Tuesday, October 25, 2011

The poisoned bank recap chalice

We don't have the full details of the eurozone Grand Plan to be unveiled on Wednesday, but some details are clear. One of the key components of the proposal is to force a number of major European banks to recapitalize their capital base to 9% within a relatively short period. Banks would be encouraged to seek capital privately first. If that is not available, the bank could then turn to the individual member state, and failing that, to the EFSF.

This is a version of the Swedish solution, whereby shareholders and bondholders take the first hit in any recapitalization before the state injects equity. I have long been an advocate of this approach, but even that proposal needs a re-think. That's because the eurozone problem stems from too much sovereign debt accumulated by a number of EU member states and much of that debt was stuffed into eurozone banks. So the solution of the state rescuing the banks who lent the state too much money becomes a circular problem of trying to insure yourself.

What's more, the spectacle of EU states trying to rescue themselves has become too big. John Hussman put some scale to the size of the problem this week [emphasis added]:
My guess is that European leaders will force a bank recapitalization within days - probably 100 billion euros, preferably 200 billion, but the larger number is doubtful because at present market values, European banks would have to sell new shares in nearly the same quantity as their current outstanding float in order to acquire the new capital. Yet Stratfor correctly notes that even in the event of a 200 billion recapitalization, a 50% haircut on Greek debt "would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder." So a good chunk of the present EFSF could end up recapitalizing banks, especially if too little is raised from private investors. This would leave little ammunition against any further strains, should they develop.
The current rumor is that size of the forced bank recapitalization will be about  €108 billion, which would be roughly half the value of market float at current prices. Bank CEOs who are incentivized by their share prices would be highly reluctant to go to the market and dilute their equity base by being a forced seller. By demanding that banks recapitalize quickly, the risks is that banks shrink their balance sheet by calling in loans in order to conform with the 9% capital target. This would result in an old-fashioned credit crunch, and in the face of the latest European PMI already pointing to recessionary conditions, such a policy would topple Europe's fragile economy into a deeper abyss.


€2 trillion = 20% of global FX reserves
If those aren't the solutions, then where else could the EU get the money? I wrote on Sunday that Europe has three choices:
  • Get more money internally from the strong states within the EU such as Germany;
  • Get more money externally, e.g. the US or BRIC countries; or
  • The ECB prints the money.
Given that Merkel is already on thin ice by asking the Bundestag to approve the latest EFSF proposals, the prospect of more funds from Germany is off the table. What about the United States, BRIC and Gulf State SWFs? While stories such as Norway's SWF is ready to invest are helpful, STRATFOR (sorry no link) put the scale of the problem into context:
[T]o put the magnitude of Europe’s crisis in context, it would take nearly 20 percent of the worlds accumulated foreign exchange reserves to account for the approximately 2 trillion euros needed to contain the EU debt crisis for a mere 3 years. The unlikelihood of such funds materializing is compounded by the fact that most of the foreign currency reserves are held by low-income countries with little political room to bail out one of the world’s wealthiest economic zones.
The kinds of shock-and-awe eurozone rescue figures that have been bandied about have been in the order of €2 trillion, which amounts to roughly 20% of global foreign exchange reserves? China has already signaled its reluctance to step up and help in a meaningful way. How likely are the other emerging market countries come to the rescue?

In short, forcing European banks to drink from the poisoned bank recapitalization chalice today could the policy mistake that plunges Europe and the world into a synchronized global slowdown. Don't expect other players, such as the IMF or emerging market economies to come to the rescue because the scale of the problem is just too big.

I guess it's all up to Super Mario now.



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.

Monday, October 24, 2011

An underwhelming summit unveils the dead euro-parrot

If this is a Monday, then it's time to read the news from the euro summit of the week from the weekend. The news appears to be highly underwhelming. Bruno Waterfield of the Telegraph reports that the level of disunity has increased and panic is setting in. First came the bombshell [emphasis added]:
[A] new bombshell hit as a joint report by the EU and the International Monetary Fund (IMF) warned that, without a default, the Greek debt crisis alone could swallow the eurozone's entire €440 billion bailout fund - leaving nothing to spare to help the affected banks of Italy, Spain or France.
What's more, the IMF is now adding a condition of a 50% Greek debt haircut to its commitment to help the eurozone:
The IMF would no longer be willing to pick up a third of the total bill for rescuing Greece, a contribution worth €73 billion, unless European banks were prepared to write off 50 per cent of Greek debt.
Personal relationships are breaking down:
Interpersonal relations between eurozone leaders have hit an all-time low, reflecting sharp disagreements between Germany and France over using the ECB to bailout the euro and presenting an additional obstacle to finding a "grand solution" to Europe's debt crisis.
 
Nicolas Sarkozy's "two faced" personality has been cited as a major factor in his dysfunctional relationship with Angela Merkel. 
The rift between Berlin and Paris is growing:
A row between the pair [Merkel and Sarkozy] in Frankfurt on Wednesday overshadowed leaving-do celebrations to mark the end of Jean-Claude Trichet's nine years as the head of the ECB.

"Their shouting could be heard down the corridor in the concert hall where an orchestra was about to play the EU's anthem, Ode to Joy," said an incredulous EU official.
While a certain amount of animosity can be expected when the horse trading happens, but this scene of euro disintegration is beyond the pale.


Merkel: "Trust us"
So what was accomplished over the weekend?

Reuters reports that Angela Merkel, who has become quite accomplished at playing the press, stated that "she expected a breakthrough in efforts to come up with a comprehensive response to the euro zone debt crisis on Wednesday". Will the markets focus on the assurances of a "breakthrough" and a "comprehensive response"? (Is a "comprehensive response" a backtrack from last week's announcement of an "ambitious solution"?)

In what few details there came out, a bigger role for the ECB has been ruled out, which is a disappointment as I wrote last week that for any plan to succeed, the ECB has to agree to a bigger role which involves quantitative easing. Further to my last post on this topic, the Economist agreed and wrote that "the single currency’s future will hinge on whether Mr Draghi is brave enough to be radical."

In addition, Italy has been pressed by her EU partners to get her fiscal house in order. Just watch the body language in the video of the Merkozy press conference when they are asked about Italy. This news is not exactly helpful to the nervous bond market as the 10-year Italy-Bund yield spread is already blowing out:


It appears that European banks will be forced to raise their capital within a very short time. In this interview with Gillian Tett of the FT, Larry Fink of Blackrock expressed his concerns that forcing banks to conform to such capital ratios in such a short time creates incentives for banks to shrink balance sheets, which would plunge Europe into a deeper recession when it can least afford to do so.


This parrot is dead
Last week, equities were in rally mode as they focused on the positive news in Europe and as I write this, ES futures are flashing green. The fact of the matter is, this euro-parrot is dead. We can either accept it now, or wait until Wednesday to find out the grisly news.

The sooner market participants move from denial to acceptance, the better.



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.

Sunday, October 23, 2011

Listen to which market?

One of the tenets of technical analysis is, "Listen to the markets." When US equities broke out to the upside on Friday, many traders sat up and took notice. True, stocks also had a failed downside thrust when it violated resistance recently, but the current move certainly shows that the bulls have the upper hand.


But which market should traders listen to? The stock market which just staged an upside breakout? What about the bond market, which shows 10-year Italian-Bund spreads rising to challenge the 4% new high level, which signals rising systemic risk in Europe?

What about the message that economically sensitive Dr. Copper is sending?



My inner bull and bear debate
My inner bull tells me that to relax and it's time to get long risky asset for the following reasons:
  • 3Q Earnings Seasons has been coming in relatively strongly.
  • Most economic indicators for the US have been surprising to the upside.
  • Even if the economy were to weaken, the Fed is getting ready for QE3. Last week, a number of Fed officials have advocated more large scale MBS purchases. As well, the FOMC minutes of the latest meeting show that two members of the policy committee “said that current conditions and the outlook could justify stronger policy action.”
  • Stocks are reacting more strongly to good news from Europe than bad news, which is an indication that the market is ready to rise. The announcement last week that this weekend's meeting was not going to produce a definitive agreement and that a second meeting on Wednesday October 26 should have been terrible news and the markets should have cratered. While they did decline between 1% and 1.5% on the news, they rallied strongly when Merkozy stated that they would produce an "ambitious" rescue plan.
  • China is showing that she is standing by her banks in order to cushion any soft patches in the economy when a SWF indicated that it would buy more shares of the big four Chinese banks. The Economist interpreted the move as a form of confidence building:
These purchases were significant not for what they said about the banks, but for what they revealed about their owner. They signalled that China’s government will act, if necessary, to shore up the economy and the banks if a sharp slowdown takes hold. It purchased bank shares (on a far bigger scale) in September 2008, the first of a flurry of rescue measures, culminating in a big stimulus package two months later.

It all depends on Europe...
My inner bear points to the headline of Schaeffer's Research note which says it all: Despite technical feats, bulls remain at the mercy of Europe. Last week, I wrote about a framework for assessing a eurozone rescue plan and later tried to assess the probable eurozone Grand Plan, which was a form of best case analysis.

In brief, the eurozone's problem is a problem of excessive sovereign debt by a number of EU member states and much of the debt was stuffed inside eurozone banks. So trying to rescue either the banks or individual states becomes a circular problem. You can't take on more debt to rescue yourself. The money has to come from somewhere. The eurozone has three options:
  • Get more money internally from the strong states within the EU such as Germany;
  • Get more money externally, e.g. the US or BRIC countries; or
  • The ECB prints the money.
The Germans are currently balking at writing a big cheque to bail out their Greek cousins as they eye their Portuguese and Irish cousins standing outside the door. That's why I wrote that for any Grand Plan to succeed, both the EU's Grand Plan has to be credible AND the ECB has to cooperate and state that they will undertake to print sufficient amounts to reflate Greece and the other peripheral countries, whether that's €1 trillion or €5 trillion.

Right now, my inner bear says that the equity market is focusing on the EU Grand Plan. Most versions of the Grand Plan that have been floated are useful, but flawed in some degree, but the fact remains the ECB has to an about face and agree to quantitative easing on a massive scale. Moreover, my anecdotal sources tell me that the Europeans on the Continent see this crisis as a same old, same old crisis where the Eurocrats will work it all out in the end. A Goldman Sachs report (via ZH) confirms this view:
  • Investor sentiment and intraday market action remain focused on news flow and speculation regarding policy developments in Europe. Our meetings with clients in the US, UK, and continental Europe during the past two weeks revealed a clear delineation between the views of those located in Europe and those looking towards Europe. Investors continue to vote with their feet as evidenced by mutual fund outflows and smaller net equity futures positions since the end of July.
  • Investors “on the continent” are more composed about the direction and pace of policy decisions. Perhaps reflecting a home field advantage in understanding the region’s culture and politics, local investors are less anxious that periphery countries ultimately will receive support and less concerned about the day-to-day public conjecture. One worrying takeaway is that European politicians seem less sensitive to swings in asset prices and thus may be more tolerant of declines than in other regions of the world.
  • Investors outside Europe are far more worried about potential policy solutions and the cumulative impact of a drawn-out resolution. Clients in the UK and US were more negative than those in Europe particularly around the methodical nature of the debate. There is genuine concern among this group that growth, financial conditions and the total cost of resolution are negatively impacted each passing day. Outsiders are also acutely concerned about the impact of fiscal tightening in Italy, Spain and Greece will have on economic growth and place a higher probability on a break-up of the euro than “locals.”

In a numerous discussions with equity analysts and investors in North America, my inner bear would also say that the majority aren't aware of many of the issues surrounding the eurozone crisis and therefore they are inclined to react to the headlines, such as the circularity of trying to rescue yourself with more debt, whether it's through EFSF as a monoline insurer or any other scheme. In effect, the upside breakout by US equities is a fake-out, not the start of a true bull phase. That's also the message of the European bond markets, which is more used to pricing default risk, as they pushed the 10-year Italy-Bund spread to 4%.

A looming American recession?
The message from Dr. Copper and other commodity prices are also signaling a weak global economy. Unlike the breakout seen in equities, the chart of the CRB Index shown below indicates that the gap from late September was filled but commodities continue to show weakness. These are not signs of a reviving economy.


As for the better than expected economic numbers and reports from 3Q earnings, John Hussman recently defended the ECRI recession call:
From my perspective, Wall Street's "relief" about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI's own (and historically reliable) set of indicators, "We've entered a vicious cycle, and it's too late: a recession can't be averted." Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.

The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a "denial" phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession ), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high.
 
Tinfoil hat time?
I am inclined to tilt towards the views of my inner bear because inter-market analysis is not confirming the upside breakout, though I am listening to the message of my inner bull. There is, however, a far-out alternative hypothesis that could prove my inner bull right.
 
The European who are sanguine about this crisis are right. There is a Grand Plan that's already been decided by the eurocrats. Anecdotal evidence suggests that many German bureaucrats understand that the ultimate solution is to allow the ECB to go nuclear and print money like Helicopter Ben and having Mario Draghi at the head of the ECB gives them political cover to blame the Italian. The objections of the Old Guard, who will still remember the hyperinflation era of the Weimar Republic and will brook no discussion about any form of reflationary policy, will eventually be overcome. What you see in the news is just posturing by various parties playing to their own constituencies but the True Grand Plan will be revealed in the near future.
 
This is getting so far into tinfoil hat territory that I am not sure what to say.
 
 
 
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.

Wednesday, October 19, 2011

Assessing the probable eurozone Grand Plan

As the financial world waits the results of Sunday's yet-another-euro-summit, there have been enough leaks and trial balloons that we know the approximate shape of the approximate shape of the plan. So let me look at the anticipated Grand Plan to assess it in the context of the framework that I had outlined earlier in the week.


The "Grand Plan"
Here is my draft of the "Grand Plan".

Preamble: We are committed to keeping the eurozone together. Greece is a special case and we will take steps to alleviate the pressures on Greece and other peripheral countries in order to put them on sustainable path to growth. At the same time, we will undertake steps to ring-fence the financial problems stemming from Greece so that the financial contagion does not spread to other member states. With that in mind, we will implement the following five point plan.
  1. The EFSF will become a bond insurance program, insuring the first 20% of the debt of any eurozone member that wishes to participate in the program. Member states that wish to use EFSF insurance will pay a fee of X% to the EFSF for that privilege. Thus, the capacity of the EFSF will expand from €440 billion to €2.2 trillion.
  2. We will offer any holder of Greek bonds a voluntary exchange: Take a 50% haircut on your paper and in return you will get an EFSF insured Greek bond of some long maturity.
  3. European banks will be required to re-capitalize to 9% of Tier 1 capital. Banks are urged to seek private sector solutions to recapitalize to the target ratios, but those that cannot will be offered equity injections from member states (i.e. the German solution).
  4. A Tobin tax will be imposed on financial transactions, either in the EU or the eurozone, in order to finance this scheme.
  5. The ECB stands ready to provide any level of liquidity to the banking system. Banks can go to the ECB for unlimited loans, collateralized by the "qualifying debt" issued by member states. The ECB continues to be mindful of its anti-inflation mandate and opposes any form of quantitative easing.


Market disappointment
If that is indeed the Plan, then it will be hugely disappointing to the market. While the €2.2 trillion figure is large enough to shock and awe the market, many of its other features of are problematical.

Let's go through them one by one.


EFSF insurance: The devil in the details
First of all, the EFSF insurance program is likely to burden France to such a degree that it will likely lose its coveted AAA credit rating. Moody's is already watching France closely (and not in a good way). Here is Ambrose Evans-Pritchard of the Telegraph:
Professor Ansgar Belke, from Berlin's DIW Institute, said any leveraging of the EFSF would be "poisonous" for France’s AAA rating and would set off an uncontrollable chain of events.

"It counteracts all efforts made so far to stabilize the eurozone debt crisis, which are premised on the AAA rating of a sufficiently large number of strong economies. In extremis, it would probably cause the break-up of the eurozone", he told Handlesblatt.

France is already vulnerable. It has the worst budget deficit and primary deficit of the AAA states in Euroland. (Yes, Britain is worse, but the UK has a sovereign currency and central bank. Chalk and cheese.)

Dr Belke said France is already under pressure. BNP Paribas, Société Générale, Crédit Agricole may need €20bn in fresh capital, with knock-on risk for the French state. He warned that France’s public debt (Now 82pc of GDP) would shoot up to 90pc of GDP if the debt crisis rumbles on. Variants of this theme were picked up by other German economists in a Handelsblatt forum.
Constantin Gurdgiev, who is the head of research at St. Columbanus AG, points that, in addition to a number of structural problems with an EFSF insurance program, there are unintended consequences [emphasis added]:
(1) How on earth can EFSF guarantees resolve the main problem faced by over-indebted nations, namely the problem of unsustainable debts?
(2) If the EFSF were to remain a €440-billion fund, how can that amount be sufficient to provide already committed sovereign financing backstop through 2015-2017, supply banks’ recapitalization funds, provide additional backstop funds for current (Greece, Ireland and Portugal) and potential future (Italy, Spain and possibly Belgium and France) borrowers, while underwriting a new tranche of CDS-style insurance on bonds? Especially since such EFSF insurance contracts will have to cover ALL of the debt issuance by the distressed sovereigns. Assigning only partial (by stressed maturities or specific issues) cover will risk destabilizing the yield curve on government bonds, inducing additional maturity profile risks.


Who recapitalizes the banks?
Then there's the problem of bank recapitalization. I assume that the German solution will be adopted as individual EU countries will be responsible for recapitalization their own banks. Not all of the banks will be able to get new equity through the private market solution. If they go the full or partial nationalization route , where will the money come from? The funds for the EFSF are already committed. Individual EU members will have to even dig deeper into their own pockets to save their banks.
 
It will be bad enough for France, which will likely lose its AAA credit rating but survives. What about Cyprus? Or Portugal?
 
Can you say "contagion"?
 
 
The ECB sticks to its anti-inflation mandate
I wrote on Monday that the success of any grand plan will depend on the cooperation of three players:
  1. The EU needs to formulate a credible plan.
  2. The ECB needs to become more pragmatic and embark on quantitative and qualitative easing.
  3. The Greek Street has to agree to any austerity plan.
So far, the ECB has been silent on the plan and does not appear to want to bend on quantitative easing. It is unclear whether they will even cooperate on the issue of qualitative easing. Suppose a European bank that is facing a bank run goes to the ECB and asks for a loan under their liquidity facility. It then offers as collateral, not Bunds, but Greek, Portuguese or Irish debt. Will the ECB collateralize that 100%?

The failure of the ECB to engage in quantitative easing is a potential disaster. I offered the following scenario:
Can you imagine the Lehman aftermath without the cooperation of the Federal Reserve? The government unveils TARP, TALF and an alphabet soup of programs to rescue the American financial system. The Fed then proceeds to obstruct the rescue by refusing to engage in quantitative easing. Their efforts to supply liquidity to the market is limited to collateralization by Treasury issued securities (and not mortgage backed and other "toxic" paper)? What would have done to credit spreads? What would that have done to inter-bank lending and counterparty risk?

Greek cooperation
Another question is, "Will Greece cooperate?"

The Greek Street is already highly stressed. The BBC reports that Greek suicide rates are skyrocketing as ordinary citizens and small business owners struggle with the fallout from the financial crisis.

Can Greece grow sustainably after the restructuring? I pointed out before that a 50% haircut only amounts to a 22% debt reduction, assuming that the ECB and IMF do not tender to the "voluntary" debt swap. The Irish Times reports that Greece and Portugal are mired in deflationary trap.

Is a 50% haircut enough?

Could the debt crisis spread to Portugal?

These are all good questions to which I have no answer, but I believe that the market will assign a high risk premium to compensate for those events. In such a case, the ring-fence will have failed.


A negative market reaction
Late yesterday, the Guardian reported that France and Germany had agreed on a grand plan, which included an EFSF insurance program and bank recapitalization (what a surprise!), and equities rallied on the news. The story was later denied. I am assuming that, given all the leaks, that the grand plan consists of the elements that I described.

I would say that my projection represents the best case - anything less would mean a more negative reaction. As it is, my draft of the "Grand Plan" doesn't stand up to scrutiny and would likely fall apart within days.

Enough analysis for now. I am now going to curl up in a foetal position and read King Lear, just to cheer up.


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.

Tuesday, October 18, 2011

More signs of the end of Pax Americana

Are these isolated incidents of a Sign of the Times?

1) In the September 2011 Vanity Fair story about Chinese cyber intrusions, an analyst was told to back off for political reasons [emphasis added]:
In this conversation—the first of several that took place over the following months—the man said that he had started his career protecting government networks against foreign attacks. On that job, he became so preoccupied with the scale of Chinese hacking that a senior military officer told him to stop talking about it, with the gruff explanation that “the reason this is still going on is that the Chinese government now owns us.”

2) Last week, the Globe and Mail reported that Canada is becoming a magnet for American job hunters:
In a reversal of historical flows, immigration lawyers report a surge of calls from Americans who want to move north. Statistics bear out their observations: A record number of Americans applied for temporary work visas last year, Immigration Canada statistics show, spurred largely by the contrasting health of the two countries’ labour markets.

On one side of the border, 14 million Americans are out of work – the equivalent of more than 40 per cent of Canada’s population. On the other side, some employers – particularly in Alberta’s oil sector – say they can’t find enough skilled workers, prompting the country’s federal immigration minister to publicly muse last month on how to admit more skilled Americans.

The U.S. jobless rate is 9.1 per cent while Canada’s comparable rate – adjusted to U.S. concepts – is just 6.3 per cent, statistics released last week show.
Canada is indeed becoming a more attractive place to live. When I moved from Canada to the United States in 1994, the top combined marginal income tax rate in Canada was about 53-55%, depending on provincial jurisdiction. When I returned in 2007, the top rate was in the low to mid-40s. While headline healthcare costs are minimal in Canada, residents still bear the costs of drugs so the overall costs between Canadian and American healthcare aren't hugely different for someone with a job (see my previous post about comparing Canadian and American healthcare).
 
3) Last but not least, even Superman is renouncing his American citizenship. (I wonder what his tax consequences are?)
 
 
Competitive devaluation = Commodity bullish
I continue to believe that America is undergoing a multi-decade process of losing its global leadership. The US Dollar will, at some point in the future, lose its status as the premier reserve currency in the world. That's why I remain a long-term commodity bull.
 
While we are current moving through a period when deflationary forces are ascendant, the long-term path for commodity prices is still up, albeit in a volatile fashion. The major industrialized countries of the world will undergo a path of competitive devaluation and those pressures will show up mainly in commodity and asset price inflation.
 
Looking longer term, low or negative real interest rates generally signal a friendly investment environment for commodity prices. Continued government and/or central bank accommodative policy responses will likely push real interest rates even lower and add to even more future asset inflation. Indeed, the latest FOMC minutes are hinting that the Fed will not hesitate to undertake QE3 should the economy weaken further.
 
Investors who are opportunistic or prepared to look over the valley can view periods of market weakness as opportunities to accumulate positions in commodities or commodity producers as a hedge against asset price inflation.
 
 
 
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.

Monday, October 17, 2011

A framework for assessing a eurozone rescue

As we approach the October 23 eurozone summit, there will lots of news, leaks and trial balloons. To cut through the noise, here is a framework for assessing the credibility of any rescue plan. In the long term, either:
  • Greece and the rest of southern Europe will have to become more competitive. The obvious answer is currency devaluation. This means leaving the eurozone, either as a bloc to form a southern and softer euro, or individually (which could mean leaving the EU altogether).
  • The eurozone forms a transfer union, with the North supporting the South through a series of transfer payments channeled through Brussels. This will mean that member states will give up some degree of fiscal control and sovereignty.
According to Jeremy Warner of the Telegraph, Jean-Claude Trichet pointed out that the eurozone is actually in pretty good shape on the whole:
As Mr Trichet pointed out at the AFME dinner, if the eurozone were a single country, it would actually look like a model economy, with a small current account surplus, a primary budget deficit of less than half that of the UK and the US, subdued household debt, low inflation and a little growth.
The reality is the eurozone isn't a single country. It doesn't have a fiscal union. Wishing that it did doesn't make the current problem go away. Warner went on to ask the bigger question raised by a Greek rescue:
Such bailouts risk an Alice through the Looking Glass world where sovereigns are borrowing money to prop up banks that only need propping up because the sovereign has borrowed too much money. There's a self-defeating circularity about it which raises the obvious question of "who bails out the bailer-outer".
All these issues don't have to get resolved at the October 23 summit, nor do I expect that they will be. More immediately, the EU member countries will seek to kick the can down the road in order to settle these two choices that I raised. To rescue Greece and stop the contagion from spreading, you need to active particpation of three players:
  1. The EU needs to formulate a credible plan.
  2. The ECB needs to become more pragmatic and embark on quantitative and qualitative easing.
  3. The Greek Street has to agree to any austerity plan.
The immediate question then becomes, "Can all these elements cooperate in a credible way to avert a meltdown?"


The EU plan is coming together
In late August, I characterized the European players as looking like a circular firing squad, with no plan and no one in charge. Today, the Germans and French have taken control and they to be forming some semblance of a plan. In the wake of this weekend's G20 meeting of finance ministers, Bloomberg reported the outline of the Franco-German plan and the sense of urgency of the participants:
Europe’s strategy currently includes writing down Greek bonds by as much as 50 percent, establishing a backstop for banks and magnifying the strength of the newly-enhanced European Financial Stability Facility, people familiar with the matter said yesterday. Optimism the two-year crisis may soon be tamed spurred stocks higher this week and pushed the euro to its biggest gain against the dollar in more than two years.

European officials “will have left Paris under no misunderstanding that there is a huge amount of pressure on them to deliver a solution,” U.K. Chancellor of the Exchequer George Osborne told reporters. Next weekend “is the moment people are expecting something quite impressive.”
There will be the inevitable sniping from the sidelines about any plan. What I am watching for is the validity of any criticism. For example:
  • The banks have come out against recapitalization. Is this grandstanding? They have threatened to get to the targeted capital ratios by shrinking their balance sheet, i.e. calling in loans, which would cause a credit crunch and cause Europe to nosedive into a severe downturn, rather than raise new capital by diluting their shareholder base. Deutsche Bank has also attacked the recapitalization plan in a similar way, yet at the same time they are said to be weighing a rights issue.
  • Will the bank recapitalization plan focus on the right ratios? This column from Jonathan Weil says it all. "Regulatory capital should not be confused with the actual amount of capital banks have in real life", he wrote, because "the French-Belgian lender Dexia SA reported having a 12.1 percent core Tier 1 capital ratio as of Dec. 31, the date the banking authority used for its latest stress tests." Oops.
  • Will the EFSF or any other bailout mechanism have enough to "shock and awe" the markets? In an interview last Friday, Bank of Canada governor Mark Carney stated that the current EFSF size of €440 billion was insufficient and went on to say, "You need to overwhelm the markets. You need to put on the table more than is necessary."  He added that the effective capacity needed to be at least €1 trillion (and he may be conservative with the €1 trillion figure because he was speaking on the record). This is an unusually frank level of public criticism from a G-7 central banker that has to be taken seriously. We have also heard similar criticism that the EFSF is too small from others, such as Tim Geithner. There are several proposals on the table to extend or lever up the EFSF. We'll have to see how credible or effective those are. The ECB has come out against the EFSF. There are, however, other proposals such as to turn it into an AIG-like *shudder* bond insurer. This brings me to my next point...
  • What is an EFSF guarantee worth? This was the question asked by FT Alphaville: "What would the state of the EU be if Italy had to default? Can you count on the EFSF guarantee in such a case?" Also see why the EFSF is not the holy grail for similar arguments. These objections raise a very valid point of the creditworthiness of the EFSF. For traders, though, it is less relevant as any rescue deal that doesn't immediately fall apart and kicks the can down the road would result in a rally of risky assets - and that's all they care about. For investors, it is an important consideration. These issues tend not to matter to the market until they matter.
  • What is the actual reduction in Greek debt vs. the level of debt haircut? This was another important point posed by UBS (vis FT Alphaville). Assuming that the IMF and ECB do not tender their Greek debt to a "voluntary" exchange offer, what level of haircut does the private bondholder have to take in order to achieve a X% reduction in Greek debt [emphasis added]:
[A] 50% haircut effectively equates to a 22% reduction in existing debt once the [Greek] banks have been recapitalised. This is far from enough. Or, to put it another way, to achieve an actual 50% reduction in the debt, Greece would need to implement a 100% haircut, i.e. repudiate its debt totally....

What the UBS economists have done is assume that both the ECB’s holdings of bonds and the official eurozone and IMF loans will avoid being written down. This will put all the load on the private holders despite the eurozone loans supposedly ranking equal with them. (Ask the Finnish government how likely that equal ranking will be…)"
This is a more important point for traders as the level of net reduction in Greek debt will be relevant to the Greek government and Greek Street. Insufficient debt reduction will have the potential to unravel the deal.

Will the ECB go nuclear with QE?
Can you imagine the Lehman aftermath without the cooperation of the Federal Reserve? The government unveils TARP, TALF and an alphabet soup of programs to rescue the American financial system. The Fed then proceeds to obstruct the rescue by refusing to engage in quantitative easing. Their efforts to supply liquditiy to the market is limited to collateralization by Treasury issued securities (and not mortgage backed and other "toxic" paper)? What would have done to credit spreads? What would that have done to inter-bank lending and counterparty risk? Might that cause a bank run like this?



Or like this?



Unlike the Federal Reserve, which has a dual mandate of fighting inflation and to maintain economic growth, the European Central Bank only has the single mandate of fighting inflation. That's why they have so far refused to engage in QE. Were the ECB to tender their Greek debt to the current voluntary 21% haircut offer, it would render them insolvent. There are two solutions, both of which are unpalatable. They can either go to member states for more capital, or they can engage in quantitative easing.

In my opinion, for any rescue deal to be credible, the ECB needs to cooperate with an EU plan. They have to be prepared to go nuclear and announce that they will print whatever it takes in order to reflate the PIIGS and that amount may have to be in the €1-3 trillion range. Moreover, they may have to hold their noses and accept toxic sludge as collateral in order to reliquify the system, just as the Fed did during the 2008-9 episode, and ride roughshod over any objections over the practice of "qualitative easing".

Such a volte-face may not be in the DNA of the Vichy European Central Bank. Consider these stories of how much of an obstacle that the ECB could be. They has come out strongly against sovereign default (FT Alphaville: You shall not default, the ECB commands it):
Against this background, the ECB has strongly advised against all concepts that are not purely voluntary or that have elements of compulsion, and has called for the avoidance of any credit events and selective default or default.
They argued that:
PSI [Private Sector Involvement] could also damage the reputation of the single currency internationally, possibly adding to volatility in foreign exchange markets. In particular, public and private international investors may be cautious about investing large portions of their wealth in assets denominated in a currency of sovereigns that may not fully honour their obligations and may be willing ex ante to rely on PSI in some circumstances.
FT Alphaville pointed out the unintended consequences of this piece of dogma [emphasis added]:
Frankly though, we’re amazed if the ECB thinks it has the suasion power to tell sovereign debtors what to do. And by linking the euro explicitly to a no-default rule, we would argue that they only make it more likely that sovereigns will leave the euro altogether in order to default
Here is another hint that the ECB may not be totally cooperative. Incoming ECB chief and current Bank of Italy head Mario Draghi, has admonished his own government for fiscal profligacy:
"We must act fast. The sorts of interest rate rises seen over the last three months, if protracted, could lead to an uncontrollable spiral," said Mario Draghi, who takes over as head of the European Central Bank next month.

Mr Draghi said austerity measures must be enacted "immediately" and warned that Italy's €54bn austerity package is "not enough"...
Mr Draghi hinted that ECB help is nearing its political limits, evoking Italy's "atavistic temptation" of waiting for an army to cross the Alps to sort out its problems. "It is not going to happen. All our citizens must be are aware of this. It would be a tragic illusion to think that the help will come from outside," he said.
Does this sound like someone who will embrace quantitative easing?

More surprising is the story that the ECB tells Belgium not to guarantee Dexia’s interbank deposits:

The European Central Bank advised Belgium not to backstop Dexia SA (DEXB)’s interbank deposits and to avoid providing guarantees on debt maturing within three months because it risks interfering with the central bank’s monetary policy.
 
The ECB also said the planned debt guarantees for Dexia may last as long as 20 years, which is inconsistent with European Union guidelines for national support measures to be temporary in nature, according to a statement published on the Frankfurt- based central bank’s website and dated Oct. 13.
James Saft points out that the ECB is a central bank like no other in that it isn't necessarily the lender of last resort (perhaps we need to rely on the SNB for that role because they vowed to prevent the CHFEUR exchange rate from rising) [emphasis added]:
While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.
On the other hand, the latest G20 communique contained an odd statement which, if it applied to the ECB, suggests that they may be prepared to play ball [emphasis added]:
We remain committed to take all necessary actions to preserve the stability of banking systems and financial markets. We will ensure that banks are adequately capitalized and have sufficient access to funding to deal with current risks. Central banks have recently taken decisive actions to defend, and will continue to stand ready to provide liquidity to, banks as required. Monetary policies will maintain price stability and continue to support economic recovery.
What does the phrase, "maintain price stability and continue to support economic recovery", mean? The latter phrase has never been part of the ECB mandate?

Of course, this may just be a turf war. This analysis suggests that the ECB may just be using a crisis to maximize its powers:
It is important to remember that the ECB is not a normal independent central bank in the mold of the Bank of England, the Bank of Japan, or even the Federal Reserve. Normative academic studies of what outcomes monetary policymaking should target and how to achieve them rarely apply to the ECB. It has no single government counterpart within Europe and thus enjoys far more political independence than any other large central bank.

This unique independence derives from Article 282 of the EU Treaty [pdf], which states that the bank “shall be independent in the exercise of its powers and in the management of its finances. Union institutions, bodies, offices and agencies, and the governments of the Member States shall respect that independence.” In other words, the ECB has no political masters. Even if it did, the treaty would bar them from criticizing its decisions.
If the ECB's ultimate endgame is more power, might it be more cooperative when the chips are down and come to Europe's rescue at the last minute? Here is what the Bank wants:
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.
Such goals cannot be achieved within several weeks, which is the timeframe for rescuing the eurozone. If that is indeed the case, don't necessarily count on them to be a team player in any rescue deal.


Will the Greek Street cooperate?
As austerity starts to bite down hard, the Greek Street can rebel, either figuratively or literally. My base case is that Greece will go along with whatever package the Eurocrats fashion, as long as it doesn't include more fiscal pain. However, here is a report from Naked Capitalism of a report from Greece that highlights the risks involved:

Red = the IMF-EU program is not beneficiary for the country
Blue = it is beneficiary
The most important slide which shows the bankruptcy of the ruling system in Greece is the following. Please pay attention…

Red = do not trust
Blue= trust
Top bar (1st) = fellow citizens/people
2nd= social movements
3rd=banks
4th=media
5th=trade unions
6th=parliament
7th=governments
8th=political parties
The Greek government is no doubt aware of the risks. The latest Reuters headlines Papandreou begs Greeks to help avert "catastrophe" as strike-hit Greece heads to standstill ahead of crucial vote are testaments of the power of the Greek Street. This is a huge wildcard to which I have no insights. This is the stuff of revolutions and civil turmoil. At the very least, Greece could pull an "Argentina", as explained by John Hempton of Bronte Capital:
When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.
The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.
The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.
At the extreme, Papandreou could be assassinated or the military could stage a coup d'etat. It was certainly within my lifetime that Greece was ruled by a military junta. (Maybe that's why they just bought 400 American tanks).

I might also add that another wildcard is the behavior of the other peripheral countries. John Mauldin visited Ireland and wrote that the Irish fully expects to be offered a debt reduction on terms similar to Greece [emphasis added]:
When you press politicians and establishment types (and I did) who are against unilaterally disavowing the debt, a strange thing happens. I kept asking, "But the voters seem to want to forego the debt. And the math suggests that Ireland can't pay back these foreign bankers without great sacrifices." At first, they would point out that Ireland is doing what needs to be done: cutting spending and payrolls. We are not Greece, they say; there is a need for "respectability." But when pressed, they would come around to admitting that, "Yes, Ireland will get a haircut." Everyone I met expected it to happen. The difference was the path to the haircut. But while the politics matter, the destination is the same.

Some favor doing it outright. Others truly believe they will be offered a haircut when Greece and Portugal get theirs. They fully expect it. In a meeting with an establishment-insider economist (off the record), who was at the table when the first deal was done, he said there was an implicit understanding with the IMF (and ECB) that whatever was offered to Greece, et al. would be available to Ireland. So Ireland went along with the bailout to keep from imploding the euro and averting a crisis that would have been biblical in proportions. The future of the euro is now not in their hands, because by taking on the debt they did not blow the euro up. Which could have happened, because European politicians were not ready for such a crisis.

So rather than having to kick the door open for a haircut, they expect the door to be opened for them by the IMF and the ECB. A far more respectable path for those who are very pro-Eurozone. But Irish leaders clearly get that voters expect that something will be done. They have time, as it will be another three-plus years before elections. By then, the crisis will have fully evolved and resolved itself, as far as the political public is concerned. And politicians will take the credit, as they always and everywhere do.

Nomura's geopolitical analyst Alastair Newton is highly concerned about Europe. Pay attention about what he says about the precarious position of Portugal [emphasis added]:
  • Greece: It will struggle to meet obligations for its bailout and could see its government collapse at any moment.
  • Portugal: Before presenting a draft budget to parliament on Monday, Portugal is expected to announce a new austerity package amidst rising civil discontent. Portugal is looking like the new Greece.
  • Spain: Despite the progress made by the outgoing Spanish government, Newton thinks the country's troubled banking system continues to face contagion from Portugal. Its November 20 general election, however, is likely to bring the Partido Popular party to power or a coalition which will push through more reforms.
  • Italy: It needs to win back market confidence as investors are panicked about contagion risk and the country's politics. The country failed to pass its 2010 budget and amidst his other scandals, prime minister Silvio Berluscnoi's leadership is in doubt.
  • France: Newton is concerned about the 2012 elections. Though incumbent President Nicolas Sarkozy is 5 percentage points ahead of his biggest threat Marine Le Pen, a run-off between Le Pen and a Socialist candidate (to be decided next week) would not settle well with markets.
The degree of proposed fiscal austerity will create enormous tensions within many European societies. Ambrose Evans-Pritchard compared Japan and Europe and noted that Europe is already suffering from youth unemployment levels that are off the charts and then rhetorically asks what will happen when further austerity measures are imposed:
Even today, the jobless rate for youth is near 10pc in Japan. It is already 46pc in Spain, 43pc in Greece, 32pc in Ireland, and 27pc in Italy. We will discover over time what yet more debt deleveraging will do to these societies.

He agreed with Alastair Newton that Portugal is in very precarious shape:
Portugal is in much the same trouble, despite the heroic austerity drive of premier Pedro Passos Coelho -- a latter day Marques de Pombal. The country’s total debt will top 360pc of GDP next year, and its current deficit is stuck near 10pc of GDP. This mix is worse than in Greece.
Rome erupted in riots on the weekend. Even in Germany, there are signs of civil unrest (see Left-wing terror group blow up railway line in EIGHTEENTH attack in three days). Once you open up the Pandora's Box of civil unrest, you can lose control and won't have any idea of where it leads.


Watching the signs 
As the week pass, my inner trader continues to watch the news headlines to see if the three main players can cooperate and form the platform for a rescue deal. Right now, the biggest question is whether the ECB will be a team player. Recall Jeffrey Grundlach's comment about cooperation and divisiveness (via Josh Brown):
On Bull Markets and Bear Markets: If you study history, you'll see that "bull markets are about cooperation, bear markets are about divisiveness." Jeffrey says the Euro common currency came about in 1999 at the very peak of global cooperation, the fact that asset prices peaked around then too is not a coincidence. Right now divisiveness is everywhere and a global bear market is underway.
My inner investor, on the other hand, is watching the bigger picture of whether Europe can move back into a sustainable path for growth, or will any solution just kick the can down the road once again without the real problems getting resolved.


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.