Angela's choice

OK. Not only have Spanish and Italian bond yields have blown out against Bunds, now French yields are blowing out and there are suggestions that even Bunds are losing their safe haven status. The contagion has moved from the periphery to the core of the eurozone. The whole eurozone is unraveling as disunity is the story of the day, as an example consider the Bloomberg report Irish Government Draws Fire as Budget Plans Shown to Lawmakers in Germany.

In the past, we would have seen some market soothing statements from Merkozy by now, but the French and Germans are at odds and we therefore have no statement.

Now what?


What does Germany really think?
There is a consensus that the ECB has to act now and buy the sovereign debt of the troubled peripheral countries to stabilize the markets and buy some time for the eurozone governments to work out a solution their long-term imbalances. Hardliners in Germany, led by the likes of Jens Weidmann of the Bundesbank, have been adamant against such a move.

The question is, what does Angela Merkel do? Merkel has been all over the map on this issue. She has shown herself to be staunchly European and does not want the eurozone to break up. On the other hand, the revelation that Germany and France were conducting informal talks about a two-speed eurozone does not make her sound very European at all. In addition, the current government position that the the ECB cannot be the lender of last resort and the EFSF must not be given a banking license so that it could be supported by the ECB appears to be designed to push the eurozone over the precipice.

I believe the way to interpret her actions is that she is a skillful politician who has to walk a fine line between the competing imperatives of appeasing German sensibilities and the Realpolitik realities of the eurozone. Consider this account of German attitudes towards the euroozone [emphasis added]:

The nature of these meetings is that the hallway chatter is always more interesting that the formal program. Part of the reason why is that, particularly when talking to journalists, the businesspeople or politicians tend to regard those conversations as off the record. So I'll abide by that here. One of the German execs was a consultant, and the other headed what I'll call a quasi-official German organization.
They were slightly irritated by the pessimism I'd expressed earlier in the day. "Don't you realize," one of them said, "that the cost to us (Germany) of bailing out Greece is far less than it cost us to reintegrate East Germany after the wall came down in 1989?"

I almost choked on my croissant. Yes, I replied, I am aware of that. I lived and worked in Berlin as a journalist in the mid 1990s, when that very painful (economically speaking) process was taking place in Germany. But doesn't that, I said politely, rather beg the question: Germany integrating their brethren, who'd been isolated and impoverished during the cold war, was a dream come true, whatever the cost. Germans, on the other hand paying to bail out Greece is, to average German, rather the opposite of a dream come true, is it not?

He waved me off. No no, he said, it will be taken care of. The Germans, he said, understood how beneficial to them membership in the euro zone has been. Without it, the gentleman said, the value of the Deutschemark would be 50% or 75% higher than it is under the euro. "German industry would be wiped off the map."

In other words, the Germans understood the benefits of the eurozone and loathed to give it up, but they wanted the periphery to take the pain of adjustment:

Now the consultant perked up, speaking what he too believes to be the unvarnished truth. They have to, he said, because "to be blunt about it, we have them [both the Greeks and the Italians] by the balls."

And make no mistake – that, in essence, is where the European crisis stands. The Germans -- and the ECB along with them -- believe (perhaps hope is the better word) that two new technocratic prime ministers, former EU commissioner Mario Monti in Italy and MIT-trained economist Lucas Papademos in Greece, will cast politics aside and force angry populations in both countries to take their medicine, whether they like it or not. Because it's for their own good, you understand. And besides, "we have them by the balls. They have to do what we say."

Germany is at risk of overplaying its hand
I believe that Merkel is well tapped into this German attitude, but she has stared into the abyss and realizes that Germany is at risk of overplaying its hand in pursuit of the goal of greater fiscal integration. As Tim Duy correctly points out, Merkel & Company is playing a very dangerous game of chicken and the whole edifice could come tumbling down should anyone make the wrong move.

She is therefore trying to soothe German attitudes (I am on your side) but at the same time steer the German public consciousness toward the view that maybe Germany doesn't quite have Greece/Portugal/Italy/Ireland by the balls.

To do that, Merkel will have to manufacture a crisis. The brinkmanship and all the hawkish statements coming out from Germany that we see today may be just for public consumption. This is all theatre to show that we are indeed headed for a crisis, so they have to take extraordinary measures to save Europe.

Don't forget, Merkel has shown herself to be very European in outlook. Consider, for example, her statements ahead of a CDU party congress which has tabled a proposal for countries to leave the eurozone:

“For months, since the very beginning of the Euro debt crisis, Germany has had only one goal, that is to bring about a stabilization of the Euro zone in its current form, to make it more competitive, to consolidate budgets,” Merkel told a news conference after talks with Romanian President Traian Basescu.

“And we firmly believe that this common Euro area is capable of winning back full credibility, including every single country.”

Moreover, this report from the FT shows that the CDU leadership is nudging its membership towards greater flexibility in allowing the ECB to take action:

At party conference this week in Leipzig, Ms Merkel’s Christian Democratic Union left room for manoeuvre, however. Bond purchases by the ECB were acceptable as a “last resort,” the party agreed in a resolution at its annual conference. The ECB may yet get to show what it can do.

At the about same time, the German Council of Economic Experts, or the "Five Wise Men", has drawn up a plan for a European Redemption Fund at sounds a lot like a eurobond with strings attached. The idea of eurobonds has been anathema to the German public and the German government. The "five wise men" is a council of economists nominated by the government to advise on government policy. Could such proposals be a way of floating a trial balloon while allowing Merkel's government to distance itself should political opposition become fierce?

Another clue that that Merkel is preparing the groundwork for a rescue of the periphery countries comes from this story of an interview of Jörg Asmussen, the incoming chief economist for the ECB. While he echoed the official German government line, some of his responses were nuanced [emphasis added]:

Mr Asmussen would not be drawn: “If you speculate about plan B, then plan A is kaput.” Plan A rests on five factors, all of which have to be in place, he said: a plan for debt resolution and growth for Greece; the prevention of contagion to Spain and Italy; creating a firewall by getting banks to mark down their holdings of government bonds and add more capital; building another firewall with the EFSF; and, finally, setting a road-map for deeper monetary union.

Easy.

Nobody really expected Mr Asmussen to discuss plan B. Nor was he likely to reveal his innermost thoughts. But so cleverly did he speak that there will be no loss of face one day when the government rolls out plan B.

Given that the crisis is already here, the question of a rescue is one of timing.


A matter of timing
Already there are rumors circulating about a plan for the ECB to lend to the IMF, which then lends to the troubled peripheral countries. The stars appear to be lining up for such a move. The plan makes sense as the IMF has the resources to monitor individual countries for adherence to austerity programs while the ECB does not. Such a move also provides a fig leaf for the German government to appease the hardliners as this plan does not appear to violate any treaty terms.

At the same time that European bond yield spreads are blowing out, technicians over on this side of the Atlantic are sounding warnings about the bearish implications of a downside penetration of a triangle on the SPX on Thursday:

I would warn the bears that this has the markings of a possible fake-out. The index is now resting at its 50% Fibonacci retracement level and I would suggest, even if you are bearish, wait for a reflex rally to get short.

The conundrum for traders is a question of timing. Does Merkel have the political capital to put such a plan in place now? Or does she have to allow the crisis to continue in order to scare the living daylights out of everybody in order to say "we had no choice but to act"?

If she chooses the latter route, events could spiral out of control (even on this side of the Atlantic). As an example, Bruce Krasting painted a nightmare scenario stemming from the failure of MF Global because of the inability of anyone to find the missing $600 million in segregated funds [emphasis added]:

Give the MFG story another month and it will be a problem. It will undermine markets. It will impact confidence in our financial system. It will impact liquidity. As those things occur it will force both Treasury and the Fed to take actions. While those actions may not take the form of any direct bailout of MFG and/or its customers there will be a significant cost to the broader economy.

In an environment of uncertainty, how do you know your money is safe in any account? Krasing believes that the MFG failure could lead to a crisis of confidence and liquidity seizing up in the financial system

I have no doubt that money in seg. accounts at the likes of Merrill and Morgan Stanley is safe. That does not matter. The cheapest thing one could do is put cash outside of seg. accounts. The most expensive thing one could do is leave it there and face a loss of principal. It’s a very lopsided risk and reward.

Weekends seem to be a good time for the authorities to act and there are wheels within wheels with the politics of this eurozone crisis and traders should just react to headlines. Don't ever forget why the EU came together in the first place and how committed the elite to this marriage.

At the very least, bearish traders may want to wait until Monday before putting on short positions.



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.

Secular bear market investing

Last week, David Rosenberg (via Pragmatic Capitalism) stated that "we’re just 4 years into a depression that will likely last 7-10 years". Ken Rogoff, interviewed by CFA Magazine, said that the current slowdown that began in 2008 is likely to take 6-10 years for a recovery to take hold.

This is a secular bear
This confirms my views from August that I expect a stock market bottom about the end of this decade. This is a secular bear market characterized by flat returns and investors need to re-orient their investment policy and portfolio strategy accordingly.

To recap my first point about a secular bear market, equity valuations are not especially attractive right now. The chart below from VectorGrader (chart is theirs, annotations are mine) shows the market cap to GDP of US equities from 1950. I use market cap to GDP as a proxy for the market Price to Sales ratio. Many investors look at P/E ratios, but P/Es can be volatile since P/E = P/(Sales x Net Margin) and net margins can be volatile depending on where you are in the economic cycle, but Price to Sales is a far more stable ratio for evaluating long-term market valuations.

Note how the bull phases, or secular bulls, coincided with expansion of the market cap to GDP ratio. The equity market then topped out went sideways and entered a secular bear market, which coincided with a corrective phase in the market cap to GDP ratio, until that "valuation" metric returned to more realistic levels.

Similarly, this chart from Naufall Sanaullah of Shadow Capitalism tells a similar story. The chart shows the require amount of work to buy the SPX as a measure of the differential between the returns to labor and capital. Just like the Market Cap to GDP chart, this relationship remains stretched in favor of equity.
 

 
Using a rough eyeball estimate of both charts suggests a valuation bottom some time around the end of this decade given the current trajectory of adjustments. These conclusions are in accordance with the views of David Rosenberg and Ken Rogoff.
 
 
Using pruning shears in a snowstorm and a snow shovel in July
Even though I am trained as a quant, I have always thought myself to be an investment strategist first and a quant second. There are different tools for different seasons. Otherwise, you can get caught and wind up holding pruning shears in a February snowstorm or holding a snow shovel in the heat of July.

In secular bull markets, such as the one we experienced in the 1980's and 1990's, buy-and-hold was a great strategy for portfolio construction. Stocks went up. To control risk, you just added some bonds to control volatility and voila, a portfolio that balanced risk and return. To raise expected returns, you raise the equity weight at the cost of greater risk. To lower risk, you raise the bond weight at the cost of lower expected returns.

During secular bear markets characterized by flat returns, buy and hold investors are likely to see flat but volatile returns. Raising the equity component in a balanced portfolio just raises volatility, but does not significantly increase returns. Under these conditions, investors need to use dynamic asset allocation techniques such as the Asset Inflation-Deflation Trend Model to capture the swings of a flat market.



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.

The very long view of Europe

When I vote in an election, I give very little weight to a politician or party's stated policies. Instead I look at the candidate's overall philosophy to see how he or she would govern. Politicians change their minds. What's more important is how they would behave when circumstances change.

In the same vein, I apply a similar analysis to the eurozone crisis. The BBC had an excellent analysis of the very long view of Europe and outlined its challenges [emphasis added]:

A hundred and fifty years ago, around 1861, China and Japan both collapsed as Western gunships and financiers pushed into East Asia. Nothing Japan or China could have done would have stopped the rise of Western wealth and power. How they reacted to that rise, however, made all the difference between triumph and tragedy.

China's rulers borrowed heavily from overseas, squandered the capital, and fell into dependency. Japan's rulers bought time, raised huge amounts of local capital and financed an indigenous industrial revolution. By 1911, Japan was a great power and China was the sick man of Asia.

A century and a half later, the EU faces the same choices. Nothing it can do will stop the rise of the Eastern wealth and power - in 100 years, Asia will be the world's economic powerhouse - but how it reacts matters very much indeed.

Today, Europe remains a powerhouse of trade. In the final days of his ECB presidency, Jean-Claude Trichet said pretty much the same thing:

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.

That's why Europe's major trading partners, such as the Americans and the Chinese, have said repeatedly that Europe has the capability to solve the problem themselves. If we were to take Trichet's comment at face value, then the obvious way forward is fiscal union, to be followed by political union at some point in the future. The alternative is to kick some of the weaker countries out of the eurozone at the price of fracturing European unity. But then, what countries don't have underperforming regions? In the United States, you just have to compare the glittering metropolises of New York, Boston and Los Angeles with parts of the Deep South, or Puerto Rico, to see examples.
The question then becomes, how will Europe go forward with a solution?


EU half-measures?
Unfortunately, the history of the European Union is littered with compromises and half-measures that don't always achieve the original stated objective and have the potential to fail because of some fatal flaw. When the euro was formed, I recall that there was some question as to some of the weaker Club Med countries would be allowed into the eurozone. I suppose that, in the end, countries like Greece and Portugal were allowed in the spirit of European unity and the tradition of European compromise.

In the same way, the European Central Bank was mandated to only fight inflation as a nod to German price-stability sensibilities. Today, the fatal flaws of the lack of a dual mandate and the prohibition to being the lender of last resort to sovereigns has pushed the eurozone to the edge of the abyss.

Going forward, the stakes for Europe are much higher than ever before and a robust framework needs to triumph over compromise and half-measures. Here is The Economist on this very topic:

The price of a cobbled-together rescue is that some day the euro zone will probably have to endure yet another existential crisis. It is all very well to talk of discipline and oversight right now, when disaster is still an imminent possibility; but wariness is bound to fade with time. Bubbles inflate precisely because people fail to recognise that they are living with dangerous imbalances. One French official remembers being told by commission economists during the boom to copy Ireland and Spain. Now the same people are telling him to copy Germany.

The question of whether the eurozone achieves a political or fiscal union, or the weaker countries get kicked out of the euro will be irrelevant in 100 years, but both roads will be hard. What matters is a robust solution, and not a weak half-measure, is implemented.

The BBC article I mentioned above ended with:

Europe should choose the Japanese path. It will take trillions of euros to contain the crisis and the pain will be immense. But the alternative, of mortgaging Europe's future with Chinese loans, might prove worse.

The challenge ahead
The alternative is further existential crises for Europe and the EU. It is with that in mind that investors should remember 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.

I wrote in my last post of why I believe Europe came to be and I find it amazing today how many of its inhabitants are utterly European in outlook and remain committed to the idea of a European Union (see one of many examples here). It is now up to them to forge a solution that will stand the test of time.



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.

Remembrance Day in the eurozone

As those of us who live in British Commonwealth countries commemorate Remembrance Day, I want to reflect about what this day means to me, especially in the context of the eurozone crisis today.

Our story begins at the close of World War II. As that war drew to a close in 1945, the leaders of Western Europe came together and surveyed the wreckage. For centuries Europe had been racked by conflict, centered mainly between France and Germany. As an example of the level of carnage, consider that the French and Germans lost over 800,000 men (dead, wounded, missing and captured) in one single battle – the multi-year Battle of Verdun in World War I. By way of comparison, the Verdun casualties were double that of American loss in Vietnam dwarf American casualties in either the Korean Conflict.

The Europeans said “never again!” Thus the EU was born. In 1957, the European Economic Community (EEC), also known as the Common Market, was formed. The intent was not purely trade liberalization, but to bind Germany to Europe so tightly that major European conflicts could never happen again. The EEC later became the European Union (EU). Further economic integration occurred in December 1995 when many EU countries adopted the euro as a common currency.

This strategy of peace through economic integration has largely succeeded. If the Germans were to mobilize the Bundeswehr today and announced to the troops that they were going to war with France, the men would all laugh and go home.

That is the miracle of Europe.

As players on the European stage manoeuvre for advantage, we must not forget the Big Reason for the formation the European Union. Also don't forget the terrible price that could be paid by future generations should the current crop of leaders fail.

Lest we forget.



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.

Two-track eurozone: wheels within wheels

I take my assertion in my last post about a possible Merkel capitulation back. The Reuters story about the Franco-German discussions about a eurozone breakup, or a two-speed eurozone, was ex[;psive on a day when Italian yields spiked, but a further Reuters story indicates that the "informal" discussions had been going on for a month. Moreover, the discussions were at a theoretical level and not centred on the nuts-and-bolts of how it would be done:

The change has been discussed on an "intellectual" level but had not moved to operational or technical discussions, the EU official said. A French finance ministry spokesman denied there was any project in the works to reduce the currency bloc's membership .

More interestingly were the affirmations of this highly risky approach from both Paris and Berlin.

French President Nicolas Sarkozy gave some flavor of his thinking during an address to students in the eastern French city of Strasbourg on Tuesday, when he said a two-speed Europe -- the euro zone moving ahead more rapidly than all 27 countries in the EU -- was the only model for the future.

And:

Speaking in Berlin, Merkel reiterated a call for changes to be made to the EU treaty -- the laws which govern the European Union -- saying the situation was now so unpleasant that a rapid breakthrough was needed.

From Germany's point of view, altering the EU treaty would be an opportunity to reinforce euro zone integration and could potentially open a window to make the mooted changes to its make-up.

Who is trying to do what to whom?
So here is the question: If discussions had been going on for a month, why did the story break yesterday of all days, when the financial markets were in turmoil? This was probably a leak. It sounded like too orchestrated to me. It seemed to me that it was done for maximum impact.

If that was a leak, then who did it and why? I have several theories:

1. Angela Merkel has come to the realization that only the ECB can save the euro. She had the story leaked to throw panic into the markets to pressure the German hardliners within her government and the Bundesbank. In that way, it would give her political cover to give Mario Draghi the nod to start monetizing debt.
2. The French want the ECB to act. They had the story leaked to throw panic into the markets to pressure the German hardliners within the German government and the Bundesbank.
3. Mario Draghi and the ECB wants Silvio Berlusconi out sooner rather than later. This was leaked to throw gasoline on the fire.
4. Ambrose Evans-Pritchard wrote:

Veteran EU watchers say the leaks appear to be a heavy-handed attempt from certain quarters in Berlin to force austerity compliance in southern Europe.

Personally, I think that either 1 or 4 are the most likely possibilities. In typical European fashion, there seems to be a lot going on behind the scenes with different factions of the elite jockeying for position. The good thing is that the Germans are actually having a hard internal debate of what they want out of the EU and the eurozone.

So I take it back. This was not a Merkel capitulation and panic moment. But don't just watch and react to the headlines, there are wheels within wheels as pawns are maneuvered around the European chessboard.



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 this the Merkel capitulation?

Is this a sign of panic from Angela Merkel? As we watched markets crater over the spectacle of an Italian bond market melt down, Angela Merkel seems to have thrown in the towel and called for a breakup of the eurozone. Reuters reports that she agreed with Sarkozy's idea of "a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected "

It is time for a breakthrough to a new Europe. A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can't survive.

The Guardian confirmed the story by reporting that Germany and France have begun talks to break up the eurozone amid fears that Italy will be too big to rescue. Bloomberg also reported that Merkel’s CDU may adopt Euro exit clause in party platform. Interestingly, the story showed Mario Draghi to be very European in outlook:

Mario Draghi, in his first week as European Central Bank president, said Nov. 3 that it’s not illegitimate to question Greece’s place in the euro area. Even so, the bloc’s founding treaty doesn’t allow for a country leaving and it would be hard to imagine it happening, he said.

Is this talk of a eurozone breakup signs of panic and capitulation from Angela Merkel? Is this a buy signal or a sign that Europe's Lehman moment is upon us?


Implications of a eurozone breakup
The implications of a eurozone breakup are profound. Despite the rhetoric, Germany has benefitted tremendously from membership in the eurozone. Credit Writedowns wrote that, since Germany runs a huge trade surplus with the rest of the eurozone, German-Southern Europe trade has become a giant vendor financing scheme.

The large euro-area internal current account imbalances should be seen as a form of vendor financing, whereby the creditors, principally Germany, forward their customers, the debtors, trade finance in order to sell their wares. Germany’s aging society meant slow growth. So German companies have looked abroad for growth, just as the Japanese have done in their aging society. Taken in aggregate, this means persistent current account surpluses which are a fancy way of saying vendor financing at the national level.

German banks were at it too, by the way. German retail banking is a low margin business and credit growth is weak. So the German banks loaded up on foreign assets, making loans abroad. German banks were very active in Ireland and Spain during the housing bubbles there, for example.

German industrial companies must know this. While the Teutonic holier-than-thou attitude may play well for public consumption, I can't believe that German exporters aren't making their views known to the government.

Even if Germany and France wanted to break up the euro. How do you get from A to B? How do you re-negotiate a treaty with 17 signatories? What do you do in the meantime? Do you sit around planning the nuances of how to revise EU treaties while watching global financial system disintegrate around you?


A green light for the ECB to go nuclear?
Remarks about "the new Europe" and the "two-speed Europe" sound either like signs of panic or carefully timed leaks. This may be a sign that Mario Draghi will be given the green light to go nuclear despite the deep reservations expressed by the likes of Juergen Stark.

Indeed, the ECB has not been idle but it has been expanding its balance sheet despite the rhetoric about treaty obligations, etc.

The latest report shows that it bought €9.5 billion in sovereign bonds. Nevertheless, its hands may be tied by treaty. Ambrose Evans-Pritchard writes that

Jens Weidmann, head of the Bundesbank and the ECB's dominant governor, said...Article 123 of the EU Treaty imposed a legal "prohibition on monetary financing", implying that the ECB cannot attempt to shore up the debt markets of Italy and Spain for covert fiscal support.

Therefore the ECB has a strict limit to how far it can go to buy sovereign bonds directly from Italy, as per Article 123.

Yet, where there is a will, there is a way. After all, don't forget that Germany went into the euro with roughly 90% of the population opposed to the move. OK, so if the ECB can't lend directly to a sovereign country, what can it do? Alan Beattie of the FT explains:

One intriguing idea floating around Washington: if the ECB can’t bring itself to bail out Italy direct (sovereign credit risk, no expertise in setting lending conditions) it could in theory, according to Article 23 of its protocol, lend vast amounts to the IMF.

The Fund would then lend them on to Italy, taking on the credit risk and enforcing conditions – both of which are what it is there for.

Panic is in the air
In the meantime, the world is in full-fledged panic mode. Ezra Klein's article entitled Is this how the euro ends is typical of the sense of terror gripping analysts. After all, Italy is a G7 country which borders two other G7 countries. Another, the UK, is in the same economic union. Will the eurocrats truly allow the European and global economy to go down in flames?

The problem, put simply, is that Italy is both too big to fail and too big to save. It’s the eighth-largest economy in the world. At $2 trillion, it’s about seven times as large as Greece’s $300 billion economy. France and Germany’s banks alone have $600 billion in exposure to Italian debt. But Barclay’s says Italy is “now mathematically beyond the point of no return.” Silvio Berlusconi might be out, but changing governments does not change arithmetic. And so the question is simple, and stark: If there wasn’t the will to really save Greece, where would the will -- and the money -- come from to save Italy?

Brad DeLong has gone even further and urged the Federal Reserve to intervene by calling up the ghost of Creditanstalt and 1931 [emphasis added]:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria--that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria. The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip. The Federal Reserve needs to do so now.

If Italy goes down and takes its G7 European partners down with it, then no one is safe.


What will Merkel do?
So the big question is now, "Is this Merkel's capitulation moment?" Does she really want to go down in history as the one who could have save the eurozone but didn't? Will Merkel, or some of the cooler heads around her, allow the ECB to go nuclear as a stopgap in order to save the EU?

A word of warning for traders. Those who wait for the ECB to act before the weekend may be disappointed. There is a theory that Draghi wants to force Berlusconi out now instead of later. So the ECB is standing aside and letting the markets do its work for them. If the markets go into freefall for the next couple of days, the weekend is the perfect time to do a deal - after which the markets would melt up in relief that the Apocalypse has been avoided.
 
But first things first. It's up to Angela Merkel to take the first step and show some adult leadership. Will she allow the ECB to take steps and save Europe (at least temporarily)? Or will this be Europe's Lehman moment?
 

Addendum: I take it all back. It wasn't a Merkel capitulation moment. See further details here.


 
 
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 financial repression the next step for the eurozone?

I would like to explore the long-term options for the EU and the eurozone out of this crisis. Most observers have offered two options for Europe, but I would like to raise a third - of financial repression. The options, which I list from the least likely to most likely are:

• Exit from the eurozone: Greece and perhaps Portugal and other weaker economies of the eurozone exit the euro, either individually or as a group. This would be a disaster, not only for Europe but for the global economy and financial system.
• A fiscal union: When the euro experiment began, it was acknowledged that this was a monetary union without a political union. A fiscal union, in which individual member states give up some degree of sovereignty to a greater EU authority, is the next step towards a politcal union. Taking such a step requires constitutional change by all eurozone member states, which is a long and involved process and may not be successful in the end.
• Financial repression: If you read Reinhart and Rogoff, first comes the financial crisis, then the sovereign crisis. The next step is financial repression, where the authorities try to extract greater wealth from its citizenry. Given Europe's predilections towards muddle through solutions that kick the can down the road and its tolerance towards higher taxation, I believe that this is the most likely solution for Europe. Though such a path will impose a significant constraints on its engine of long-term economic growth.

Eurozone exit
I am getting  tired of writing about gloom and doom so I won't dwell on this option too much. I wrote about it before here and extensively elsewhere. The worst case scenario is the Argentina one, as described 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.

If Greece did that, it would mean the end of the eurozone banking system in the weaker countries:

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.

You get the idea. Pulling an Argentina would create chaos in the financial markets.


Canada as a model for fiscal union
What about a fiscal union? A fiscal union would mean individual eurozone states ceding some form of taxation power to a central authority - sort of a "Brussels on the Rhine". What would a fiscal union look like? Well, it would sort of look like...Canada. Jeffrey Simpson, columnist for the Globe and Mail, explains:

The great virtue of real federalism is the sharing of risks, which is why Canada is a much sturdier federation than Europe. Canada’s central government raises far more revenue as a share of the national total than Europe’s central institutions, redistributes far more of it to less well-off regions, and takes a large share of borrowing.

In Europe, member-states must pay their entire debts; in Canada, provinces pay some of their debt, the whole country pays the rest. The difference means when highly indebted European economies falter or interest rates skyrocket, they face burdens that the European Central Bank and member-states try to ease with Band-Aid solutions.

In Canada, weaker provinces and/or highly indebted ones (Quebec and the four Atlantic provinces) don’t have to pay both their debts and their per capita share of the national debt. Ottawa pays the per capita share. The sharing of risk, opportunity, burdens and good fortune is what makes a federal system.

The European Union was never a federal structure like Canada. It worked best in sharing good fortune and some risk; it worked badly, as we now see, in sharing burdens because it lacks the central resources of a federal system.

The Canadian system is workable, but not perfect. We have seen our share of constitutional crises over the years and the Quebec sovereignty movement continues to lurk as a threat in the background. In Canada, the stronger provinces send money to the weaker ones in the form of equalization payments via Ottawa. This arrangement works because it isn't just welfare, but a form of counter-cyclical stabilizer. Simplistically speaking, Canada is economically divided between resource-based regions (which are mostly in the west) and the manufacturing heartland in southern Ontario and parts of Quebec. When resource prices are low, the manufacturing base booms; and when resource prices are high, manufacturing margins suffer. Equalization is a therefore a form of counter-cyclical stabilization for provincial economies and budgets.
 
In the eurozone, however, such counter-cyclical arguments fall flat. The perennially weak countries are not resource producers, nor does it appear that their economies are in any shape or form counter-cyclical to the industrial heartland. Consider how some of the more troublesome PIIGS countries achieved their recent success. Spain saw a property boom, which subsequently collapsed. Ireland became the Celtic Tiger because of its low corporate tax rate, which encouraged offshoring. Italy remains a world-class centre of manufacturing and design (think Ferrari and Gucci as examples) but suffers from competitive problems. While some of the PIIGS problems are cyclical, the root cause appear to be a lack of competitiveness that is usually solved by currency devaluation.
 
Such an arrangement leaves the industrial heartland permanently digging into their pockets to support their poorer cousins. The Germans get this concept quite clearly. German finance minister Wolfgang Schäuble has stated that Germany does not want to rule Europe (and by extension, be permanently on the hook for support payments).

For the recipient of EU largesse, the consequences of giving up fiscal sovereignty to a "Brussels on the Rhine" can have governance effects that appear to be heavy-handed. It may feel like your country is under occupation. Ambrose Evans-Pritchard of the Telegraph wrote about this problem when the EU presented Italy with an ultimatum [emphasis added]:

The EU has woven itself into this drama by presenting Italy with an ultimatum last week, giving the country barely 48 hours to commit to very specific and radical reforms.

It is in effect taking sides in an intensely polarized debate within Italy, intruding in the most sensitive matters of how society organizes itself. It is demanding ideological changes – in this case in favour of employers, and against unions – as a condition for further action to shore up Italy’s bond markets.

"We have three deaths in front of us: democracy, politics, and the Left," said Fausto Bertinotti, the elder statesman of Rifondazione Communista and one of Italy's great post-war figures.

"We are living in a neo-Bonapartist financial system. Not a single decision has been taken by the Italian parliament since the end of August except those imposed by the foreign power that now us under administration."

Those of us who live under an "Anglo-Saxon economy" may not find it odd that we demand our partners to end the labor friendly practices that seem outrageous to us in return for financial support, but Evans-Pritchard wrote that, in a democracy, you have to get the populace to make the decision freely:

The two bones of contention are Article 18 protecting workers from being sacked for economic reasons, and “firm level agreements” that undercut the power of trade unions to craft deals across sectors.

Those of us in Anglo-Saxon cultures may find it remarkable that Italy still has laws that make it extremely hard for companies to lay off workers when needed. It is clearly a reason why the country has struggled to adapt to the challenge of China, rising Asia, and Eastern Europe.

But that is not the point.

Are such changes to be decided by Italy’s elected parliament by proper process, or be pushed through by foreign dictate when the country is on its knees? “Political ownership” is of critical importance. The EU is crossing lines everywhere, forgetting that it remains no more than a treaty organization of sovereign states. Democratic accountability is breaking down.

Today, we have Troika monitors in Greece and IMF monitors in Italy. How far will it go before the people of the peripheral countries feel like they are under occupation? Jim O'Neill of Goldman Sachs Asset Management has stated that he believes that a number of countries, ranging from Greece to Finland, would rather pull out of the euro than live under the rule of a Brussells on the Rhine.
 
 
Financial repression
The most logical solution, given a willing populace, is then financial repression. Governments practice forms of financial repression all the time. CLSA's Russell Napier lays it all out:

So far, only a small section of the private sector has been forced to pay up for the follies of the public - the depositors whose saving are being destroyed by negative real interest rates and those on fixed incomes they can't force up to meet inflation. But the extension of this theft is likely to mean forcing institutions to buy government debt on previously unimagined scales. In India, the banks have a standard liquidity ratio of 25%, the explicit aim of which is to “augment the investment of the banks in Government securities.” Why not Italian banks too? And why not the pension funds?

The template was laid out by Carmen Reinhart and Ken Rogoff:

If you want to see how all this unfolds you should simply read - or re-read - what appears to be the best road map of the crisis so far, Reinhart and Rogoff’s This Time is Different or the paper Reinhart co-wrote this year titled The Liquidation of Government Debt. As they say “first comes financial crisis; then comes sovereign debt crisis; then comes financial repression.”

Already, such proposals are being floated. FT Alphaville wrote last week that while the Italian government is in debt, Italian households are remarkably debt free and have an abundance of liquid assets:

[There is] €8,600bn of household wealth vs. the €1,900bn public debt mountain. Around 50 per cent of Italian government bonds are already in domestic hands, according to Credit Suisse, but there still could some firepower left, in theory, thanks to the country’s decent stock of financial assets at a tidy €3,565bn, according to the Italian central bank.

The solution sounds a lot like financial repression to me:

Here’s one thought experiment floated by Tullio Jappelli, economics professor at the University of Naples Federico II, who told us via email that if the government decided to launch a raid on savings it could:

…seize a part of our checking / saving accounts and convert this cash into bonds.

In 1992, under the Amatao Government there was a wealth tax, passed in 24 hours (0.6 percent of deposits were seized by the government). [The above] proposal is better from the consumers’ standpoint, because you convert cash into bonds, not into taxes. But you need to do it VERY quickly, otherwise you risk a bank run and deposits to disappear. All these things are dangerous objects, so please be careful with how you handle them..

Governments have long practiced this form of financial repression. As an example, pension funds under certain regimes have been mandated to hold a certain portion of their assets in government bonds for "prudent" reasons.

Given the alternatives, this solution is probably the least politically painful for the authorities and will kick the can down the road for a few years. So watch for financial repression - coming soon to your European neighbourhood.



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.

Market indecision

The behavior of some asset classes have been downright puzzling. I have been writing for several weeks about what a basket case the eurozone is. Despite the results of the Greek vote on the weekend, nothing is solved. The contagion is starting to spread to Italy, as 10 year Italy-Bund spreads are blowing out.

The EFSF, whose details are still not finalized, is starting to look more and more DOA. Here is Lisa Pollock of FT Alphaville discussing how many investment banks won't even touch making a market on EFSF CDS:

With the EFSF though, it’s all about self-referencing, which is another way to describe the wrong-way risk involved.

To have a quick and dirty example of that, think about whether you’d buy protection on France from BNP Paribas, or protection on the UK from RBS, or protection on Germany from Deutsche Bank. If the CDS spreads on any of those banks started widening out significantly, it’s safe to bet that their lender-of-last-resort sovereigns will start widening too. This is something we’ve seen happen a lot over the last few years. Similarly, one can see banks widening with their sovereigns, as their backstops look increasingly vulnerable.

If you did any of those trades, you’d be deeper in-the-money, but at the same time, your counterparty is starting to look increasingly fragile (and you’re probably having to hedge against the possibility that they might not be able to pay you too).

A deteriorating outlook
What's more, the forward looking indicators are in decline even though the backward looking indicators are appeaing relatively buoyant. Both the Fed and the ECB cited deteriorating outlooks last week in their statements. Here's the ECB:

The economic outlook continues to be subject to particularly high uncertainty and intensified downside risks. Some of these risks have been materialising, which makes a significant downward revision to forecasts and projections for average real GDP growth in 2012 very likely.

And here's what the Fed said:

Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

Ed Yardeni observed the same phenomena when he analyzed 3Q Earnings Season [emphasis added]:

It has been a great earnings season. It’s not over yet, but of the 388 S+P 500 companies that have reported their Q3 results, earnings are up 22.9% on a 12.7% increase in revenues. The problem is that even as companies have provided lots of positive surprises, analysts have been cutting their earnings estimates for Q4 and all four quarters of 2012. That’s because they are turning increasingly cautious on the outlook for revenues and for the profit margin.

The WSJ also echoed a similar sentiment when it wrote that Earnings Warnings Ratio Highest in a Decade.


Some excellent questions
If Europe is such a mess and the economic outlook is tanking, then why isn't the US Dollar, which is undervalued using PPP measures (see examples here and here) and the traditional safe haven, rallying harder? Shown below is the point and figure chart of the USD, why isn't it at least in an uptrend?

You could argue that investors are avoiding the USD because of fears of currency debasement, which is a serious problem with fiat currencies in the current environment. In that case, pressures should be showing up in hard asset prices. Why aren't commodities in a well-defined uptrend?
 

Those are, as they say, excellent questions.
 
 
Beware of policy intervention
Despite the overwhelming macro risks that face the market, I believe that the reasons that the price of risky assets haven't totally fallen apart is because Mr. Market is discounting the possibility of policy intervention. Last week, the FOMC statement had a decided dovish tone. While they did not outright announce QE3, they did say that the outlook is decidedly weak. More importantly, the two more hawkish members of the FOMC fell into line and voted with the rest of the Committee. The only dissenter was a dove who wanted greater accommodation. In the post-meeting press conference, Bernanke did allow that the Fed would look at MBS purchases if the circumstances were right.
 
On the next day, the ECB surprised the markets with a quarter point rate cut. Mario Draghi appeared to be far more pragmatic than Jean-Claude Trichet, though just as European. He did appease the German wing of the ECB by stating that sovereign debt purchases were intended to be "temporary" - which was very European of him.
 
Larry Jeddeloh of TIS Group is accordance with my views about market anticipation of central bank intervention [emphasis added]:

The ECB Moves and The Bernank Places a Put Under the Market—In the past forty eight hours, several important changes have taken place in the global central banking community. When new ECB chief Mario Draghi unexpectedly cut interest rates even by 1/4 point on Thursday, he confirmed what I have been saying about Europe’s economic position. Continental Europe is in recession and the models I look at suggest all of the major European economies will see rapid decelerations in their economies. This is one of the reasons why Draghi did what new central bankers seldom do, cut interest rates on virtually his first day at the job.
 
One day before Draghi moved the ECB into easing mode, the Bernank held a press conference after the FOMC meeting. For the first time in a long time, the stock market actually went up, rather than down after he finished. What did he say that the market liked? I think he was absolutely clear that the Fed will be there, if needed, should the economy decelerate. He set the stage for QE3 by reducing the Fed’s forecast for the economy and he gave little comfort on the employment front. He set up a move to QE3 solely on the basis of the Fed’s mandate...
 
There is more evidence the markets/CB policy have reached an inflection point. In the emerging countries, Brazil’s central bank has cut interest rates twice. India appears to have stopped tightening. China is beginning to make noises that their tightening cycle may be over. Japan is easing and intervening in their currency. If China begins to reflate and the Chinese equity market is behaving as if something is changing, then the outlook for Asia/commodities changes. My point here is the CBs are turning bullish on money creation. As a result, inflation is about to pick up, though with some lag.

That's why the markets aren't behaving worse and financial crisis safe havens like the US Dollar aren't behaving better. They are discounting the possibility of policy intervention, which would buoy the prices of risky assets such as commodities.


Still a tug-of-war
So where are we today? The markets continue to be dominated by tail-event headline risk. On one hand, it's fearful of the macro risks such as a eurozone banking crisis. If calamity strikes, it's a long way down from here. On the other hand, the possibility of central bank intervention lurks around the corner. In the meantime, the drip-drip-drip of news that we have avoided the firing squad one more day, e.g. Papandreou's vote of confidence, are prompting the rallies and provides an upward bias for equity markets.

I wrote in last week's post, Defying gravity, that my base case for the next few weeks remains a sideways market with a slight bullish bias and I continue to stick with that view:

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?

Until the risks are resolved one way or the other, the markets are likely to be volatile, news-driven and range-bound.



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.

Don't be too eager to get bearish

While the stock selloff in the last two days has been breathtaking, (just as the rally last week was breathtaking), even if you are bearish, I wouldn't be too eager to commit to a bearish trade here. There are just too many bullish triggers over the next few days that could rip the face off anyone positioned to the short side.

First of all, the market just kissed the 50% retracement support level as shown by the chart below.

Another short-term bullish data point came from Marty Chenard at stocktiming.com. He showed that, as of Monday night, institutional investors haven't panicked and the positive momentum seen last week appears to be intact.


The Greek referendum a domestic power play?
The news of the Greek referendum called by prime minister Papandreou caught investors by surprise yesterday and the markets sold off. Upon closer examination, the referendum story just didn't make sense. He caught his own cabinet by surprise with the news and even his own finance minister wasn't briefed on the plan. Joseph Cotterill of FT Alphaville wrote that it wasn't clear that Papandreou may not have had the votes to pass the referendum bill in parliament. Moreover, the Greek constitution specifically prohibits referendums on fiscal matters. So what would the referendum question be?

If the question were to be phrased in the form of, "Are you in favor of knuckling under to the EU and the IMF?" The answer would be an overwhelming "No". On the other hand, if the choice was to be accepting the austerity package as a price for staying in the eurozone, or to leave the eurozone and be ejected from the EU, then the outcome is much hard to predict.


Beware the Bernanke Put
I also wrote that bears should be careful about the possibility of central bank intervention (see Defying gravity and  When will bad news be good news?). We have the FOMC decision today and press conference afterwards. Consider, for example, this analysis of how far the Fed has strayed from its dual mandate and tell me that there's no Fed intervention risk.

What about the Draghi Put?
Not much is know about the views of Mario Draghi, but there are some insights to be had in a speech he gave in July 2011. First, he gives lip service to the idea that EU states must stand on their own [emphasis added]:

For years interest rates in the various parts of the euro area did not diverge significantly from those obtaining in Germany. For a long time the spreads between sovereign securities and German Bunds remained narrow and the interest rates charged by banks reflected the credibility of the public securities of the euro-area countries. This is no longer the case: the solvency of sovereign states has ceased to be a foregone conclusion but something that has to be won in the field with rapid and sustainable growth, which is only possible with sound public finances. Interest rates reflect today’s new situation: they are higher for countries with low growth and weaker public finances. The cloak of credibility provided by the stronger euro-area countries has been lifted; we must grow without relying on its shelter. The structural reforms invoked for years are now even more crucial.

In the next breath, Draghi goes on to talk about "innovative" monetary policy and "more appropriate set of economic governance tools", which is a signal that he may be more pragmatic than his predecessors in their approach to central banking:

On several occasions I have noted that Europe reacted to the global financial crisis by drawing on the credibility of the ECB and the latter’s timely and innovative conduct of monetary policy and by equipping itself with a more appropriate set of economic governance tools. We now have a system of autonomous authorities for banking and financial supervision, a European body to monitor and mitigate systemic risks, and new procedures for the coordination of fiscal and structural policies.

On last Wednesday, just as the eurozone summit was about to convene, Draghi "independently" released a statement that he supported the continuation of the ECB program of buying sovereign debt. That program was supposed to be discontinued when the EFSF came into being. It sounded just a little bit too orchestrated to me. To understand the significance of this statement, Brad Delong sounded off on the ECB's refusal to be the lender of last resort to the eurozone:

When the European Central Bank announced its program of government-bond purchases, it let financial markets know that it thoroughly disliked the idea, was not fully committed to it, and would reverse the policy as soon as it could. Indeed, the ECB proclaimed its belief that the stabilization of government-bond prices brought about by such purchases would be only temporary.

It is difficult to think of a more self-defeating way to implement a bond-purchase program. By making it clear from the outset that it did not trust its own policy, the ECB practically guaranteed its failure. If it so evidently lacked confidence in the very bonds that it was buying, why should investors feel any differently?

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Mechanism.

Did Draghi just signal that a Draghi ECB is ready to embrace its responsibility as lender of last resort and to move off the one needle on its compass? Then take a look at Felix Salmon's account of what happened at MF Global, which was essentially a leveraged credit bet gone wrong. The story of MF Global is a cautionary tale of how quickly a financial institution can go south should it lose its liquidity funding. Is the ECB watching this is this scaring them?

What's more, did anyone catch the odd language at last G20 communique?

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.

When did the ECB's mandate include supporting economic growth and recovery? Or was the G20 referring to other central banks?


The Red Knight to the rescue?
Moreover, there have been hints of Chinese intervention. In the wake of the disappointing Chinese PMI release, Global Macro Monitor asked:

Interesting official PMI was less than the HSBC PMI, which was also released today. Are they paving the way data for an easing of monetary policy or to justify contributing to the Eurozone bailout? Just askin’.

I wrote before that Chinese appear to be signaling a policy of selective stimulus, these "hints" may be part of that campaign.


Don't get bearish too soon
In conclusion, I know that the headlines and recent price action look dire, but I would be cautious about getting bearish too early. The technical backdrop is improving for the bulls and as we face two back-to-back event risk days where central banks may signal imminent intervention.

Even if you are a bear, wait for a rally before putting on short positions. Sell into strength, not weakness.

Even if you are a bear and believe that the Fed, ECB or PBoC can't save the world, they can still rip your face off with a trillion or two of quantitative easing.




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.

When will bad news be good news?

The ink is barely dry on the eurozone Grand Rescue Plan and now we have a chorus of "it won't work". I was part of that chorus (see my previous posts here and here). Over the weekend, the bad news kept on coming:

• Greek prime minister George Papandreou has proposed a referendum early next year on the wildly unpopular rescue package. I wrote here that the success of the Grand Rescue Plan depends on the cooperation of the Greek Street and thought that they would acquiesce as long as no further austerity cuts were asked of them. Now that assumption seems to be unraveling.
• Portugal is unraveling and asking for a bailout. Analysis from John Hussman indicates that the implied default probability from Portuguese bonds is somewhere between 68% and almost 100% within two years.
• Chinese premier Wen Jiabao has pledged to maintain curbs on the Chinese property market.
• China has signaled that it will not be the savior of Europe.
• The 10-year Italy-Bund spread is blowing out. Though Macro Man postulates that the selloff in Italian bonds is a natural reaction because investors don't trust the sovereign CDS market because the rules can be changed so defaults become "voluntary". As a result, they are shorting Italian paper as a hedge.

While the news appears to be bearish, I also wrote in my last post to beware the policy response. We have the FOMC meeting this week and the subsequent press conference on Wednesday and the ECB rate decision and press conference on Thursday.

Will the Bernanke Fed stay with the message of "we can't do anymore, it's up to fiscal policy" message in order to put more pressure on the deadlocked Super Committee? Or will the doves win the day and signal it is willing to undertake QE3, which will likely be in the form of MBS purchases, were the economy to weaken further?

What about the Draghi ECB? Will it lower interest rates? Or will Draghi show the Germans that he is more German than the Germans in the price stability message. Ed Yardeni may already have an answer to that question. The (Trichet) ECB has already been quietly expanding its balance sheet, perhaps as a sign of pragmatism or a precursor to QE.

While I hate conspiracy theories, these actions by the ECB suggest that a backroom deal had been done. First, on the day that the Grand Rescue Plan was announced, Mario Draghi "independently" asserted that he supports continuing the ECB program of sovereign (read: periphery country) bond purchases, which was supposed to be temporary and end when the EFSF came into being. Now we find out that the ECB under Trichet has been expanding its balance sheet, albeit in a minor way.

Putting it all together, these signs point to an imminent ECB easing and friendlier environment for quantitative easing in Frankfurt.


Watching for a shift in market psychology
For me, the most important "tell" of market psychology is how it reacts to good news and bad news. Supposing that the Fed and ECB were to signal tilts towards easier monetary policy this week. Bruce Krasting wrote that the September NFP figures may have been unusually strong because it had five Fridays, which meant that people getting paid every two weeks may have received three paychecks and that Five-Friday effect would have distorted the economic releases for September. By contrast, October 2010 had five Fridays but October 2011 only had four Fridays, which could lead to disappointment on a yoy basis.

Supposing that Krasting is correct and the NFP release next Monday is disappointing. If the Fed were to signal a more accommodative monetary policy based on further economic weakness, will bad news become good news for the equity markets?



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.