Gavyn Davies: European sovereign debt is not really sovereign

Desde el Financial Times:

The events of the last few weeks have shone a very harsh searchlight on the nature of sovereign debt within the European Monetary Union. Although critics of EMU have always argued that monetary union without fiscal union is “impossible”, it was only when Angela Merkel started to call for a procedure to handle a possible default on the sovereign debt of a member state that the markets began to focus on the fact that such a default really is possible. In substance, nothing much has changed with Mrs Merkel’s remarks: it always was possible for a sovereign state within the EMU to default. But now that the markets have realised that some key elements of “sovereignty” are missing from the EMU member states, market psychology has changed. It will be very hard to put this genie back into the bottle.

When the euro was launched a decade ago, critics of the single currency said that it would prove impossible to run a single currency without also establishing a fiscal union. The reason generally given was that the countries inside EMU would face a free rider problem, under which those governments with a history of fiscal profligacy would choose to run much higher fiscal deficits, secure in the knowledge that they would not face either a run on the currency, or a rise in domestic interest rates. In practice, this situation did indeed arise in the case of Greece but, contrary to fears, it did not arise elsewhere. Ireland, Portugal and Spain all found themselves in severe financial difficulties, but in none of these cases was fiscal profligacy the root cause of the problem. So fears of fiscal free riding were, for the most part, misplaced.

However, the critics of EMU also aimed another argument against the design of the monetary union. They said that in the absence of a central fiscal authority (i.e. a European central budget), there would be no mechanism to redistribute the costs of a severe economic shock from the weakest members to the strongest. They pointed out that the federal government in the US has a budget which is many times bigger than  the central budget of the European Union, a fact which would greatly increase the efficacy of the burden sharing mechanism within the US dollar zone. In the US, the financially strong states of the union would automatically support the weak states when the economy hits trouble. This would not be the case in Europe. And the problem would be even greater if there were an asymmetric shock which hit one group of countries harder than others.

This criticism has proven accurate.  Several economies find themselves stuck in a situation where they are forced to choose between a massive fiscal retrenchment and leaving the monetary union. A conceivable third choice, under which strong countries like Germany and France mimic the effects of a fiscal union by increasing budgetary inflows into the peripheral states does not seem to be on the agenda. (See this excellent analysis by Wolfgang Münchau on the topic.)

Inside EMU, this would be classed as a “donation” from one country to another, and would almost certainly be politically infeasible. In consequence, the financially strong member states have limited themselves to making loans - loans which are at preferential interest rates, but which otherwise involve no fiscal transfer and which eventually have to be paid back in full. This may solve a liquidity crisis, but will not handle a solvency crisis, any more than the solvency crisis of the global banking sector was solved by liquidity injections in 2008. The analogy in 2010 is that the peripheral countries of Europe may need a capital injection, as did the banks two years ago.

It does not seem at all likely that they will get one. Instead, Germany and France have agreed that a mechanism is needed to handle future defaults of sovereign debt inside the EMU. In a truly sovereign nation, the government has two mechanisms for ensuring that it cannot go bankrupt - the ability to use its central bank to finance government debt by printing money, and the power to raise tax revenue from the private sector. These are among the powers which are unique to a nation state. The first of these powers has been removed from the members of EMU and their sovereign debt has in effect been issued in a “foreign” currency, the euro. Member states cannot print the euro, which automatically increases the risk that they will default on their debt. (Admittedly, it also reduces the risk that they will inflate their debt away. The markets are not too worried about this in these deflationary times, though one day they might be.)

Now that markets have been forced to focus on the fact that EMU members are more likely to default than truly sovereign states, they have started to charge a variable risk premium to finance the debt of these troubled economies. In the days of the old ERM, this market pressure eventually forced adjustments in the exchange rate regime, though the arena for market speculation in those days was the currency market. Now, the bond market has replaced the currency market. It is no less dangerous for that. A very unpleasant feedback is developing between a weakening fiscal position, higher bond spreads, and further weakening in fiscal solvency. This is very reminiscent of the ERM crises in the early 1990s.

The markets, which for a long time had no effective way of undermining the monetary union, now recognise that it can be done. And so far the response of European policy makers to this new threat has been inadequate. No one wants to accept fiscal transfers, and no-one wants to see the monetary union breaking up. Something, somewhere has to give

Pensamientos de Hussman

"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess."

MIT Economist Rudiger Dornbusch, November 1998

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Comprar protección (2ª parte)

IBEX 35: continuamos viendo en los 9.300 puntos un objetivo razonable mientras la deuda española se mantenga por encima de los 200 pb de diferencial frente Alemania en todos los plazos

Las decisiones de inversión a lo largo del ciclo

Felix Zulauf:

• Cyclicality: Economies and markets move in recurring cycles;
• Valuation: Relative valuation between asset classes reverts to a mean over long periods of time;
• Sentiment: Sentiment is a useful contrary indicator, especially at extremes;
• Momentum: Over the medium term, cyclical trends can develop their own sustaining momentum;
• Risk Management: Minimizing losses and managing exposure are crucial components of positive returns.

Reacciones QE: Nikkei vs S&P 500

Desde pragcap.com:

"When the BOJ first announced QE in Japan in March 2001 the Nikkei 225 went wild.  Over the following 6 weeks equities rallied over 16%.  The reaction has been almost identical in the S&P 500 over the last 2 months.  But as investors in the USA begin to realize that QE is not the panacea it was first advertised as the S&P 500 has begun to reverse course.  In Japan, this was a scenario that did not end well as equities declined 43% in the following two years.  Although history rarely, if ever repeats, this is one chart that might be worth taking note of:"

Rango objetivo IBEX 35: 9.300-10.200

La repreciación de riesgo soberano periférico ha saltado esta semana a España e Italia. En el caso español, a la superación de los 200 pb en el diferencial de deuda a 10 años con Alemania hay que sumar la prima de riesgo relativa que también está soportando el IBEX 35. Así, frente al 5,5% de prima de riesgo implícita que extraemos de las valoraciones del EuroStoxx nos encontramos con un 6,58% para el caso del IBEX 35, una prima de riesgo diferencial que supera los 100 pb. Niveles sobre los que podría mantenerse en las próximas semanas si no observamos una mejora en los diferenciales de deuda pública.

Implicaciones para los niveles objetivo del IBEX 35: con un ciclo de beneficios creciendo a ritmos del (4%-6%) en acumulado a lo largo de los próximos 5 años junto con una prima de riesgo diferencial en la parte alta del rango 100-125 pb frente a EuroStoxx, obtenemos un rango objetivo entre los 9.300-10.200 puntos.

The Cliff

Desde el semanal de Hussman:

"It should not be a surprise if present levels of corporate profits are followed by negative profit growth over the coming 5 years"

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Primas de riesgo y bancos centrales

En adelante, los 110 mil millones USD de compras mensuales de deuda que va a ejecutar la Reserva Federal hasta JUN11 apuntan a que (1) el balance de la Reserva Federal volverá a ganar peso explicativo en la dinámica de las cotizaciones bursátiles y (2) estas últimas podrían continuar con la inercia alcista apoyada exclusivamente por la estrategia de inflación de activos de la Fed a la espera de un relevo desde el ámbito “fundamental”. Mientras tanto, las valoraciones continuarán muy alejadas del outlook económico actual, y por lo tanto, en una situación muy vulnerable.

The Many Faces Of Deleveraging

Desde Contrary Investor:

Enough charts and numbers and all that other stuff.  We think the summation messages are very clear and certainly have implications for at least a domestic economy that is suffering primarily from a lack of aggregate demand, let alone a global economy in part suffering from the same.  As hard as this may be to hear, deleveraging is still barely out of the total cycle starting gates.  At the household level we have not yet even seen organic deleveraging, but rather deleverageing through defaults.  Jobs and income growth are the keys to the deleveraging process at the household level, but they are for all intents and purposes missing in action in the current cycle.  And that speaks to time.  Time for true balance sheet healing and ultimately a recovery in aggregate demand.  The very means for households to delever independent of default are not visible.  Not yet.  And so we need to expect 1) a stop-start real world domestic economic recovery, 2) Fed QE that does nothing to reinvigorate the real economy, but has the real potential to create yet more unproductive asset bubbles, 3) continued volatility in financial asset and commodity prices based on investor perceptions of Fed and global central banker sponsored liquidity and the effectiveness or not of liquidity injections at any point in time.  In reality, this is nothing we have not already been dealing with up to this point.  But for our investment activities specifically, we believe it all comes down to just how far the Fed and their global central banking brethren are willing to push the envelope in terms of money printing, currency intervention, etc.  For now, investors still view these activities as virtuous.  But at some point unless we do indeed see true real world economic reinvigoration, we believe the markets will come to view further Fed and global central banker monetary "experiments" quite negatively.  All part of the psychology of a financial market and economic cycle.

El informe completo, aquí

PIB 3T10 EEUU: importan los detalles

Dave Rosenberg

U.S. REAL FINAL SALES 60 BASIS POINTS SHY OF DOUBLE-DIPPING

The major problem in the third quarter report was the split between inventories and real final sales. Nonfarm business inventories soared to a $115.5 billion at an annual rate from the already strong $68.8 billion build in the second quarter -- this alone contributed 70% to the headline growth rate last quarter. If we do get a slowdown in inventory investment in Q4, as we anticipate, it would really not take much to get GDP into negative terrain. We estimate that if the change in inventories slowed to about $94.0 billion in Q4 (about $22 billion below Q3 levels), GDP would contract fractionally. In other words, it won't take much for GDP to slip into negative terrain.

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