Tuesday, January 11, 2011

Uh oh, euro



Yes, that pattern could be seen as a nice head and shoulders top for the euro. No surprise, really, with Europe's bail-ins rolling inexorably toward Portugal. As FT Alphaville illustrated so nicely overnight:
...it took Greece and Ireland less than a month to request EU/IMF aid after their 10-year bond yields breached that all-important 7 per cent level (as indicated in the charts above). Though it’s worth noting that Portugal has been through the 7 per cent barrier a couple of times before and saw yields decline after. Nevertheless, all eyes are on the Club Med member this week.

The crisis has no end in sight. Also in the FT, one of the clearest thinkers on the rolling debacle, Wolfgang Munchau, explains why:
The most glaring manifestation of this lack of leadership is the EU policy consensus that this crisis will eventually be self-correcting, and that a robust liquidity backstop is all that is needed. This is a tragic error. What makes this crisis self-sustaining is the presence of two interacting components: a combined private and public sector solvency crisis, and a competitiveness crisis. To address a lack of competitiveness, southern Europe, including Italy, would need outright deflation. In some cases wages and prices would need to drop by 30 per cent to fall in line with northern eurozone levels. Yet deflation would increase the real value of debt. It may just be conceivable that the periphery will get on top of their competitiveness problem, or on top of the debt problem, but surely not on top of both at the same time, without devaluation or default.

And indeed, that's what David Rosenberg sees coming sooner rather than later. His proximate cause is one of this blogger's favourite themes, that the Irish body politic may flip the bird at the European bail-in in its March/April election.

This blogger has been relatively confident that European fiscal authorities will see reason in time to avert catastrophes. But there is a rather uncomfortable convergence ahead that will put a great deal of pressure on this thesis. As we know, following Portugal is Spain. The Source offers this asessment of the extent of that bail-in:
A rough calculation by Barclays Capital suggests that after paying for Ireland and Portugal, the EFSF would have about €235 billion left, not enough to cover the €290 billion that a Spanish bailout would likely entail.

The yield on the Spanish 10 year is currently 5.5%. Last November, it took just three weeks for Portugal's 10 year bond to rise from the same level to above 7%. It seems to this blogger that it is quite possible that Spanish bonds could trace the same path even as we approach the Irish elections.

The spectacle of the European Financial Stability Facility (EFSF) concurrently attempting to bail-in Spain whilst Ireland defaults out is so Kafkaesque that the credibility of European authorities may suffer an altogether larger run, with all too predictable outcomes.

But let's take a breather for a moment and back away from this precipice. Let's assume instead that some form of eleventh hour fiscal integration solves these problems (which is this blogger's central case). The pressure needed to bring that about is still going to be very large. The euro is going to fall and the US dollar rise on the flight to safety.

This will set up a self-fulfilling sell cycle for global equities. As this blogger has noted many times before, contemporary capital markets are not based upon discipline and fundamentals but sentiment and liquidity. As such, behavioural economics is king and the narrative that underpins recovery is just as important as the recovery itself. Without a weakening $US, the recovery narrative of correcting global imbalances that supports internal Chinese growth, US exports and rising commodity prices ceases to make sense.

As this blogger described late last year, it's central case is that European convulsions are buying opportunities because the growth in emerging markets is so impressive and the larger global cycle will grind higher. If you ignore the danger of a critical crisis in European fiscal credibility, this is still the case.

But this is no time to be toying with markets.

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5 comments:

Anonymous said...

Why do you have conviction in the case for buying on the dips? The majority of emerging market growth is ill-directed (non-productive investment spend on infrastructure that as yet does not have sufficient demand) and the emerging markets are ultimately still reliant on Western demand which, while being propped up by stimulus, is fundamentally broken.

Anonymous said...

and yet i suspect italy may be the real elephant in the room...

David Llewellyn-Smith said...

Hi Anon,

I see the larger global reflation as pushing ahead in the medium term so equities look an ok bet to me.

But only for traders. There is nothing sustainable about this cycle.

I agree with all of the imbalances you mention but see them as subordinate to the reflation until we hit some roadblock and they all come crashing down together.

When that happens is the trillion dollar question of course. But I don't see it as Europe unless they royally screw up (which is quite possible).

I wouldn't call that 'conviction' exactly. Closer would be 'the most likely outcome'...

David

Birch Creek Trader said...

David us quite correct. This is a traders market, with only a few choice investments available (think utilities and non discretionary retail). Australia will not be immune from the end of the reflation. Keep your powder dry!

Ben said...

Understood. In that case I agree with you (apologies, I didn't realise I could input my name). My sense is most investors are holding positions on the basis that they'll be able to pick the right time to sell. Makes for a fickle market.