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4 CREDIT BUBBLE
BULLETIN It's all
Greek to me Commentary and weekly watch by Doug
Noland
The focus of analysis this week
shifts back to Europe. My thesis remains that the
unfolding European debt and economic crises
provide a potential catalyst for a bout of
problematic global de-risking/de-leveraging. An
argument can be made that the recent rally and
short squeeze throughout global risk markets
actually heightens market vulnerability.
I
have expected that policy would have little
success in halting the bad debt cancer spreading
methodically from Europe's periphery to its core.
I have also posited that with core country Spain
enveloped in credit tumult, crisis momentum had
passed a critical juncture. It is worth recalling
that Spanish 10-year yields reached
7.5% in late-July, as
Italian yields surged to 6.6%. An important part
of the thesis, as well, has been that the European
crisis would expose bubble fragilities fermenting
in the "developing" economies, especially in
China, Brazil and India. There has been important
confirmation in the thesis, both from financial
and economic perspectives.
Not
unexpectedly, global policymakers have responded
to heightened systemic risk with extraordinary
vigor. In Europe and the US, central bankers have
introduced the world to the idea of open-ended
liquidity creation and market intervention. Global
risk markets have responded strongly to the latest
iteration in New Age monetary management, only
widening the gulf between securities prices and
fundamental prospects. Markets now anxiously
anticipate the implementation in Europe of the
Draghi Plan and Federal Reserve chairman Ben
Bernanke's big monetization. At the same time,
there is justified caution with respect to the
impact all this liquidity is going to have on
already problematic economic imbalances.
Last week's Credit Bubble Bulletin focused
on the premise that "economic structure matters -
and it matters tremendously". This is one of those
"master of the obvious" comments, yet these days
one sees essentially no attention paid to such
analysis. The evolving European crisis has
provided important confirmation of this analysis.
We've watched how Greece's tiny little
economy evolved into a formidable financial black
hole. Why? Well, years of credit excess fomented
deep structural maladjustment - maladjustment that
remained largely concealed so long as ample
credit/spending power was forthcoming.
Post-bubble, the Greek economy is just not capable
of creating sufficient real economic wealth to
support its population - not to mention its debt
load. Greece's economy remains in a steep downward
spiral - and in desperate need for bailout #3 and
ongoing outside assistance. Meanwhile, the social
fabric badly frays or worse.
A critical
question today - for Europe, for international
markets and for the global economy - is whether
Spain is following in Greece's footsteps.
According to International Monetary Fund (2011)
data, Greece ranks just below Venezuela as the
world's 35th largest economy (gross domestic
product, or GDP, of US$303 billion). About five
times the size of Greece, the Spanish economy
ranks #12 in the world at $1.49 trillion. While
not as debt-ridden as Greece, Spanish federal and
regional government debt now exceeds 100% of GDP -
and is rising rapidly.
Spain will require
enormous financial support. It has both a
substantial economy and substantial banking system
- both today in serious trouble. Similar to
Greece, a prolonged credit boom has resulted in a
terribly maladjusted economic structure. Literally
hundreds of billions of euros will be required -
and I fully expect the bailout tab will, in Greek
fashion, expand on an annual basis.
Fear
for Spain and Italy was the impetus behind the
creation of large bailout facilities (the European
Stability Mechanism joining the European Financial
Stability Facility) and, more recently,
commitments for open-ended bond purchases from
Mario Draghi's European Central Bank - Outright
Monetary Transactions (OMT). In a sign of the
times, global markets to this point have viewed
Spain largely in a positive light, as a likely
catalyst for hundreds of billions of governmental
and central bank market interventions/liquidity
operations.
Developments this past week
provided a hint that complacency might be
unjustified. With an unemployment rate of almost
25%, social tensions have reached the boiling
point. Public protests that had been peaceful
turned violent - recalling a critical crisis
inflection point in Athens. At least Greece has
not had to deal with regional governments calling
for independence.
This week, Artur Mas,
president of Catalonia, called early elections for
November 25. Catalonia is the wealthiest of
Spain's 17 regions, accounting for about one-fifth
of Spanish GDP. From the Financial Times:
Catalonia has a proud tradition of
self-rule dating from the Middle Ages ... In
recent times a decisive moment came in 2010 when
Spain's constitutional court largely rejected a
new statute of autonomy for Catalonia approved
by the national parliament in 2006. The statute
was favored by Spain's former Socialist
government but opposed by the center-right
Partido Popular, which now holds power in
Madrid.
There's no love lost between
Mr Mas and Prime Minister Mariano Rajoy. In recent
meetings, Rajoy rejected Mas' request for more
financial independence (including control of local
tax receipts) from Madrid. Catalonia's economy has
faltered badly, and the heavily indebted region
was forced to seek bailout assistance from the
federal government.
The Rajoy government
has been seen as using the crisis backdrop to
wrest control from the regions, something that has
inflamed latent animosities - especially in
independent-minded Catalonia. Catalonians resent
paying significantly more to Madrid than they
received in services, essentially subsidizing
other regions. They blame Madrid for their
problems. Catalonian officials have been
determined to take control of their own purse
strings, a right enjoyed by the nationalistic
Basque region. On September 11, an estimated 1.5
million protested in support of "Catalonia, a new
European state" in the streets of Barcelona.
There has been some concern that Spain's
military may be forced to respond to Catalonia's
move to independence. This further complicates an
already complex economic, social, political and
historical backdrop. Spain on Friday afternoon
announced the results of an "independent audit" of
the country's 14 largest banks. As expected, the
government reported a $76 billion (euro 62
billion) short-fall in bank capital.
While
the European Union would like to believe these
stress tests are a "major step" in restoring
confidence, few analysts believe the results
accurately reflect the size of the rapidly
expanding hole in Spain's banking system. It takes
a major leap of faith to believe that half of the
banks tested are today adequately capitalized. And
from the UK Telegraph: "The audit was based on an
assumption that the economy would shrink 0.3% in
2012, but this already looks outdated as
conditions quickly deteriorate."
And while
we're on the subject of economic deterioration and
incredulous assumptions, Spain on Thursday
released its 2013 budget. The Rajoy government
plans to use spending cuts, tax increases and $3.9
billion of pension reserves to reduce its budget
deficit to the agreed upon 4.5% for 2013 (in the
face of an expected 30% increase in debt service
costs). This budget assumes economic contraction
of 0.5% next year, when some forecasts now call
for deepening recession and GDP contraction of at
least 3%. On Tuesday, Spain reported that its
deficit for the first eight months of 2012 had
already increased to 4.77% of GDP (vs year ago
3.81%), with spending rising 8.9% and receipts
declining 4.6%. It's all Greek to me.
While Spain's budget and "stress test"
results have limited credibility, it hasn't much
mattered. Some go so far as to recommend holding
Spanish debt on the view that it's good to own
what governments are about to buy (holds true, as
well, for US Treasuries and mortgage-backed
securities). It's now a matter of ironing out the
timing and details of an ESM bailout and,
presumably, ECB purchases in the secondary market.
And, to this point, it is a case where the more
rapidly things deteriorate the more confident
market operators become in the imminent arrival of
the liquidity onslaught.
Here's where
things get more interesting. The original plan
calling for Spain to tap the ESM for funds to
recapitalize its banks has hit road blocks.
Earlier in the week, ministers from Germany, the
Netherlands and Finland (the Northern AAAs) argued
against direct bank recapitalization, while also
stating their view that problem bank assets must
remain the responsibility of the sovereign.
Besides, there is supposed to be a European-wide
bank regulator in place before recapitalization
fundings are considered. The whole scope of a
single bank supervisor has become a source of
heated debate, with Germany strongly opposed to
the idea of the ECB attempting to supervise all
6,000 European banks.
And it is worth
noting that the Bundesbank's Jens Weidmann was out
in force again last week, in one instance speaking
in support of the Northern AAAs: "In order to keep
liability and control in balance, only risks that
have arisen after common supervision is
established can be taken under joint liability.
The legacy burdens on bank balance sheets have to
be underwritten by the countries under whose
supervision they have arisen... Mutualization of
risks can't be the primary purpose of a banking
union."
Spain has made a disastrous mess
of its banking system - and market hopes that it
was about to offload some of this risk to the
EU/ESM is at this point little more than wishful
thinking.
Europe remains an unfolding
disaster, although the region's bonds and stocks
remain speculating vehicles of choice under the
assumptions that Draghi is about to lend hundreds
of billions of support and, at the end of the day,
the Germans will backstop the European debt
markets.
As for the Draghi Plan, I'll
presume many on the governing council hope that
the ECB is never called upon to use its bazooka.
Indeed, the true capacity of the Draghi Plan is
much in doubt. The Bundesbank is adamantly opposed
to the OMT, while questions remain as to its
legality. And in Germany, it appears there is
mounting political opposition to the ECB and other
transfer mechanisms.
I know, when
faltering markets place the barrel of a gun to
German Chancellor Angela Merkel and others' heads,
mouths open and market-friendly utterances pop
out. Yet, once again, we're witnessing how it is
incredibly difficult to go from talk to actual
bailout program implementation. Meanwhile, the
politics seem to only get more difficult by the
week - if that's even possible.
Right now,
markets are focused on the inevitability of a
Spain bailout and the unleashing of the vaunted
ESM and OMT programs. I'm not sure whether it will
be weeks or months, but I do expect we're heading
in a direction where the markets will turn
attention to sinking Italian and French economies
and worry that these bailout programs are not
going to be up to the task.
WEEKLY
WATCH The S&P500 declined 1.3% (up
14.5% y-t-d), and the Dow lost 1.1% (up 10.0%).
The Morgan Stanley Cyclicals sank 3.0% (up 10.8%),
and the Transports slipped 0.4% (down 2.5%). The
Morgan Stanley Consumer index declined 0.6% (up
10.1%), while the Utilities gained 1.0%
(unchanged). The Banks were down 1.3% (up 25.9%),
and the Broker/Dealers were hit for 3.2% (down
0.8%). The S&P 400 Mid-Caps fell 1.7% (up
12.5%), and the small cap Russell 2000 dropped
2.1% (up 13.0%). The Nasdaq100 was down 2.2% (up
22.9%), and the Morgan Stanley High Tech index
dropped 2.0% (up 16.2%). The Semiconductors were
slammed for 3.3% (up 4.9%). The InteractiveWeek
Internet index declined 0.8% (up 14.0%). The
Biotechs fell 2.6% (up 42.8%). Although bullion
was little changed, the HUI gold index dropped
2.2% (up 3.0%).
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