What kind of plan to save Europe would get Timothy Geithner's applause?
A plan that would justify the United States' central bank actions taken since the financial crisis began in 2008.
Is a $1.3 trillion bailout package (which has been reported by Bloomberg) enough to prop up Greece, Spain, Italy, Portugal, and the other European nations facing default? Yes, but only for a little while.
Despite North American markets rising sharply and the S&P 500 (SPY) extending its longest weekly rally since February, the problems in Europe are far from resolved and will not go away over the weekend (it'll likely take about 10 years to clean up this mess, but for this report we are focusing on the short-term market potential).
No one knows exactly when or how much money the EU will commit to saving its fiscally weak countries, but we believe if it's in the ballpark of $1.3 trillion, the markets will experience a multi-month rally. If the EU debt issue fades away for a few months, it will allow 'inflation talk' to resume amongst market participants, which will drive commodities and equities higher.
The EU leaders recognize something must be done and they appear to finally be making some progress ('some' being the operative word). If we can take one thing from this European mess it's that EU leaders are not in agreement on many economic and monetary issues - a revelation that will plague the reputation of the euro from this point on.
The strength the EU leaders boasted about in the mid 2000s has been exposed for the sham it is. The EU is more divided than the Republicans and Democrats. This is because countries that demonstrate fiscal responsibility and productivity end up being punished by having to bail out deadbeat countries that provide zero value to the strength of the eurozone.
When you come up negative on job growth, negative on GDP growth and fail to keep your word on paying investors back, as Greece has, there is only one option left; you print money. Or in Greece's case, you beg big brother to print money for you and keep the lions at bay before they divide up all your assets.
The markets will continue to go up with a substantial EU bailout, but it will also spark long-term inflation.
US markets and those around the world are betting that the EU will come together, at least for the time being, to delay an impending crisis. What this undoubtedly means is an injection of access to capital for the European Financial Stability Facility; a.k.a. the EFSF (to avoid twisting your tongue).
The EFSF is an interesting financial entity, which deserves an explanation taken from its official website. The excerpt is below:
The European Financial Stability Facility (EFSF) was created by the euro area Member States following the decisions taken on 9 May 2010 within the framework of the Ecofin Council.
The EFSF's mandate is to safeguard financial stability in Europe by providing financial assistance to euro area Member States.
EFSF is authorised to use the following instruments linked to appropriate conditionality:
* Provide loans to countries in financial difficulties
* Intervene in the debt primary and secondary markets. Intervention in the secondary market will be only on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability
* Act on the basis of a precautionary programme
* Finance recapitalisations of financial institutions through loans to governments
To fulfill its mission, EFSF issues bonds or other debt instruments on the capital markets.
EFSF is backed by guarantee commitments from the euro area Member States for a total of €780 billion and has a lending capacity of €440 billion.
EFSF has been assigned the best possible credit rating; AAA by Standard & Poor's and Fitch Ratings, Aaa by Moody's.
EFSF is a Luxembourg-registered company owned by Euro Area Member States. It is headed by Klaus Regling, former Director-General for economic and financial affairs at the European Commission.
Learn more about the EFSF
The key statement to take from the above excerpt is that the, "EFSF is backed by guarantee commitments from the euro area Member States for a total of €780 billion."
The EFSF raises money by selling bonds and issuing debt in countries that other central banks around the world might still actually buy. Germany and France are two examples and why attention has been squarely on them in recent months.
Issuing debt leads to printing money. Printing money will lead to higher inflation. Inflation is good for commodities and in most cases, equities. However, it's not good for savers. Savers will be punished from all of this mess and will have to take on risk by investing (a tactic to help stimulate GDP) in order to try and preserve wealth. This scenario is great for markets, despite how unfair it may be to the savers.
Germany Could Get Screwed
If the EFSF is to extend access to an additional $1.3 trillion dollars, to hold the EU together and bail out its southern delinquent members, Germany and France are risking their own fiscal reputation.
This is why our team said that the EU should have made an example of Greece months ago. Let it go. Let it fail like the failures its leaders are. Demonstrate that poorly managed countries will feel pain for their fiscal mistakes. Isn't that how it works for all of us? If we make bad investments or spend more than we can afford, no one but us pays the price. Without tough consequence, lessons are never learnt. The EU should strengthen the countries that actually contribute a decent percentage of GDP to the eurozone.
The global economy wouldn't miss a beat if Greece's economy never existed. Greece contributes less than a half percentage point to global GDP. The EU has failed at convincing the world it would be stronger without Greece. The fear of contagion and pressure from the US and other countries appears to have been too much for Germany and France.
If Geithner is happy, as he appears to be now, it means Germany and France are most likely about to go all in.
Forget about Greece or Spain; what happens if Germany and France are facing default in 5 years?
It would appear that both of these countries are set to exponentially expand their domestic deficits. In a rationally thinking mind, this has to raise the question: If GDP in the EU continues to falter, who will be there to bail out Germany and France?
Demographics in the EU suggest that GDP will slow with its aging population, high taxes and declining birth rate.
Unlike the US, the EU doesn't control the world reserve currency. It can fail. It can collapse.
So with that stated, always remember that the slippery slope of inflation is the last ace up the sleeve for these wishful politicians and central bankers. Inflation is good for commodities and, for the most part, equities.
The US Will Inflate Too
The United States is nowhere near a default and as its economy slips, it will simply inject more stimulus and more money. Of course this behaviour has tremendous consequence, but we expect a full blown QE3 at some point in 2012. Close to negative GDP would definitely bring on another fierce round of money printing by the Fed.
We will be anxious to see the EU's decision. Whether it is this weekend or next, decision day is near. These are historic times to be investing and to be alive for that matter. As stated many times in the past, we strongly believe these nations and their central banks will choose inflation over default. We are sticking to our guns and holding commodities and precious metals.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.