S&P 500 futures were sharply higher after it was announced in the wee hours of the morning in Europe on Thursday, October 27 that a comprehensive deal had been agreed to by the heads of state of the EU.
In the medium term (the next 6 months at the latest), it will become clear that the announced plan will not work.
In the short-term, the situation may become reminiscent of the period from mid 2007 through mid 2008 – right in the middle of the sub-prime melt-down. By mid 2007, it was abundantly clear that given the size of the problems in the mortgage markets, a systemic financial crisis was inevitable. However, this rather obvious fact did not prevent strong rallies in equity markets, nor did it prevent commodity prices from rallying to stratospheric levels. Vague hopes that unspecified government and/or central bank actions would somehow avert the inevitable kept markets buoyant for an entire year before they finally collapsed.
Reasons Why The European Plan Will Not Work In The Medium Term
There are many reasons that the current European plan will NOT work in the medium term. Here are only a few:
1. Not enough money for bond guarantees. Since much of the $440B Euros is already committed, the remaining funds can probably only be stretched to cover bonds worth 900 billion to 1.3 trillion Euros. That is not enough. Probably 2.5-3.0 trillion would be needed for the plan to work.
2. Covers financing needs through mid 2013. So what happens after mid 2013? What is going to change between now and 2013 to suggest that the PIIGS can be taken off of life support? Nothing. Their debt will only be higher than it is today. If the PIIGS were growing briskly by mid 2013, they could be taken off of life support and they could service their debts organically. However, because of the PPP imbalances described here these countries will find themselves in the same uncompetitive position that they found themselves in before the onset of the crisis. Since it will be near impossible for these countries to counteract the contractionary effects of current account deficits via fiscal deficit spending and/or capital inflows, the PIIGS simply cannot grow. This is the real crux of the PIIGS problems. Unfortunately, this problem is not even being addressed.
3. A 20%-25% guarantee is insufficient. No sovereign would choose to assume the massive costs associated with default in order to obtain a mere a mere 20%-25% haircut on public debt. Thus, to the extent that a default ever occurred, it would be for much more than 20%. Since bond-holders know this, the guarantee will not be sufficient to satisfy bond investors. Unmanageably high interest rates will be the consequence.
4. The guarantee is not credible. The “guarantee” that will allow the EFSF fund to be “leveraged” is to be provided by the same basket cases that need their debts to be guaranteed. This “guarantee” is a paper paper tiger that will fool no one. A basic principle of credit analysis is that the credit is only as good as its weakest link. Debt issued by PIIGS basket cases guaranteed partially by the same by PIIGS basket cases is an arrangement that is not credible.
5. Germany doesn’t want to assume risk as guarantor. Exactly how the guarantees will be structured has not been decided. However, the Germans have already made it clear that they do not want to be direct guarantors of the debt. They want the PIIGS basket cases to borrow money from the EFSF and use that money to guarantee their own bond issues. It’s the broke guaranteeing the broke with more debt! Again, this guarantee arrangement is not credible.
6. Outside investors will not participate meaningfully. The Europeans have tried to fan speculation that private investors, including sovereign wealth funds of nations such as China could be major investors in the bail-out bonds. It is highly unlikely that sovereign wealth funds and/or private investors will be keen on assuming risks that Germany was unwilling to assume. The Chinese will make supportive sounds. But in substance, I believe that sovereign wealth funds will not make the sort of investments that will alter the equation substantially. Neither the Chinese nor private investors are foolish. They know that the PIIGS cannot service their debt while they remain crucified to the Euro.
7. Bank recapitalizations not credible. Let us assume that European banks can recapitalize as stipulated in the current plan. This recapitalization will be rendered useless if the threat of default of other major Euro members is not taken off the table. For example, it has been estimated that a mere 10% haircut on Italian debt would render the entire European banking system insolvent.
8. Core credit risk. It is not just the credit risk ratings of the PIIGS countries that is at stake here. The default risk of the PIIGS clearly imperils the economies of the core countries via the exposure of the banks of the core countries to the PIIGS. Thus, core countries such as Germany and France face the prospect of financial crises, massive bank-recapitalizations and huge recessions that greatly increase the perceived credit risk of the core countries. This makes the EFSF paper tiger much less credible.
9. Insane cost. Under the proposal being discussed (this one is not certain yet) to raise $100, a PIIG will have to borrow an extra $20 from the EFSF in order to provide insurance, thereby increasing their indebtedness substantially. A country would essentially have to become indebted by 120 Euros in order to simply receive 100 euros in cash.
10. EFSF as preferred creditor. In the past when there have been defaults, nations have chosen to continue to pay multi-lateral creditors rather than private bond-holders. This is exactly what has happened in the case of Greece – only private investors are getting a haircut. Investors are aware of this. Thus, having PIIGS borrow from the EFSF potentially places another creditor ahead of private creditors – no mater what the formal covenants say.
11. Fake Brady Bonds. As I have explained recently, the plan to partially guarantee debt issued by the PIIGS sounds a little like the Brady Plan used to rescue Latin American basket cases and their creditors in the 1980s and 1990s. The problem is that Brady bonds had a credible guarantor in the US Treasury. These “euro Brady bonds,” do not have a credible guarantor.
12. No restructuring. The Brady plan was based on an integral restructuring of all of a country’s sovereign debt. Investors took hair-cuts that lowered debt burdens and made the debt more manageable. There is no restructuring in this plan to make the debt lower or more manageable. Thus, the plan is not credible.
13. Reference interest rates too high. This plan will do nothing to contain the high level of interest rates that is choking off growth in the PIIGS. Sovereign bonds are the reference interest rate. The yields on old uninsured sovereign bonds will become the new reference for private sector interest rates – not the yields on the bonds with the guarantees. After all, private sector loans will not be guaranteed by the EFSF. Furthermore, just like what occurred with Brady bonds, the market will calculate the “striped yield” of the EFSF bonds that is the theoretical yield of the bonds without the guarantee. Since nothing has been done structurally to lower the credit risk of the issuers, there is little reason to think that these “stripped” yields will be any lower than the unguaranteed yields are now. These yields choke off growth in the PIIGS and ultimately make the debt unserviceable.
14. Without ECB money creation, any plan will fail. The funds for financing of new deficits and debt can only come from three sources. One source would be direct purchases by the ECB and/or ECB financing. These options have been ruled out. Another source would be the banks. The problem is that the European banks have no more room on their balance sheets to expand credit. Indeed, right now, given their low capital levels, European banks either need to raise capital to simply support their current level of assets or to shrink their balance sheets.
Finally, foreign investors such as the Chinese could step in to provide funding. This might help, but it is doubtful that this source can be relied on for much. (This requires ECB monetary accommodation to be expansionary anyway). Thus, without new asset purchases by the ECB and/or injections of foreign money, financing becomes a zero sum dynamic: Credit to the private sector must contract in order to provide money to the public sector. Without massive ECB money creation, this “crowding out” would be contractionary and ultimately makes the whole project unviable.
In the Short-Term Markets Can Rise Anyway
After mid 2007, well after it was clear that a crisis in the US was inevitable, US equity markets (^GSPC, ^DJIA, ^NDX) actually had several significant rallies. Furthermore, commodity prices actually rallied to all-time highs. Nervous short-sellers worried about this or that government action fueled many of these relatively low-volume rallies.
For many of the same reasons, US and global equity markets may stage substantial rallies during the next few weeks/months.
A combination of rising equity prices, along with justificatory narratives developed in the news media could entice many investors into a capital-destroying “sucker’s rally.”
Investors should keep in mind that the final outcome in Europe has likely only been postponed, but not altered. Europe will be back to square one and descend toward a terminal crisis – ostensibly the same crisis -- within a matter of weeks or months. Global equity markets will collapse, and the S&P 500 will test and possibly penetrate recent lows of around 1,075 on the way to a date with 950-1,020.
In late July of 2011, with the S&P 500 (^GSPC) at over 1,340, I sold all equity positions and established short positions on the market. I have no hesitation in remaining in cash and short-term bonds even if the US market rallies back to 1,340 or beyond. It is far preferable to leave 10%-20% upside on the table than to risk downside of 30% or more. Furthermore, in the medium term, short-side opportunities look far more attractive than long-side opportunities.
Thus, I believe that the correct posture at the moment is for investors to be entirely in cash, or at least equity neutral via paired trades and/or hedges.
Even if Europe manages to get by and markets are substantially higher six months from now, it will simply not be worth it to have assumed the risks posed by equities at the present time. I do not believe that even the perspective of hindsight could alter this assessment in the future
Quite the contrary. Equity investors will likely find themselves in the position that existed in mid 2007. By mid 2008 these same equity investors were wondering how they could have been so foolish to have remained long stocks, or even to have increased their equity exposure, despite very clear signs that the global financial system and economy was irreversibly about to experience a major crisis.
Greed, which is just another form of fear (fear of “losing out), is an extremely powerful motivator. It takes courage to stray from the stampeding herd. This is one reason why preservation of wealth is so difficult.
The question is this: Do you have the courage to stand aside and possibly leave 10%-20% or even 30% on the table? Or would you rather not take the “risk” of missing out on that gain -- even if it means assuming the possibility losing 30%-50% when and if the European plan unravels?
US stocks (SPY, DIA, QQQ) are at reasonably good values. Indeed, they are quite cheap relative to bonds. Many stocks such as Apple (AAPL), Microsoft (MSFT) and Pepsico (PEP) look attractive on a long-term basis. However, it is my belief that these stocks will get much cheaper. And even if they don’t, over time, the markets always provide investors with many opportunities.
Investors do not have to take advantage of every single “opportunity” in order to be successful. In equity investing, there is no such thing as any particular moment representing a “last chance.” In particular, it is my view that investors do not need to be in any rush to assume the sorts of historic risks involved with equity investments at the present time.