Europe And The Equity Dilemma

Includes: EU
by: Kevin Flynn, CFA

Good news - the U.S. economy is still hanging in there. Housing is a little better of late, manufacturing and employment a bit more mixed, but all are doing better than last year. However, caution has undeniably taken root. Corporate CEOs consistently talk about hesitant customers and weakening end markets. China and Europe are slowing, with the latter in recession and the former subject to many assertions that the country has slowed more than it wants to admit.

With the European Union ((NYSEARCA:EU)) summit set to begin Thursday, the burning question is whether or not Germany and Chancellor Merkel can take a step towards joint liability and perhaps ease the EU's financial logjam. Did she, or did she not say, "not while I'm alive?" What one says at a party meeting and what one does in office are of course two different things -no one thought Richard Nixon would go to China.

The outcome that Merkel is right to fear is one of post-bailout spending by other EU members. If eurobonds were to be issued, rates driven back down and the system reliquified on at least a temporary basis, the temptation would be quite strong for governments from Greece to France to go back to boosting public-sector salaries and benefits. We're not taking sides in culture debates here, just pointing out that there already is considerable political pressure to do such things. Many already argue such spending as necessary stimulus, or at least relief, for the national economies.

Wherever you stand on spending, it is undeniable that watching countries such as France, Spain or Greece take their eurobond funds and turn around to use them - directly or indirectly - to increase public sector compensation and employment would be a political disaster from the German point of view. Merkel and her party would be pilloried and dismissed. Her outraged successors, possibly dealing with a lowered credit rating, could be a greater threat to EU unity than the Greeks.

Seemingly more modest steps to ensure stability, such as jointly-guaranteed deposit insurance for the eurozone's banking system, face the same problem. The method might be different, but the temptation would remain the same: Instead of receiving funds from eurobonds, governments could raise extra money by stuffing their banks with domestic sovereign bonds, then use the proceeds to pursue additional public-sector spending. It's no wonder that Merkel wants to ensure that spending controls be put into place first - without them, things could go quite awry from the German point of view. The eurobonds meant to defuse the crisis could very well lead to a splintered EU and the undoing of the union that everyone wants to preserve.

Merkel and her allies want controls that the national governments are unwilling to concede. The phrase "Lehman moment" has been used enough that a certain fatigue with it has crept in, us included, but from a distance the view is beginning to uncomfortably resemble the Lehman drama.

The financial system meltdown began with one actor and ended with another, starting with two Bear Stearns-backed mortgage funds hitting the rocks in the summer of 2007. Equity markets went about their business and prices hit a peak in October, yet only nine months later the 85 year-old investment firm had foundered. Markets wobbled, then rallied, but the focus of attention drifted onto the next weak link, as it always does, and just as we have gone from Greece to Spain.

Like France or Spain today, Lehman Brothers (led by CEO Dick Fuld) did not initially want to make any concessions. Lehman was a sovereign too, with no reason in Fuld's mind to give up board seats (beyond a token) or accept investments at less than a premium to the stock price. Though government agencies were involved, with Treasury and the Fed monitoring the situation from beginning to end with increasing involvement, nothing came of it. Criticism in the wake of Bear Stearns left the authorities with an aversion to any more "bailouts" (though Bear Stearns wasn't bailed out, it was diced up and sold).

As in the current EU situation, neither the debtors nor the lenders ever managed to stand on common ground. The debtors - Fuld and his successors - never believed that the government would ever let Lehman disappear. It was too unthinkable. The ones with the money - Treasury, the Fed et al - insisted to the very end that it just wasn't their problem. The clock ran out on both of them.

The post-mortem on Lehman has been done elsewhere, but the parallels are there - one side tired of putting up money and increasingly averse to doing any more, another side believing that the other surely must act to stave off catastrophe. The public watches from the sidelines, believing that somehow both sides will muddle through.

Bernanke maintained that the Fed lacked the necessary apparatus and legal authority to put up the money for salvaging Lehman. That sounds very much like the tone Chancellor Merkel is using now. Dick Fuld started out wanting to preserve Lehman intact; does it seem like France, Spain and Italy are about to make concessions on sovereignty? They're going to want to see the money first. Simon Nixon observed in Wednesday's Wall Street Journal how "politicians are reluctant to dismantle expensive entitlements and voters even less willing." In the meantime, the latest EU council paper used the expression "moral hazard" in connection with joint bond issuance, two words that were very popular in the summer of 2008.

As Marc Antony might say, they are all honorable, but the net result could be very much the same, right down to the calendar. The Lehman crisis reached high anxiety in July, but when August came people went on vacation and the markets put on a rally. Right up to the morning that Lehman filed for bankruptcy, the prevailing feeling across the globe was that somehow an accommodation would be reached. Maybe the ECB will reverse the order next week and induce July to rally instead of August, but the fundamental problem of too much bad debt will still be there in the fall.

We are not alone in believing that only a good look into the abyss can get the principal actors to a place where they can cut a deal, and only a collapse is going to get them to the edge of the abyss. The U.S. wasn't any different - our own Congress initially balked at the TARP emergency measures, needing an 800-point drop in the Dow Jones to get them to rethink their position. The EU actors may get to the edge slowly via the depression route, or quickly through sudden financial panic, but the changes are fundamental enough that only clear acts of self-preservation are going to sell them back home.

Out of pure self-interest, we hope that the crisis comes sooner than later. The damage to the global economy could hopefully be more quickly repaired after a flash meltdown-and-repair job, as happened in 1987 and 1998, rather than after a painfully drawn-out affair like 2001-2002 or 2008-2009. It certainly seems preferable to sitting through another year or two of failed hopes and being ground to dust by seemingly endless squabbling and recession.

We hear considerable talk about the will to preserve the EU and the euro, and we believe it. There wasn't any will we know of for Lehman to fail or the economy to crash either - on the contrary, everyone was trying to do the right thing. This week's summit may well be a good faith effort to keep moving in the right direction, but it isn't likely to produce more than agreements to talk about to get there (the German goal is "a framework for discussion"). But the clock is running. Europe won't get out of its bind by doing nothing, and Germany cannot protect its credit rating and economy by doing nothing either. Neither can we. They thought they had more time at Lehman Brothers, too.

Equity investors could be faced with a dilemma: The stock markets are set up for people to invest, such that an upward bias is structurally built in. Sometimes, though, the normal rhythm of the markets can obscure the sounds of termites chewing in the basement. A good example is current ten-year Treasury and German Bund yields. They represent extreme fear levels, yet equities soldier on. Perhaps one difference is that equity traders always think that they can get out the next day, while fixed income traders know that there might not be any bids tomorrow.

The ECB may well launch another liquidity program next week, and if it does equities will rally. Sovereign yields could back off again, and worries take another summer vacation. But the termites will keep chewing, and the clock will still be running. The EU has less time than it thinks. Ask anyone from Lehman.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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