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Founder of The ECU Group plc in 1988 was CEO & Chief Investment Officer for 19 years. 25 years of experience in managing FX mandates and presided over the successful management of all ECU's core currency products until Nov '07. He returned to ECU in 2011 and was appointed interim CEO in Feb... More
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  • The Eurozone - Time To Get Real And Fasten Seat Belts.... 0 comments
    Apr 30, 2013 7:33 AM

    The Eurozone is a disaster - economically, politically and socially. The EZ PMI & GDP data trends are clear and they are pointing down.

    (click to enlarge)

    It will fail (as we know it). No if's, no but's. It is a political dream, based on theoretical ideology, which has no chance of survival in practice. Fixed exchange rates in history have an appalling track record at the best of times, but with this one we have gone beyond redemption. Had the EZ undertaken proper financial, economic, political, fiscal and welfare reforms over the past 15 years and disciplined themselves to a strict convergence towards a level playing field on all levels, then maybe (just maybe) there would have been a slight chance that this project could have worked for a reasonable length of time. As it is this hasn't happened and it is now too late. Some countries are simply too far gone and will be unable to recover before this crisis rotates from financial, economic and sovereign debt onto political and "social" (which is where it all ends as we know it).

    The major flaw in any political dream is that politicians are only there for as long as "the people" are prepared to tolerate them or (the consequence of) their policies. In political terms, "the swing of the pendulum" is beginning to swing hard against austerity, against enforced erosion of cultural heritage and against the one size fit all. Not everyone in Europe wants to become a German - economically or socially. The cultural divisions in Europe are simply enormous and as a consequence of not starting as they meant to go on (15 years ago) and total neglect over the ensuing years to move to a level playing field via major reforms in many areas has meant that bitterness and resentment has built up on all sides as, much too late in the day, policy makers try to put the genie back in the bottle amid a fractious blame game. It's too late.

    Effort so far have papered the cracks but real damage has been done and the only way to save the EZ as we know it is for Eurobonds and an absolute commitment to a "one for all and all for one". The Germans will never go for this and so it won't happen.

    The really interesting question in all this is how the break up unfolds - do the weakest ones leave (one by one or as a group) or does the elephant leave the room……? The market has always assumed the former, it may actually be the latter. In many respects, Germany (with a few smaller Northern allies) leaving would be far less disruptive. You would then have a hard euro and a soft euro (and at the margins, just possibly, no defaults). Either way, this will be extremely messy and cause major volatility in markets.

    The next major shoe to drop over the coming months (which commentators do not seem to be fully focused on) is France. Most worrying for the EZ is the descent of France's economy into what was known during the gold standard era as a "secondary depression". France risks following this historic course because it cannot devalue its currency. Government spending accounts for 57% of national output and is unlikely to fall, especially with Hollande as President. Therefore, the burden of adjustment will have to be borne by the private sector……….again.

    (click to enlarge)

    Source: GK Research

    The chart shows the close correlation between the INSEE Business Survey and industrial production showing that the latter has much further to fall. France has been more akin to a communist state than many so-called communist countries of Eastern Europe. The public sector has grown faster than the private in every year since 1987. In the process, it has effectively pillaged from the private sector thus creating a self-reinforcing cycle of economic decay that lowers corporate profits, feeds into reduced private investment and resulting in low economic growth and rising unemployment.

    The radio silence from France's policy makers is deafening. As you know, Hollande was slapped down by the Constitutional Council on his 75% income tax band, saying it "failed to recognise equality before public burdens" because, unlike other forms of income tax, it was to be applied to individuals rather than households. So what now…?.… a wealth tax (+/- capital controls) …..ignore the deficit and try and convince the Germans to ease up on austerity……..? The latter is a given, I think, and, depending on the outcome, we will then know how this is going to pan out.

    In short, France's economic outlook is horrendous. If the French fall out with the Germans, politically, the euro project as we know it is all but over anyway. As it is, Italy now has an anti-austerity Prime Minister who is firmly is on a collision course with Germany after vowing to end death by austerity, and warned that Europe itself faces a "crisis of legitimacy" unless it charges course. Spanish unemployment is so intolerable that without some give, somewhere, civil unrest must surely follow. Slovenia is in very deep trouble too and the Dutch are reeling from a bursting real estate bubble which is now stalling growth and hitting jobs. With Cyprus as the cherry on top, an economy that is in it so deep that it is bereft of any ideas at all other than to attempt to restart the economy by opening a whole load of new casinos. It is like watching a very major motorway pile up happening in slow motion!

    Finally on the EZ: Myths versus realities.

    Despite Angela Merkel's protestations that the following statistics from the ECB is distorted, it is still likely to enrage Germans (as if they needed any further razzing up on the subject of other EZ citizens getting rich off the back of a free for all having entered the euro. Germans are already acutely aware the public sector pay inflation disparity between them and their counterparts in the PIIGS over the past 15 years - before the bailouts. They now have data showing them that they have the least net wealth per household or per person within the EMU. Is this, one wonders, quite the model the olive branch of Europe will want to emulate…..? Methinks not!

    DE in the charts below is Germany. Note Cyprus (CY)………

    Source: ECB

    Source: ECB

    More on that if you have trouble sleeping!……..http://www.ecb.int/pub/pdf/other/ecbsp2en.pdf

    Bottom line: on a macro view - the euro will fall (apart). Notwithstanding the knock on implications, financially and economically, for the UK - "relative" to the euro, GBP outperforms the euro on a 6m to 18m view.

    One thought…………..and something I have been asked about quite a bit recently……… might we actually see a major wealth tax across Europe as a possible endgame to try and preserve the euro and in order to redress unsustainable government debt levels ……?? Unthinkable…..or maybe not…? The Cyprus example to tax creditors on their savings shows us the way German policy makers has perhaps steered the debate behind closed doors. Retribution perhaps for the bailout counties where their citizens have - on the ECB's own analysis - been the main beneficiaries of their incompetent and mismanaged sovereigns. It shows to me that actually there are no limits, no boundaries, no taboos when dealing with the spiral of debt. We all need to be very careful about where we keep our wealth - and in what.

    The Boston Consulting Group came up with an interesting notion as to what the quantum of any wealth tax that may become necessary in order to deal with a future financial crisis and deal with the government debt burden, both in the US and Europe………. The sums involved are huge. Their assessment assumes a sustainable debt-to-GDP ratio for a country's total debt is 180% - double the Reinhart-Rogoff (now shown to be flawed) model that suggested 90%. Currently the amount of debt above this 180% level is about US$11 trillion for the USA and US$7.4 trillion for the EZ………and $1.7 trillion for the UK…..yikes!.

    ($ bn)Wealth Tax NeededFinancial Assets% Tax on Wealth
    United States$ 11,216$ 43,13426.0%
    European Union8,32924,49334.0%
    United Kingdom1,7046,31427.0%
    Total21,24973,94028.7%

    As bad as is this excessive debt burden, it gets even worse when the off-balance sheet liabilities, covering items that are largely age-related, such as pension obligations, social security and health-care programs are included. Under any realistic economic scenario most of these liabilities cannot be repaid. Actually, in the UK, the figures are rather distorted compared to the rest of Europe due to the degree of retirement savings which are significant for this generation of retirees. Indeed, until about 10 years ago, the UK was one of the best retirement savings cultures in the world. The UK had more money in private pensions than the rest of Europe put together! Even still…………

    (click to enlarge)

    An integral part of the problem is the aging of societies in the advanced economies. The old-age dependency ratio, that is the number of persons aged 65 or above per 100 persons of working age, in Germany was 14% in 1950. It is now 31% and will increase to 57% in 2050: and in Japan the respective figures are 5%, 35% and 70%. In the more developed regions, life expectancy was only 46 years in 1900 but is currently 76 years. The implication is that is that two-thirds of all those who have ever reached the age of 65 years are alive today. By 2020, 33% of the population of advanced economies will be over 55 years. Just pause and think for a moment: in seven years' time, one-third of the entire populationof the West will have either retired or will be saving for retirement.

    In summary, excess global debt is at such a high level that realistically it cannot be repaid. The situation is made worse by the aging of societies in advanced countries. No government in advanced economies is addressing the real issues: cutting entitlements and spending sufficient so that future spending is less than revenues. All that governments are doing (can do under conventional wisdom) is tinkering at the edges. The financial system will not be able to cope under today's "rules"; a new crisis period will come.

    Under the current financial system, a combination of high debt levels and changing demographics condemns advanced economies to much slower growth. It is a simple fact and a matter of maths. Only the actions of central banks have prevented most economies from re-entering recessions. In fact, what distinguishes this period from previous recessions is that the world is suffering from the aftermath of a monster credit crisis which has mutated into a government balance sheet depression in Western advanced economies.

    The bottom line here is simple: As Herb Stein said, "Anything that cannot last forever, will not." The current dynamic within the Eurozone cannot last forever and nor will it. Like it or not, the buck stops with "the people", not the politicians - something politicians and policy makers would do well to remember. Accordingly, if one stands back from the day to day noise, subterfuge and obfuscation, what one can see is that the Eurozone, as we know it, is in a big hole and, as Dennis Healey once famously said, "if you're in a hole, stop digging". In the Eurozone, however, this is clearly more easily said than done. Is Germany ready for turning....after everything....? I doubt it and, in any event, not without a fight. The problem is that a growing number of nations appear ready for that fight.

    As managers, we are paid to assess and price risk properly. Over this past decade, it has become an inescapable fact that our ability to price risk properly has been found wanting and that the current pricing in the Eurozone is one of the starkest examples of risk mispricing imaginable. History shows one ignores Herb Stein's maxim at one's peril. It's time to wake up and smell the coffee in Europe and to stop living in la-la land. Something has to give. The inescapable conclusion is that either the Germans relent on a number of levels (and the euro becomes a much softer currency as a consequence) or its tin hats on time for this is going to break. Either way, this is not a time for any complacency - it is a time to get real, fasten seat belts and manage risk properly.

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

    Additional disclosure: I am short EURGBP.

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