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Will Europe Tail Risk Shift To Political Unrest From Policy Making?

Feb. 07, 2012 4:43 PM ET
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Continued better than expected U.S economic data, Apple's truly astounding blowout Dec quarter, and Facebook's IPO filing epitomize to many investors the differences between America and Europe. Bullish markets' feel they can safely ignore Greece and Europe, e.g. very sharp declines in VIX. With markets' very strong "risk on" beta rallies, that has been a far more profitable and pleasurable assumption lately.

No one knows if/when that might change. So here I will simply ask whether perhaps the ongoing negotiations over Greece's PSI and austerity deals may come to mark the small beginning of markets' feeling that European tail risk may be shifting in 2012 to political opposition, to austerity and slowing economies in the south, to bailouts in the north, from that of policy makers being behind the curve in 2011.

As markets came to perceive Draghi's Dec 8 and 21 ECB's LTRO announcements as taking the risks of European bank funding and deleveraging off the table, removing fear of a "Lehman moment," (my Dec 22 "Draghi as Euro Santa Claus a Big Deal,") they have been able to focus on positive news, e.g. on the U.S. economy, creating a huge "risk on" beta rally that has safely ignored potential tail risks so far.

Political opposition would have the potential of making market tail risk even more unpredictable than it was in 2011. Other contentious political things with that potential that bullish markets are currently ignoring are Monti's negotiations over Article 18 labor reforms in Italy, and the prospect of Sarkozy losing the April French elections and its impact on Merkozy's Dec 9 fiscal compact.

Europe printing money, as Draghi has been doing with the huge expansion of the ECB's balance sheet, is far easier, it's just computer entries, than gaining enough political support for unpopular bailouts, from the north, and austerity, from the south.

European policy makers have had to sequence things to make them achievable,and at least somewhat politically acceptable. I.e., installation of trusted technocrats, then LTRO, then fiscal compact, then Greek negotiations, then Italy labor reform. The tail risk was that the sequencing seemed too slow for markets' tastes, but so far Europe's policy makers have pulled it off, as markets' have belatedly recognized, with Draghi as their Bernanke.

From late Jul to early Oct 2011 markets focused on the perceived risk from Europe's policymakers. That began to change with the installation of trusted technocrats at the head of the ECB, Italy and Greece. On Nov 16 I distributed an e-mail titled, "Merkel's Game of Chicken Installs Technocrats, Now Hard Part Begins." The "hard part" was gaining "political support," as I quoted Geithner's advice at the time: "They have to figure out a way to get enough political support for what has to happen…"

As I've said since Sep 2011, there has been no "serious organized" political opposition anywhere to "too big to fail" bank policies, so investors have naturally just come to unconsciously assume that will continue to be the case. Draghi's Dec LTRO, just like America's TARP in Oct 2008, which was more heavily supported by Dems than the GOP though Bush was President, proved that once again.

That lack of serious political opposition was one of two reasons, the other being the huge political capital that European policymakers have invested in their Euro project over decades, that I felt Americans were over-reacting in 2011 to the prospect of policy failure in Europe. They perhaps may now be starting to run the tail risk of under-estimating the impact of popular opposition to Merkozy policies.

Left click on chart to enlarge. Daily market updates in "Summary" on my LinkedIn profile.

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