Stock markets remain under constant pressure in both G7 and emerging countries. The picture is beginning to look fairly gloomy, with the S&P and Eurostoxx 50 down 15% from their peaks of 2010, the Nikkei off 19% and Shanghai suffering a 28% plunge!
Interest rate markets remain in anaphylactic shock, with safe havens in deflationary mode and "doubtful" issues totally avoided.
In the United States, the yields on 10-year T-Notes are below 3%, which is the lowest in modern history, excluding the End-of-World period following the Lehman Brothers bankruptcy. German bond yields are hovering around their historic lows, at 2.60%.
In contrast, government bonds yields in Portugal, at 5.60%, or in Greece, at 10.30%, have returned to the panic levels of May, before the ECB launched its SMP and the approval of the European bail-out plans.
The Baltic Dry Index (shipping rates) has plunged 42% in five weeks to its lowest levels since September 2009 and now represents just 20% of the peak hit in the spring of 2008!
The euro has fallen to a record low against the Swiss franc, falling as low as SF1.3075 Friday morning, bringing its decline since December to 14%. This depreciation has accelerated sharply in recent days, after the SNB lifted its foot off the accelerator. At Y108.50, the euro is calmly heading toward our target of 100 yen.
And Mr Greenspan's comments Friday morning that "something has to give" in Europe will hardly help the euro's situation or that of PIIGS spreads.
On the other hand, some commodities appear to be immunised well against the risk aversion contagion, such as oil, which, at $70:barrel absolutely does not price in the "New Normal" theory of Mr Gross (‘Alphabet Soup’), and especially gold which, at $1,240/ounce, is in a space all its own.
Gold buyers, who based their purchases on inflation fears and who are now confronted with the cold winds of deflation, claim a potential future wave of deflation logically lead to hyperinflation, via the debasement of the flat currencies.
To sum up, I don't see inflation as much of a current worry. If anything, there is a small risk of deflation that must be monitored.
With that sort of declaration, it is just a small step to preparing public opinion for a second round of QE, should financial conditions remain restricted and real estate sales end up in free fall, which I would not hesitate to make.
Such explains the current fears of the Austrian school ostriches, who, absorbed by the repetition of history, as per the Mark Twain's comment:
It is not worth while to try to keep history from repeating itself, for man's character will always make the preventing of the repetitions impossible.
Although the above comment does not jibe with my way of viewing the world, it brings us back to today's headline, which refers to the run in May 1931 on Kreditanstalt Bank, the main Austrian bank at the time, which triggered the second wave of the Great Depression.
Let's see if the similarities with the current crisis are legitimate cause for worry.
1920-1929: the main Austrian bank, Boden-Kredit Anstalt, rides the credit wave to become the leading bank in Eastern Europe.
1929: Knocked to the mat by the October crash, Boden-Kredit Anstalt is absorbed by Oesterrichische-Kredit-Anstalt, thanks to a capital investment by a banking consortium (JP, Schroeder, Rothschild) and the Austrian government's backing for part of the "toxic" assets. This new establishment henceforth takes the name, Kreditanstalt Bank.
1931: Kreditanstalt Bank announces that it is unable to publish 1930 accounts in time, due to the English auditor's discovery of misstatements in the accounts of ex-Boden-Kredit Anstalt. At 11 May, the bank declares unexpected losses totalling 140m schillings, triggering a run on the bank, probably encouraged by French creditors seeking to block the Austro-German customs union plan.
Unable to freeze the deposits of the country's largest financial institution, which includes half the nation's total businesses, Austrian authorities set up a number of public-private sector bail-out plans, with help from The House of Rothschild and the Central Bank.
But the run spreads to all the country's banks and those of Germany, as savers fear that the country's credibility been hit. As such, they demand that their schillings be converted to gold, given that the country operates under the gold standard.
Despite international loans from the Bank of England and the BIS, backed by the Fed, and interest rate hikes meant to attracted in-country capital, in the end, Austria defaults and abandons the gold standard, while freezing the assets of non-residents still in the country's banks. Germany then follows suite and prohibits transactions in gold.
British banks, with their heavy commitments to German banks, fall victim to this wave of distrust. 20 September, Great Britain uses a disguised default, with its abandonment of the gold standard, but not before accepting $650m in loans from the Fed and the Bank of France, causing them to rack up huge losses, although Bank of England Governor, Sir Montagu Norman, had visited the Dutch Central Bank chief, Dr Vissering, two days earlier to assure him that there was absolutely no chance that the pound sterling would be unhitched from the gold standard to convince that country to maintain its assets in the British currency.
Japan and the Scandinavian countries then proceed to abandon the gold standard.
1932: Fears about the soundness of the banking system and government's credibility spread to the United States, which also tries to attract capital via the conduct of austere monetary and fiscal policies. However, over 40% of banks go bankrupt (10,000) from 1929 to 1932, money supply and GDP contracts 31%, 13 million people lose their jobs, farm produce prices plunge 53% stock markets nosedive 80%.
President Hoover increases the top income tax rate to 63% from 25% and the Glass-Steagall Act of 1932 passes. The US sticks to the gold standard.
1933: Roosevelt takes office and declares March a Bank Holiday, following a third wave of banking panic. He prohibited individuals from holding gold as of 5 April. The Glass-Steagall Act of 1933 is approved and the FDIC is created. The United States then abandons the gold standard.
1935-36: The Gold Bloc, led by France, with Poland, Belgium and Switzerland end up abandoning the gold standard.
Bear in mind that in the United States, the top income tax rate peaked at 91% in 1945, and remained at 88% until 1963.
Investors have quickly drawn the parallel between the chronology of the Great Depression and the Great Financial Crisis we are experiencing today:
- The stock market crash (1929/2008) and the collapse of the credit system.
- As the crisis spread to Europe, the "discredit" of banks spread to governments.
- Greece plays the role today of Kreditanstalt Bank.
- As the G7 countries bet on devaluation, the yuan is playing the role of the gold standard.
- The euro plays the gold standard role within the eurozone, as macroeconomic stress is intensified by pro-cyclical government austerity budgets and by an ECB rigidly fixated on money supply despite being in free fall and its lack of any velocity whatsoever!
In such a situation, it is hardly surprising that risky assets come under this type of pressure, as government bonds of countries still deemed solid (but for how much longer?), like the United States, Japan and Germany, pay yields similar to those of the Great Depression/Deflation.
Under the circumstances, it should come as no surprise that the gold standard (and oil, to a lesser extent) plays the role of the absolute safe haven investment.
And yet, despite my concerns for risky assets in the context of a deflationist credit crunch and a very fragile Minsky ladder in China, I have the feeling that investors are not factoring in some major differences between the current situation and that of 1931-1933.
First of all, within Europe, despite the slow and complicated co-ordination of national fiscal policy, the context today is not at all the same as that between the two world wars. Members of the eurozone have been participating for the past 60 years in an unprecedented civilisational adventure in the history of mankind.
Europe started as a common zone allowing for the free circulation of goods and individuals in which certain government functions were federalised (justice, parliament, borders). Later, a single European currency was launched without the slightest recourse to arms, as was the case in the creation of history's other great federations (the empires of Egypt, Greece, Rome, USSR, US and China).
My optimism about the institutional future of the eurozone may be based on idealism, but that is where I stand.
I would encourage you to read the following surprising text which makes the case that the eurozone is still far from being optimal (Robert Mundell and the theoretical foundation for the European Monetary Union). It seems to me that eurozone leaders are now well aware of that, which leads me to think the measures needed to bring it about, mainly fiscal integration, are in the process of being fulfilled before our eyes.
We also know just how much the lack of international monetary and budget collaboration and the establishment of obstacles to international trade heightened the crisis of the 1930s.
Today, the situation is very different.
Despite the obvious differences between the emphasis on consumption in the United States (and France?) and on mercantilism (of Germany and China), at least countries are talking with each other and are maximising efforts to avoid excessively sharp counter-cyclical clashes between respective macroeconomic policies.
At the same time, the world has avoided the sort of tariff wars, as represented by the Smoot-Hawley Act, and international trade has picked up since the plunge of early 2009.
And many of the world's major central banks (US, UK, Japan, Switzerland) have clearly learned the lessons of the past and, confronted with 0% lower bound, have adopted their banking doctrines to the situation by carrying out unorthodox quantitative easing operations.
The ECB is another story, which is why I have been continuously, if not obsessively, warning that the eurozone has the greatest chance of falling into the deflationist trap. But once again, I dare to hope that we won't have to storm the monetary Bastille in Frankfurt to help our august Austrian ostriches finally pull their heads out of the ground!
In conclusion, I find this latest stock market plunge to be a bit overdone, although I remain convinced that investors should limit themselves to betting on tactical rebounds. And the Bund is a bit ahead of the macroeconomy.
And the death of the eurozone appears indeed premature!
And no, I still do not agree with the end of the world theories and find gold attractive. This is undoubtedly the biggest mistake I have made in many years, but I still wonder what will happen should gold prices shift abruptly downward, pushing the Animal Spirits to pull out of their ETFs.
Asset allocation biases and advised option strategies
- The long-term macro biases remain downward on eurozone government yields and negative on risky assets (equities, European real estate, commodities) and a deflation/depression scenario, which will require much more effort by the ECB than a shame-faced QE.
- Our short-term biases: a tactical rebound of about 10% on Eurostoxx indices (2800?), accompanied by a narrowing of sovereign debt spread, resulting in a 2-point decline on the Bund (127-126.50).
Disclosure: Long 20 year OAT and 30 year BTP Zero Coupons, EDF Corp 5 Years 4.5%, Greece 2 Y and 10 Y bonds, Long Eurostoxx 50 ETF