Europe: Masters Of Kicking The Can Down The Road

by: Derastone

Europe: the can kicking goes on. In the past two weeks, we’ve had a powerful kick of the can that “should” buy us some time. However, this European mess isn’t over. Last week was the beginning of the end, but we are a long way from the end. What happened last week was a magnificent exercise in “can kicking,” and it could buy us a couple quarters.

But given the general economic situation, it doesn’t have to, and in particular if Italy doesn’t turn around, we’ll be having an even bigger European crisis in just a couple months. Think of this period as an intermission between acts at the theater, relax; go to the bathroom, grab a drink, but don’t forget that the show isn’t over, it’s just on a break.

The EU has been using the easiest bullets available, which means that each kicking of the can will get harder than the last one. In terms of EFSF leverage, we’ve reached a dead end; the next kick of the can will involve a decision between (a) debt monetization by ECB (b) proper fiscal union/major treaty changes (c) the EFSF/France becoming AA.

What is important to realize is with each “can kicking,” the ties that hold Europe together are multiplying. The “shadow” collectivization of peripheral debt through the EFSF and ECB is increasing. Soon it will reach about 2 trillion euro; it’ll be equivalent to the largest bond market in Europe (Italy). Theoretically, the more times the can is kicked, the higher the price, both politically and economically, to back-out and reverse course later. That doesn’t mean the crisis is solved, we’ll still have years of bad economic growth, unbalanced current account balances, large deficits, etc.

What is the positive side of this? Whatever small probability of the Euro disbanding is even smaller now.

As for psychology, funds that were short have covered. There are a lot of funds now that are underperforming this year. Hedge funds in particular are on average DOWN roughly 6%. This relative underperformance has skewed the incentives. Once a fund has underperformed this much the incentives change; managers are willing to take on more risk because underperforming further will hurt them less than it will benefit them to close the gap. From a psychological perspective the field is ripe for people to put risk on and try to make it up. As long as the US data holds up and the kicking of the can holds, we could be in for some silly stuff into year end.

Once volatility settles down, I will go long puts. I also think the emerging market's outperformance last week will continue in the rally; it’s not only beta, there’s a lot of catch-up to do.

Europeans are selling this plan as Parmesan cheese, but it is more like Swiss cheese - full of holes.

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