Ignore European Rhetoric And Focus On The Alarmingly Negative Fundamentals

Includes: TZA
by: Convex Strategies


After avoiding last week's near global meltdown, global markets seemed particularly upbeat on Monday. Italian 10-Year yields have sunk below 6%, the Fed has displayed its willingness to intervene, and the Greek/French "Merkozy" alliance has announced that it aims to basically redo the Eurozone treaty so as to alleviate the current crisis and prevent future ones from occurring.

It's exciting until you take a look at what Europe is actually dealing with.

First of all, the political divide in Europe is terrifying. You think the U.S. legislative system is messed up? The "failed political experiment" (as stated several times by Nigel Farage, a member of the UK Independence Party and outspoken critic of the EU system) that is the Eurozone, is quite frankly run by carefully selected, anti-democratic leaders.

Herman Van Rompuy, the President of the EU, was "elected" at an informal meeting in Brussels. Shortly after his appointment, he stated, "The financing of the welfare state, irrespective of the social reform we implement, will require new resources." Though seemingly a bit dramatic, Van Rompuy and his partners effectively want to tax the living heck out of the European financial system, and citizens themselves, in order to control all components of economic activity.

Jose Barroso, the President of the European Commission and former Prime Minister of heavily indebted and recessionary Portugal, often fights with Van Rompuy for power, given the two men's confusingly similar titles.

Far worse is the arrival of Mario Monti's technocratic Italian Government. Monti, regardless of his policies, has very little power to do much of anything. Berlusconi can effectively remove Monti if the going gets tough (which he will of course; austerity isn't an easy process to swallow politically), crimping Monti's political abilities. Additionally, the Italian people's overwhelming approval of the takeover should be a scary sight for any defender of democracy. Italians are in effect handing over their voices in order to allow an all-knowing entitiy to steer them out of trouble. Can you say Julius Caesar?

Of course, we can't forget Greece, which requires money every month quite literally to pay its bills to avoid default. One missed bailout, and Greece defaults; pretty simple. Greece has been largely unwilling to meet mandated austerity measures, and all monies handed to Greece are likely to have been wasted. Greece's debt to GDP is likely to close in on 200%, and their 1-year note yield is over 300%. The game is eventually going to be up, and Greece will at some point have to default.

All of these burgeoning issues should not be surprising to anyone. When you throw a bunch of countries together that have different cultures, economic factors, and political beliefs, you end up with garbage.

Take Ireland for example. Ireland's entry in the Eurozone of course transferred most of its economic decision making over to the ECB. Unfortunately, while Ireland desperately needed to sharply increase interest rates to cool a dangerously expensive real estate market and overall economy, the Eurozone rates were lower than those previously set by Ireland. We all know what happened next. The prices popped in 2006, and an inability to lower the rates to match economic productivity (among other factors) sent Ireland into disarray, and the situation ended up requiring a bailout. Rescue money reserves aren't exactly awash with cash at this point, however, and the EFSF may be unable to fund the bailout for much longer.

"Positive Rhetoric"

The markets jumped at what can only be stated as upbeat, enthusiastic rhetoric coming out of the Sarkozy/Merkel conversations. Basically, the following has been disclosed:

  • EU nations have to renew their vows that they'll actually undergo painful austerity measures to contract their debt to GDP ratios.
  • Italy announced a tiny $40 billion austerity package that basically taxes Italian citizens to the hilt (further stymying economic growth).
  • Even more fiscal unity is necessary.

And that's pretty much it. The real question is, even if the Eurozone members can actually adhere to slashing spending, how will that affect productivity (tax receipts)? Clearly, lower revenues are bound to result as the World's largest (collective) economy cuts life support for their overleveraged economies. Government debts are bad enough, but we can't forget household debts, whereas many citizens are already over-extended to meet payments on their bills.


The enthusiasm showed by global markets on Monday was a bit of a joke, and for the Dow to still be positive for 2011 given everything that has happened this year is incredible. While strong corporate profits and stock buybacks have certainly kept a floor on the U.S. stock market, the upside in the market is basically non-existent. The fact remains that, at best, Europe is going to enter a recession in reaction to austerity measures, and at worst, Europe will attempt to (fatally) kick the proverbial can down the road just one more time. Throw in likely credit downgrades of some of the world's largest debts (namely France, which has already been downgraded by Egan-Jones) and markets have likely not tested 2011 lows yet.

I still recommend keeping shorts on over at least the next several weeks, and I'm playing this week with TZA. Traders should note the value decay in leveraged funds.

Disclosure: I am long TZA.

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