At this week's European Union summit, the 17 nations of the euro currency bloc (also known as the eurozone or EMU), along with a few hopeful entrants, agreed to Germany's condition of tighter, integrated fiscal oversight of national budgets.
The U.K., an EU member, dissented - it would have been far more surprising in our view if they hadn't, despite its current masochistic fiscal proclivities - so the new treaty that arises from this agreement is likely to fall outside of the European Union framework. With this agreement, Germany is now likely to entertain proposals for closer financial integration, which proponents are not expected to finalize until mid-2012, judging by comments made by the EU Commission and Eurogroup presidents, Jose Manuel Barroso and Jean-Claude Juncker, respectively.
The problem with the planned arrangement is that, like all previous attempts to resolve the eurozone's government debt crisis (sovereign debt is is a misnomer for the eurozone), it is doomed to fail, because almost no one in Europe has gotten their head around the concept of net financial assets yet. This fact makes recent allusions to the gold standard incredibly ironic, as the primary purpose of gold mine operations under such systems was to continuously add to the stock of net monetary assets, hopefully at a pace that accommodated the economy's demand for them (it rarely happened, as new gold discoveries and output were very lumpy, while the nominal price of gold was fixed). For both inconvertible ("fiat") and convertible (e.g., gold standard) systems, over the long-term, an expanding stock of net financial assets is the only thing that makes positive rates of nominal interest and economic growth possible.
However, since the global monetary system's most recent link to gold was broken in 1971-1973, many economists have failed to realize that sovereign fiscal and monetary authorities must now fulfill the role that gold mines used to play, by running net deficits sufficient to create the optimal stock of net financial assets required by all other sectors of national and the global economies. The system has still worked since then for two reasons: (1) non-sovereign credit has continuously expanded with the Baby Boom generations in most advanced economies, and (2) governments have tended to run deficits over the long-run, through "supply-side" tax regimes (e.g., the U.S. in the early 1980s, mid-1990s, and 2001-2003) and automatic stabilizers in response to the recessions that have inevitably followed overly tight fiscal conditions. (Unfortunately, the first condition is receding, and the second is threatened by austerity fetishes.)
In the EMU, as in most of the world, they believe that the European Central Bank (ECB) somehow creates net financial assets through its lending operations to banks. But think about this for a moment - when a lender and borrower strike a credit agreement, they agree that the loan will be repaid at some point in the future. In other words, there's an asset created, but there's also a liability created in the same amount. In other words, when central banks carry out their usual operations, they are influencing interest rates, but they are not adding to the overall supply of government liabilities, which are financial assets to the rest of us. Only when they carry out "extraordinary" measures such as permanent open-market purchases of non-government securities or paying interest on reserves (a normal procedure for a few of the world's central banks) do central banks carry out the work that gold mines once did. Otherwise, it's up to sovereign fiscal authorities to do so, by deficit spending.
Germany, in its infinite monetary wisdom, does not want the ECB to play the necessary role of adding to net euro assets, and it wants the 3% Maastricht Treaty maximum for national budget deficits in the EMU enforced. It should be noted that under a gold standard, if there was a lot of slack in an economy (a shortage of aggregate demand in technical terms), the required gold production to reverse that situation could run well north of 3% of current GDP, with little risk of causing inflation. Today, there is an almost intolerable amount of slack in European economies, but its center of gravity (Germany) is demanding yet more austerity, despite the fact that its own economy is now following everyone else's into recession, and its enviable standard of living is now on a slippery downslope.
Market reactions to Germany getting what it wanted are interesting to say the least. German government bond yields are up by 50 basis points, a 2.5% move:
Click to enlarge
(c) Bloomberg, LP
While this might signal improved economic expectations, other credit market indicators say otherwise. Credit default swaps reflecting the current cost of insurance against the German government defaulting were 10% higher yesterday:
(c) Bloomberg, LP
And the spread of French government yields over German government yields declined by over 13.5%:
(c) Bloomberg, LP
Together with a rising bund yield, this implies that the German government has become a riskier credit as a result of this week's agreements-in-principle. And that indicates that while Germany got what it wanted, what Germany wants is wrong for Germany, wrong for Europe, and wrong for the world.
The investment implications?
- It does not appear that a financial crisis in the eurozone has been taken completely off the table. There are massive funding requirements looming in Europe in early 2012. As long as the ECB stands ready to write the checks to cap government bond yields, Europe's banking system should be able to limp along. But there appears to be plenty of resistance to even that common sense measure.
- As a result, European equities offer a high-risk proposition. They look cheap and include some strong franchises. If Europe can eventually get its act together (i.e., gets its collective head around net financial assets and where they come from in an inconvertible currency regime, and puts the Weimar hyperinflation in proper context), they could provide attractive returns. But until that happens, they are more likely to go the way of Japanese equities over the past 20 years.
- Europe is heading for what looks to be at least a 4% contraction in GDP in 2012, and there's very little chance that this won't impact the rest of the world, even if it isn't accompanied by a financial crisis. The U.S. running high single-digit deficits-to-GDP has helped it and the rest of the world, but with China also looking very shaky, the global economy could be squeezed pretty hard between Occidental and Oriental book ends. And if the U.S. gets serious about jumping on the same leaky austerity ship that most of the world is on, watch out.
- As long as most economists, policymakers, political leaders and voters equate sovereign fiscal operations with household budgets and behave accordingly, global economic performance will continue to disappoint, and the trend will be for national economies to continue turning inward in a slow abandonment (at least at the margin) of global economic integration. Many smaller economies could be hurt by this trend.
In this type of environment, it makes sense to truly diversify. For example, allocating to international and domestic equities does not provide the diversification it did 30 or more years ago (though if item four above persists long enough, some day they could). For investors with exposure to risky assets such as stocks, it might make more sense to also hold long-term sovereign government bonds, for example (in this area, U.S. and U.K. long bonds look the most attractive to us).
Assets like gold and other precious metals are widely touted, but at current levels, and with emerging market income growth likely to level off for a time, we're more wary of them (though a long-term strategic allocation might still make sense for many investors). Cash is also going to be in short supply relative to demand, as long as the world insists on going the austerity route, so a certain percentage of "dry powder," with a plan for deploying it, might make sense for many investors. And as always, it makes sense to follow a sound rebalancing discipline as that improves the odds of "buying low and selling high" over the long-run.
Whichever route you decide to go, be prepared for plenty of volatility in the years ahead, and consider working with an experienced professional who has your best interests at heart.
Important Disclosures: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.