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Growing Implications of Europe's Fiscal Crisis-Threat of Global Deflation Spreading

 
 
Global Commodity Markets (copper, oil, base metals…) have been telegraphing a slowing global economy. Consistent with this theme, emerged (BRICS) and emerging markets will continue to come under downward pressure.
 
Mounting negative deflationary forces in the PIGS in the coming months will spread to their northern neighbors, then eventually the United States. Expect credit growth in the Euro to dry up just as it did here.
·         Spain's underlying inflation rate just turned negative in April for the first time since at least a quarter-century, this is likely the thin edge of the wedge as we have yet to see the full brunt of fiscal austerity hit aggregate demand.
·         Ireland is already experiencing deflation, with nominal GDP falling faster than real GDP (both are down for two years straight the nominal is falling faster-nominal GDP was down by 11% in 2009, real down 7.5%)
·         There is a lot of slack in the PIGS, the problem is now widespread-Spain has an output gap of -5.3%, Portugal -3.6%, Italy -5.7% and Greece -4.6%.
 
 
Currency flight from PIGS to core French and German banks began last week and now has morphed into a flight from French/German banks to Swiss banks resulting in massive intervention by the Swiss Central Bank.  Ken Rogoff (author of It's Different This Time-The Definitive Study of 66 Countries over 800 Years of Financial Crises) states that "he would be absolutely shocked if there was not a sovereign default in Europe and that Chinas property market bubble is a poster child for It's Different This Time"
 
Expect mounting bank problems in PIGS to begin to spread to over levered French and German banks. US banks remain vulnerable to Europe's financial contagion (Fed stated in closed-door meetings May 15, 2010). Additionally, the Fed stated that (if problems spread from smaller euro zone countries to bigger economies like France or Germany that it may threaten the viability of the euro, potentially paralyzing credit markets globally, just as happened following the collapse of Lehman Brothers.(WSJ)
 
The Fed also stated on May 15, that if French and German economies/banking system were affected negatively by developments in the PIGS, this could spell big trouble for the US’s five largest banks: J.P. Morgan, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. Exposures to France and Germany, along with second tier Euro countries, is equal to about 81% of the banks combined tier one common capital, a buffer to absorb losses, according to first quarter and year-end filings.(WSJ)
 
Headlines from US housing market this morning:
  • Mortgage Applications Plummeted To 13 Year Low As Buyer-Bait Expires
  • One in seven US house owners paying late or in foreclosure
  • Mortgage Foreclosures It Record as job Losses Strain Budgets
George Schiller expects reversion to the mean for US housing market meeting another 20% down leg-Meredith Whitney's expects another 10% down leg stating that banks have not reserved against this and are not prepared for any downward valuation. Whitney also anticipates state and municipal layoffs in the coming year to be approximately 1.5 million.
Schiller PE ratio pointing to big correction. In the past 130 years, whenever the Graham/Dodd/Schiller normalized P/E ratio goes above 20.6 times (it is 21 times today), the market experiences a significant correction-a correction of 31% on average over the next 16 months. It never fails. (Dave Rosenberg)
 
Equity markets will continue to come under downward pressure in the coming quarters; combined with lower housing prices effecting consumer and business confidence negatively-creating deflationary forces in the economy.  CFO of Walmart Thomas Schoewe states, "more than ever our customers are living paycheck to paycheck-they are very concerned about their own personal finances".
 
Access to capital for small and medium-size businesses which make up 70% of the US economy has virtually dried up-Meredith Whitney expects another $1.2 trillion to be removed from credit markets in the coming year. She also states that new credit card regulations as proposed are likely to make it extremely difficult to access a credit card in certain parts of the country.
 
Government policymakers will over regulate the financial industry and stay too long, with unintended consequences of the industry becoming less efficient and very possibly causing mortgage rates to be higher than would normally be the case.
 
Risk aversion will grow in the coming quarters as will global deflationary forces-expect the 10 Year US government bond to break 3% and move lower.
 
Policymakers have no playbook to go by and will continue to be surprised by events as they unfold. Expect Europe's problems to spread, there will be global implications.
 
 
 
 
 


Disclosure: Long GLD Long PHYS