Dec 11 3-4
Dec 11 3-4
Dec 11 3-4
financial and political crisis is underway in Europe. Just listen to comments made by Europes leaders over the past two weeks. According to UK PM David Cameron, the European Union is an organization in peril representing a continent in trouble. Per Nicholas Sarkozy, the euro will sooner rather than later be too strong for some and too weak for others, and the euro zone will explode. German PM Angela Merkel perhaps overdid it when she said that Europe is in one of its toughest, perhaps its toughest hour since World War Two, but one gets the idea. As this article is being written, Mr. Sarkozy and Mrs. Merkel have announced their plans to reopen the fundamental European Union treaties. There is no question that Europe is sick. Since European markets began their convulsion in mid-July, the German DAX has posted a -18% return, the French CAC 40 a -17% return, the Spanish IBEX -18% and the Italian MIB -22%. As recently as November 25th, the declines were in the 20-30% band across the board. The Bloomberg European Financial Index has returned -35%. Major European banks including Barclays, Deutsche Bank, Banco Santander and Credit Suisse have seen their share prices decline by as much as 50% (or more in the cases of BNP Paribas, Societe Generale, and other major French lenders). The sovereign debts of nations such as Italy and Spain have been successively downgraded by ratings agencies and more importantly repriced by markets. When Italian yields shot up from 3.3% to 7.3% between early July and late November, it translated into mark-to-market declines of 30% or more for holders of Italian 10-year bonds. In this environment, it is almost astounding that the euro has only declined by 10% at its worst. To read the press, you would think that the causes of the turmoil are related exclusively to government policy. The conservative view, perhaps most forcefully expressed
GLOBAL PROSPECTS
vs. 120% at the end of 2010. Frances 2003 vs. 2010 numbers are 69% vs 82%. Germanys are 64% vs. 83%. The Netherlands are 54% vs. 62%. Spains are 62% vs 62%, i.e. unchanged. The issue is not the debts themselves but rather what those debts would look like if massive bank recapitalization and loan guarantees were piled on top of them. Italys two largest lenders, Unicredit and Intesa Sanpaolo, have cumulative balance sheets of 1.6t EUR. Spains two largest lenders, BBVA and Banco Santander, have cumulative balance sheets of 1.75t EUR. Deutsche Bank and Commerzbank have cumulative balance sheets of 2.6t EUR. BNP and Societe Generale have cumulative balance sheets of 3.1t EUR. Imagine if the tier 1 capital of those banks had to be replaced. Could Spain add a 175b EUR bailout of its largest lenders to its budget? Could France add a 300b EUR bailout of two banks to its already ballooned deficit? For that matter, can Germany afford to bail out its banks? If Europe sounds like the America in 2008 to you bad loans culminating in big bank write-offs and a bailout well, youre right. The difference is that while the U.S recapitalized its banking system in part by raising funds at the national level (remember the 700b USD TARP?), we now know that the U.S. mostly paid for the bailout via the Fed, i.e. with printed money. During 2008 and 2009, the Fed increased the size of its balance sheet by 1.7t and opened as much as 4.5t in additional liquidity via its Term Auction Facility. While TARP represented roughly 5% of U.S. GDP in 2009, the Feds expenditures represented 35%. There is no way that the U.S. could have sustained that level of spending by borrowing in public markets, and neither can Europe. Borrowing enough money to recapitalize European banks and fund the borrowing needs of countries frozen out of credit markets would increase the debt burdens of all of the European countries to untenable levels Germany included. Alas, Germany, fuelled by what we call Weimar memories, refuses to allow the ECB to monetize costs of recapitalizing Europes banking system. Its our considered view that until Germany prints, Europe will remain highly unstable and European financial crises will episodically disrupt financial markets and indeed the global economy. No exit Among the inevitable conclusions of this analysis is that forcing weak members to leave the euro will not alleviate any problems as the issues are as much core as peripheral. German and French banks are in fact much more of a problem then tax recidivism in Greece. Another conclusion, and one that is more investable, is that the monetization of Europes debts is inevitable. There are two very straight-forward investment themes here: a) However the Euro crisis evolves, it will be highly negative for European financial companies, the recapitalization of which will be by necessity highly dilutive. At the same time, if such recapitalizations are to occur, they will present opportunities, as proven by the experience of American banks in the first half of 2009. b) Printing of trillions of euros will be highly negative for the euro against essentially any other currency. The euro is trading above fair value as measured both by interest rate parity models and Purchasing Power Parity. It is unimaginable that this situation can outlast meaningful quantitative easing by the ECB. But perhaps the most important conclusion is that many of the foundational tenets of contemporary European society need to be reconsidered if both monetary and fiscal union are to be maintained. This crisis is too severe not to result in fundamental changes to the social contract in Europe, and we watch with a mix of interest and trepidation as to how society will adapt and react to the medicine required to ward off Europes financial flu.
HB & DZ
Page 4