The words quoted in the title above, were pronounced by Christine Lagarde (the head of the IMF) at the Davos annual economic conference. She was referring to the EU experience in 2012. Without a doubt, the Euro zone almost collapsed last year, and her recommendation was to avoid a relapse in 2013 while not letting their guard down by thinking that the existential threats to the Euro zone are over.

In mid December we wrote that we expect a good year for the markets in 2013. Temporarily the fears of a market collapse have receded, and thus our call that for the time being precious metals may go sideways –or even experience a decline – given that the fear premium may not be justified. On the contrary, equities seem to be destined for good returns, especially if money leaves the bond markets and parked in equities. However, we need to emphasize that what is described above is not a long term picture of how we view things. On the other side, to leave money on the table is not wise.

We believe that 2013 and possibly 2014 will be pivotal years for the structural transformation of global public finance. The term “finance” is traced back to the Old French word finer referencing the notion of settling a fine and a debt, or paying a ransom. From that old French word it developed into the Middle English word finaunce meaning a fine or forfeit. The semantic development of the concept of finance can also be traced in the Spanish word finanza which hints to its Gallicism origins. Over time the word has come to imply flows of resources. We are of the opinion that the structural makeup of those flows is experiencing a systemic makeup. The primary focus of finance is the supply and pricing of capital assets – such as equity, bonds, structured notes, options, etc. – in an environment that takes into account risks and returns while (hopefully) it allocates resources in an efficient manner that does not neglect opportunities for arbitrage.

Finance refers mainly to private financial operations. This is because historically private flows have been much larger than public flows (except in major war periods when public finance consume the majority of the resources). Even during periods of “big government”, private financial flows (new shares issued, corporate debt raised, net private borrowing, etc.) exceeded public flows (net public borrowing of federal, state, and local governments). The financial crisis of 2007-’08 set the foundations for the reversal of that historical reality.

We are moving into an era where public flows will systematically exceed private flows, and central banks are at the center of that reversal. If that is the case, then we should start thinking hard if the central banks’ independence can be sustained in the long run. Signs from Japan in the last month point to the fact that the central bankers there seem to be getting their orders from the new Japanese government, possibly paving the way to competitive devaluations and irresponsible monetization. We shall return to this important topic in future commentaries when we will also respond to Professor Krugman’s call for extreme monetization, in what we shall call the “Monetization of our Nothingness”. At this point we only want to state that this is a dangerous path (and an existential threat) that could metamorphosize the global economy into a monster.

Returning to the Euro zone issues, here is a list of six existential threats to the EU:

  • Cyprus: There are considerable reservations in Germany as to whether Cyprus should receive a bailout. Already the economy there (while rich in newly discovered energy resources) has started collapsing (according to reports the government needed to raid public pension funds last month in order to pay salaries and pensions), while Steinbruck’s SPD party (opposition party to Merkel’s CDU) is seeking opportunities to attack the Chancellor for irresponsible bailouts, ahead of September’s election.
  • Spain: Public finances, illiquid banks, high unemployment, regional independence movements, depressed business confidence, and a stagnant economy in retreat make up a lethal combination that may sooner or later demand an EU bailout.
  • Italy: The polls show that one month before the election the center-left party (DP) of Luigi Bersani is ahead but falls short of a Senate majority. PD is facing serious questions about its relationship with Banca Monte dei Paschi de Siena (the world’s oldest bank) and the widening scandal of derivatives losses at the bank. If the PD is forced into a coalition with Monti’s centrist party, then we may end up with an unstable government that cannot make decisions. An ungovernable Italy is not the best prospect for a founding member of the EU, especially when Silvio Berlusconi is waiting at the corner.
  • Greece: Despite the decent efforts by the Greek government, only minor improvements have been observed in the economy. Good public relations campaign, good cosmetic fixes, but minor changes in terms of substance, while incomes have been declining, fines and taxes are increasing, and the under-stated unemployment rate is at record levels of over 26%. The people there have started losing their hope. Historically, that is a very dangerous place to be which may jeopardize social unrest.
  • France: The report published about two months ago about French competitiveness by Louis Gallois was a wakeup call for France. At about the same time, the IMF issued a call to arms regarding the same topic. Budget deficits, chronically misallocated funds, declining productivity, and unfunded liabilities, may force France out of the capital markets within 18-24 months.
  • United Kingdom: The announced referendum regarding a UK exit from the EU infuses uncertainty and could become a source of instability in the UK (why should investors pour funds with the threat of an exit above their heads?) and the EU. Without a doubt, Brussels inclination to grab power from regional governments is troubling. Frankfort’s tendency to become a center for capital markets threatens City’s business. Euro skeptics in Sweden, Denmark, Finland, Poland, and the Czech Republic may join forces with the UK and form another EU which will invite Turkey to join them.

In conclusion, we would say that while positioning portfolios in a way to take advantage of opportunities in 2013, we should not be carried away by majestic voices that proclaim that the existential threats are over, and heavens are ready to rain wealth to mankind. Over-indebtedness, re-hypothecation of assets, toxic paper, derivatives, and waste is still around us.