Liquidity has dried up in Europe. Banks in the greater EU are unable to refinance their unsecured bonds that are approaching maturity. Moody’s cut the credit rating of French banks last week, and it is expected that France and other nations’ credit rating will be cut in 2012. The exposure of French banks to peripheral countries’ debt approaches $700 billion. With the expected 50% haircut of Greek bonds, their balance sheets will become even shakier and the threat of potential downgrade of French paper makes it more difficult for the French government to assist her banks, let alone become a player in the EU’s bailout fund.
Of course, as we have mentioned before EU banks face a major challenge as their covered and unsecured bonds denominated in US dollars (close to $650 billion for the first half of 2012) need refinancing. US money market funds have cut lines of credit to EU banks by as much as 65%. The inability to tap the long-term debt market adds to the EU banking woes and demonstrates inefficient banking practices in terms of liability management as well as lack of strategy in building firewalls.
Liquidity provisions require credit lines which in turn depend on assets that become the cornerstones of capital formation. The inability to create real capital and wealth (vs. the paper wealth that depends on others’ liabilities) limits the credit creation mechanisms and hence restricts liquidity. The US faced that reality in 1906-’07 with the result being the creation of a lender of last resort known as the Fed, in the late 1920s with the result being the depression of the 1930s, in late 1960s with the result being the Nixon shock of 1971, and again in mid 2007 with the result being the financial crisis of 2008-’09.
When capital cannot be created, existing assets’ value deteriorate, and thus the time will come when derivatives and securitization won’t be able to buy time and create credit.
In last week’s commentary we advocated the position that the central banks’ swap lines announced on November 30th, and the ECB’s pronouncements on December 8th, formulated the most pro-active statements to temporarily address the crisis. We characterized both events as much more important that the EU politicians’ decisions of December 9th. We also advocated the idea that both announcements constitute new forms of quantitative easing.
In the garden of credit there are many forms and facilities that central bankers can utilize in order temporarily address the liquidity needs of banks, and as evidence showed today, banks in the EU tapped those new facilities in an unprecedented manner, by borrowing close to $640 billion (a record for ECB’s liquidity operations) in three-year loans from the ECB (the three year is the new facility) and pledging lower quality paper (also new invention of the ECB). More than 500 banks tapped those new facilities which by the way imply an unlimited amount of loans for three years as long as there is sufficient “collateral”, and we know well by now, that there is plenty of the latter in the form of toxic paper.
The discussion above brings us to the point of formulating the first assessment/outlook for 2012. This assessment takes place in a battle field where the forces of optimism fight with the deteriorating outlook in the greater EU land.
We currently believe that the outlook for 2012 will take the following form:
- The US equities market will decouple from the EU market and will exhibit good signs of life and returns.
- The US equities market may surpass emerging markets in terms of returns.
- The US in general will be the destination that attracts capital and hence even bonds may continue showing positive returns (but lower than equities).
- In the first few months the uncertainty will continue in the EU land, which will force people to seek safe havens (US and possibly precious metals). However, we anticipate that as months pass by and the central banks’ actions get digested, fiat money will not be questioned, and thus a decoupling between precious metals and markets in general will take place, which may lead gold and other precious metals to experience negative returns by year’s end. Of course, this will be the first time in over a decade that gold may experience a negative return. Despite that, we believe that a minimum strategic allocation in precious metals is needed in every portfolio.
- Russia will retreat into her own territory and will not be messing with other markets’ affairs. The generally positive outlook may even uplift their own prospects.
- The Euro will continue losing ground against the US dollar, something that is not necessarily bad, since EU exports will pick up speed, jobs will be created in that sector, imbalances will start been correcting, competitiveness will improve, and capital will be created (which as we discussed above is the necessary condition for asset formulation, credit creation, and non-central bank liquidity provisions).
- EU banks will breathe given the unprecedented liquidity measures provided by the ECB. At the same time they will sell assets (such as real estate), reduce the size of their balance sheets, reshuffle uncovered bonds with covered ones, use hybrid measures and accounting schemes (see commentary of Dec. 5th), and will build firewalls and capital through carry trade maneuvers (borrowing cheaply from the ECB and investing in higher yielding paper, something that worked in the US between 2009-‘11). However, that does not mean that EU banks will be out of the woods.
- Bank mergers in the EU will assist their capital requirements and generally speaking the re-arrangement of assets (via changing ownership) will set in motion interesting plays and may even set the tone for subsequent years.
- Speaking of subsequent years, we are of the opinion, that 2012 and 2013 may become the foundational years for asset assessment and valuation, where new assets (e.g. new minerals) are allowed into the valuation and credit creation mechanisms.
- The foundations for a new Euro-zone will be set. We anticipate that in a few years time the Euro-zone will be different than it is today. Greece may adopt a currency board with the US dollar as its anchor. If that happens, we anticipate a gradual devaluation of the Euro that will strengthen the capital formation mentioned above. At the same time Greece will avoid a hard default, and the US currency will demonstrate its supremacy in the field where Russia wanted exit in the warm waters of the Mediterranean in order to control emerging energy assets. Of course, such a currency board (where Greece will not circulate its new currency unless it has equivalent US dollars as reserves) may be imitated by other countries too, and will allow for a natural haircut of the country’s debt given the strength of the local currency against the Euro-denominated debt. The credit facility that will be established will advance the cause of transforming Southeast Mediterranean into the key for the energy needs of the greater EU land, while other assets and sectors will also benefit from foreign direct investments. From that perspective, Greece is condemned to succeed, assuming that politics does not mess up its prospects.
- Real estate markets will exhibit good signs of life due to liquidity provisions, the change of ownership, and the need to improve asset values for credit creation.
- Energy and other commodities markets such as agribusiness will probably perform well, given the growth prospects, the formulation of optimism, and the new platforms for capital creation.
- As far as Asia is concerned, we do not anticipate a hard landing in China yet given that 2012 is a year where the guards will change. Japan will continue struggling, but probably will benefit from the overall climate, while emerging markets are anticipated to perform decently but not as well as US markets.
- Africa on the other hand may surprise in a positive manner and thus some exposure there might be wise.
Let’s close with a thought that reflects the spirit of the days. The celebration of lights, mangers, shepherds, and stars seeks for an incarnate shamash that will guide, inspire, and provide a second chance.
Ode to the incarnate Logos!