Author : John E. Charalambakis
Date : December 12, 2011
In the last few days the markets tried to breathe a breath of new life and optimism in the midst of developments in the EU and the initiatives taken by central banks.
It has been our position that the EU is suffering from two deadly problems, namely: cancer (public debt) and heart failure (bank financial debt). The former can lead to long or medium-term death. The latter to instant death. Let’s review the major events that took place, then highlight what we consider to be the most important and vital steps taken, and finally close with an introductory assessment of what we expect in 2012.
We are of the opinion that the above measures are necessary but not sufficient for the impending Euro-crisis, which is primarily a private debt crisis (bank-originated via unsecured instruments that they circulated). Hence, they address some of the cancerous problems but do nothing for the immediate problem which is heart failure a.k.a. bank failure and collapse of the credit system. The graph below shows the public face of the crisis, which now is thought to be addressed via making the markets to believe that measures taken put the EU-house in order for the purpose of refinancing those public debts.
Now, let’s review the actions taken by the central banks.
With all due respect to the EU leaders, the above measures were the ones that will possibly avert the heart failure and save the patient now, so that the cancer problems could be addressed later via measures agreed by the EU leaders. The ECB having the backup of the Fed (the unsecured paper that EU banks have circulated is denominated in USD), has unlimited USD funding (private money market funds do not trust EU banks and have mostly frozen their credit lines to them), and now has declared “come you thou have toxic assets, and find comfort under my wings. You shall rest assured that I shall bear your burden and take it upon me and in my balance sheet”.
The graph below shows two things: First, that the bank-issued unsecured debt in the EU has declined substantially, and second, it shows the magnitude of the financial debt issued by EU banks which needs immediate refinancing in the next few months.
The lowering of the standards by the ECB and the assurance of the Fed that it will backup the ECB with swap lines, postpones the problem of instant death due to banking collapse/heart failure, it buys time, but does not address the issues of limited – if any – growth, joblessness, business liquidity, and capital formation in the EU. However, it does address – at least partially – the banking issue, and hence, establishes a safety net for banks (or at least for the majority of them). Of course, banks would need to raise additional capital, continue deleveraging, keep selling assets and unloading toxic ones (partially to the ECB via the new credit facilities for three years and the lowering of standards), reduce lending (hence Eastern Europe’s reduced credit lines), and generally increase tightening which makes austerity even harder.
We do not expect the increased liquidity (via the central banks’ lines) to leak into the marketplace. It will remain electronic entries into the central and commercial/investment banks’ books, and hence there is no fear of uncontrolled inflation. Of course, it is of major concern that growth, income, and employment issues are not addressed, and that more austerity measures will emerge in the horizon.
However, all those central bank measures are forms of quantitative easing, and thus in the medium and long term they are but a bullish sign for hard assets and precious metals. The latter may experience some downward pressure temporarily due to liquidity squeeze, but ultimately should benefit.
At the same time, EU banks are using complex maneuvers that improve their balance sheets and capital levels. Specifically, they use liability management techniques by buying back (or exchanging) hybrid securities- such as convertible bonds – at a discount. Then, they book the difference as a profit. While this scheme improves the capital ratios, it drains the banks from liquidity, and if for some reason something goes wrong in the swap lines or the lowering of ECB’s standards, then those major EU banks will face Hades.
In conclusion, we believe that while the US will be experiencing moderate growth in 2012 (which may actually be above expectations), it will be a safe haven attracting capital, with good chances for single digit returns in the equities market. The EU will suffer from recession, but if proper measures are taken especially in the area of common Treasury Department (ministry of Finance responsible for Euro-bonds), and the ECB starts acting more like a lender of last resort (by expanding its announced form of buying the toxic assets of EU banks and including more purchases of government bonds), then we would not be surprised if the Euro-wide equities market turns positive for the EU too.
In the meantime, we look into what we believe will be the interim main form of energy (between the petro and the renewable era), and will be reporting on it in our January-February newsletter.
Allow us to say again, ode to hard assets and to arks, but woe to snakes!