That’s just a terrifying prospect in my view because then you’re just strengthening this banking-sovereign-debt-feedback loop.
Megan Greene – Roubini Global Economics
Macro Overview
Big Year Ahead For Europe
Merry Christmas!
2012 will be, quite simply, a monumental year for Europe. I’m going to be away over the next few days but I just want to introduce you to a great interview with CMC and Roubini Global Economics’ Megan Greene.
I agree with much of what is said and, if anything, the progression of the conversation highlights just how complicated and desperate the situation in Europe has become. However, I’m not quite as pessimistic on the European mess as they are. Megan Greene effectively dismisses Germany’s appetite for financially backstopping so-called rogue states ad infinitum to near-zero. Believe it or not, I think the possibility of this happening is distinctly non-zero (although I admit it is still a long-shot).
Let me put it in the form of a question. Albeit at glacial pace, for the past 50 years, the union of European only been moving in one direction: towards greater political and fiscal union. How would this trajectory be possible without both a political and societal/cultural appetite for it? I feel there is a certain sense of inevitability towards Germany’s call for treaty change and 2011 has set the stage for 2012 to take one giant leap towards fiscal and political union in the World’s largest continent, economically speaking.
Given the history of intent, I cannot help feeling that there are still potentially viable political solutions to the challenges Europe faces – if only politicians can strike the right chords (yes, that’s a BIG IF, I know). For example, German taxpayers may be willing to make significant direct contributions (looks like they may already be committed to contributing indirectly via a newly inflationary ECB, under Draghi) towards bailing out fiscally rogue states provided they get something significant in return. There are many ways this can be accomplished. Loyal readers of mine know that one of solution I suggested could manifest in a political power-transfer from the, fiscally imprudent periphery to the, fiscally prudent, core (aka a calibrated loss of sovereignty by the offending states). Indeed, these were ideas I was talking about months before Treaty Change was the buzz-word of the month.
Enough from me, watch this well-reasoned video between CMC and Roubini Economics… and have a great New Year!
Market Overview
European Banking System Still Fragile
I’m not going into too much detail at this, the eleventh hour of the year. I’ll just show the LIBOR – OIS spread for the Euro – courtesy of Bloomberg (see Chart of the Day).
Chart of the Day
EURO LIBOR-OIS (Source: Bloomberg)
Events
Macro Events:
Update:
Nothing Significant
Alerts:
Irish GDP this week
Japanese Inflation Numbers out this week
Japanese Industrial Production Numbers out this week
… we’ve certainly seen a big contrast between him and Trichet…
Danny Blanchflower (ex-BoE Committee Member) on ECB President, Mario Draghi
Macro Overview
Jury Is Still Out On Draghi
Well? Is Draghi a Hawk or a Dove? We were led to believe he was of the same mold as Trichet – stringently hawkish and as stoic as a Bundesbanker. But we’ve been getting mixed signals. Announcements sound a little dovish but confrontations with the press sound hawkish. So how should we judge the new ECB: by its official announcements or by its verbal jousting with the press?
Perhaps the answer is: neither of the above. Ex UK BoE Committee Member Danny Blanchflower thinks (on Bloomberg TV) Draghi has turned on the hawkish precedent of the ECB. Make no mistake, the LTRO and rate cuts is a distinct culture shift from the ECB. They are pre-empting potential deflationary hazards with money-printing – this is QE European style.
There are some interesting questions though, for all the talk of German fears of inflation, where is the backlash? Has the German taxpayer been genuinely hoodwinked into paying for peripheral debt, not via direct tax contributions to the EFSF, but in the guise of indirect taxation from an inflationary creep on their cost of living? Hey, perhaps the timing was impeccable, perhaps Super Mario and Merkel knew all the inflation hawks would be distracted at the butchers, spitting feathers at the cost of their Christmas Turkey?
Or did Merkel cunningly overplay the inflation hand so she could secure the negotiation over a Germanic political structure (aka treaty change)? This is what I wrote at the beginning of the month…
Consider this: could Angela Merkel and her CDU Party be playing their EU hand beautifully? Many theoreticians and economists make the mistake of looking at the EU through a “lens of logic”. This could not be further from the reality. In a political shake-up as violent as this, self-interests, horse-trading and power-plays dominate and economic logic takes a back seat. Like shifty characters at a high-stakes poker table, EU leaders size each other up as they pore over the political hands they’ve been dealt … and some are playing their hand with much adeptness.
Consider this: Germans have always been paranoid about inflation. But are they really as paranoid today as they are making out? Is the average German truly petrified of inflation in the midst of a (deflationary) global slump, (deflationary) debt crisis and lurching violently into a (deflationary) pan-European recession? It would be awfully clever of Merkel’s CDU to suggest that they indeed are still vehement inflation hawks (and indeed some are). But, by publicly over-blowing this risk, Merkel’s CDU have irrefutable leverage over other states (like France and the Southern Europeans) to acquire what it has truly wanted since the dawn of the European experiment.
Consider this: Germany has has never taken its eyes off the prize. A Germanic Central Bank was a significant milestone for Germany in the context of the Euro, but, in this final chess game, Germany recognizes it as merely a sacrificial pawn. Merkel, the longest serving leader of a G8 country, is no mug – indeed Sarkozy is a political lap-dog by comparison. She may be happy to throw her lap-dog a political bone and trade a Germanic Central Bank for the ultimate prize: a Germanic European Constitution. A supra-national political body which, incidentally, would command a strategic force (economically, geographically, militarily, politically) more powerful than anything we’ve ever seen.
Sigh… politics…
Market Overview
Traders… Saddle Up For Inflationary Trades Again
Yep, the ECB is the new cowboy in town. Draghi’s regulators have their had on the printing lever and one swift wrist action from Super Mario would re-invigorate some of the old relationships we’d gotten used to a couple of years ago… Gold up, commodities up, equities up, dollar down etc. Ah… all the old trends that we know and love.
Warning: Potential Buying Opportunity For Equities and Commodities Ahead!
Of course, history never repeats itself, but it often rhymes. We have to balance this new global fiat inflation paradigm with an ensuing Eurozone recession (no matter what solution they come up with) and a distinctly more challenging economic crux for Asia (lower growth with persistent inflation). One thing I’m actually quite excited about, I think the coming economic hardship will present some great buying opportunities for risk assets like selected equities and commodities.
But my Chart of the Day is a sanguine, cheerfully Christmas chart. The VIX (normally a measure of uncertainty and risk aversion) has plummeted to new lows. Too early to call an end to economic hardship (we can start by keeping an eye on ISM numbers out in early Jan) but there is light at the end of the tunnel, things are indeed looking up in The West – yes, that’s right… I did actually say that!
Don’t Drink Too Much This Christmas!
Finally, I think we have to end with a message of caution for all you Christmas party-ers – by all means have a drink… but don’t drink as much as this British woman!
What if it’s true that, as Kevin Philips recently stated in an article in Harper’s that:
“Ever since the 1960’s Washington has gulled its citizens and creditors by debasing official statistics, the vital instruments with which the vigor and muscle of the American economy are measured.”
Chris Martenson – quoting Kevin Philips
But stop and think what it would mean if there were 4% of persistent and undeniable… y’know, you can’t explain away this 4% inflation rate …it would mean that the Fed would clear its throat say, in the marble-mouthed way that it speaks, that… “AHEM! The Party’s Over”.
Jim Grant
Macro Overview
Helicopter Draghi Treads a Fine Line – But Do Not Be Too Quick To Judge
There are a couple of things that the ECB wants.
It wants to preserve its inflation-fighting credibility (its only mandate!) and it wants to be perceived as a bank which keeps inflation firmly under control.
Secondly, it wants to help the Eurozone survive. This means it wants to help lower the yields of sovereign debt at the periphery but without the moral hazard of favoritism (i.e. directly purchasing PIIGS paper is a no-go).
This is the fine line the (Long Term Refinancing Operation) LTRO tries to circumnavigate but it may be achieving the exact opposite. The World’s largest fund manager described it first as a shell game, then later tweeted that it may also mean “Cash for Trash”, “3 card “monti” or all of the above – implying, of course, that it was basically a thinly veiled inflationary monetary response (aka QE – European style).
What do I think LTRO means? Lying To Restore Order. There is only one thing worse than lying to make things better for everyone… and that is lying to make things worse for everyone! The ECB is truly putting its credibility on the line here, but so far it’s showing signs of actually working… kinda.
The WSJ featured Tchir of TF Market Adivsors, who thinks that the banks would use the facility to repair holes in their own balance sheets but to purchase new high yield paper in Europe anyway. So it is possible that, rather than preserving the credibility of Europe’s central bank while reducing yields of periphery debt, the LTRO may have the exact opposite effect.
There is a lot of skepticism in the air on this and, I admit, the ECB is treading a fine line here. But the facility has certainly been well received by the banks and actually the LTRO + Treaty Change combo may be as close to my original multi-layered plan to save the Euro as you are going to get. I still think they are missing the middle piece, which is the collateralization of the EFSF/ESM/whatever-they-think-of-next with real taxpayers’ money from the core, but let’s not beat the Europeans up too much – it does appear for now that they are trying to take decisive and truly penetrative action to stop the contagion of a Eurozone Crisis.
Never-the-less we should give it some time to see how it sits in the market digestive system. It may be that the German is “able” to pay for the profligacy of peripheral states via an “inflation creep plus a-little-something-extra, perhaps” – as observed in the US shell games and deception.
The European Central Bank was the last major Western bank to resist cranking the printing press. But it appears that this card may be falling too. Things to watch:
The German press in response to ECB QE.
The response/rhetoric from other central banks to ECB’s new stance (including BoE, BoJ, Fed, SNB).
The commodity markets in response to a global printing frenzy.
Global Inflation Trends – especially in high inflation-risk economies such as China, Brazil, Arab Spring etc.
Market Overview
Oracle Puts A Spanner In The Works
Oracle didn’t get the memo – the business cycle is supposed to be turning upward! But the stock went crashing to it’s year lows as it missed earnings. See Chart of the Day.
Commodities Poised For Rally
Oil was up too today – let’s keep an eye on these commodities now that the ECB has one hand on the printing lever.
Big GDP Numbers Confirmed Tomorrow
Look out for US and UK GDP numbers out tomorrow to confirm Q3 growth.
Have yourself a merry little depression…
What’s this? Christine Lagarde, IMF chief, said last week that the world’s nations needed to work together to avoid a 1930s-style depression.
But seeing the way they work together… and where they seem to be headed…we’d prefer a depression.
Bill Bonner – The Daily Reckoning
Macro Overview
Focus Still On Europe
For now, the market is still digesting just what is going on in Europe. As I mentioned, treaty change was a great first step. But it was only a first step – there needs to be at least a short and medium term bridges to ensure traction for this structural change actually sees the light of day. If “Merkozy” determine that this is the only step they are prepared to take then they may have ensured their dominance in Europe, while also ensuring the disastrous fate of the continent. In many respects, jeopardizing the recovery of the region to ensure/protect national economic dominance in this way could be even more destructive to the equitable “European dream” than Britain leaving The Union altogether.
A Telegraph article exhibits an interactive graph which shows that Britain may not be as much of a loner as everyone thinks it is. I still feel Cameron played his hand badly (even with an inevitable veto, no need to make enemies in Europe unnecessarily) but it’s too early to say that this was an entirely disastrous outcome for Britain. Let’s see just how much of a “union” the European Union truly is, as we approach Sarkozy’s election campaign.
The Other Economic Engines Are Spluttering And Stalling
Every time we experience a lull in the European drama, a little more light is shed on the other main economic drivers in the World – specifically Asia and North America. Unfortunately, what the market sees East and West of Europe is hardly encouraging.
China’s property market is in the midst of a contraction. America is looking quite sick and not all blame can be put on the European doorstep. Here is Chris Martenson (courtesy of ZeroHedge) explaining the simplicity of the problem for many Western Governments:
…it’s a simple math problem. You can’t forever increase your loans or your indebtedness faster than your income. I don’t care if you’re a person, a private individual, a family, a town, a nation state.
If you remember, hedge fund legend, Michael Platt, said something similar on Bloomberg TV, when he said that for countries like Italy:
… arithmetically, their debt it going to blow up.
Chris Martenson then attacks the US Dollar’s current safe haven status (what Gross would call the “least dirty shirt” status), saying that buying US Dollar assets in this environment is like:
…climbing on to the tail end of the Titanic and saying that: “this is the place to be”!
So let’s just rewind to where we were this summer, before Europe distracted us so. In China, fears of a growth recession (I define as where reported real growth exceeds reported inflation) and the potential tail-risk that comes with this.
In America, by continuing his money printing process, Bernanke was continuing his debasement of the World’s reserve currency. The Fed succeeded in exporting inflation to the World but not in reviving its own economy. Unemployment was still structurally extremely high (even as the numbers are systematically fudged lower) … oh yeah and the S&P had downgraded the US from the top rating after the embarrassment of political gridlock in Washington. Europe has provided America with a timely distraction, but it will not always be this way.
Market Overview
Asian Stocks A Little Rocky
Was anybody as surprised as I was about the huge drop in Taiwanese stocks a couple of days ago? I mean Sure they were up a bit today, but this was quite a fall. News today that the Taiwanese government will step in to prop up stock prices because the “economic and stock fundamentals remain sound”… hmmm…
India’s Sensex index hit a new low today. Everything is pointing lower inAsia, but there are some positive things to take away from this. Hopefully, a recession in the tide of growth will ensure an inflation rate low enough to mitigate the tsunami of fat-tail events that would otherwise hit the shores of South andEast Asia. UnfortunatelyHong Kong’s CPI does not yet reflect this (see below), but remember there are lag effects.
Chart of the Day – Indian Sensex.
Chart of the Day
Indian Sensex (Source: Bloomberg)
Events
Macro Events:
Update:
Hong Kong Inflation is persistent at 5.7% (in fact, slightly higher than expected)
I’m mildly interested in tomorrow’s HK CPI number (anything under 5% would come as welcome respite – especially given the slowdown in greaterChina).
Of course, Kim Jong Il’s death is big news but economically there is not much happening in the World today. It seems we have taken a day off. So I have nothing to say… and I’m saying it…
Market Overview
Zzzz…
Pretty dull day and you must be tired reading my macro bit so I’m not going to waffle for the sake of it. I’ll just introduce my Chart of the Day – Greek CDS spreads to defy gravity.
Chart of the Day I introduce Goldman’s KOSPI chart of North Koreaactivity – highlighting that the effects of North Korea have been short-lived.
This is your last chance, after this there is no turning back.
You take the blue pill, the story ends, you wake up in your bed and believe what you want to believe.
You take the red pill, you stay in Wonderland and I show you how deep the rabbit hole is.
Remember… all I’m offering is the truth… nothing more.
Morpheus – visionary leader in the film The Matrix
Macro Overview
Recapping …
Last comment I put forward the motion: Is Germany positioning itself for a European deflationary depression?
This is an alien concept to many – who on Earth would want deflation in this environment? Well that’s an interesting question which we’ll try to answer. It’s not an easy question as I think the answers lie in cultural and historical aspects of each society – and, as “The Union” that is the new 26-member cast inEurope, is finding this out the hard way.
Cultural Attitudes To Debt Play A Huge Role In Differentiating Between Remedial Policies
Right, so when debt levels reach a certain point there is a pretty horrific economic inflexion point – it’s a bit of a “red pill / blue bill moment” that the lead character, Neo, faced in the movie “the Matrix”.
In terms of fiscal options, I likened it to a chicane on a race track where the driver either has the option of braking and slowing right down or accelerating and hoping the aerodynamics of the car keep him on the road. Kyle Bass puts it slightly differently, he uses the “fork in the road” concept – hey, pick your favourite analogy. But listen carefully to what Bass says in this video after about 5min 30 seconds [emphasis mine].
So this is a belief commonly held by most central bankers and academians who, as you know, unfortunately run many of these countries. They believe that when you get to this proverbial “fork in the road” (and this fork in the road means that there are two options that you believe that you have: one is default and one of them is inflation… and you believe that these options are mutually exclusive of one another).
When you sail into the zone of insolvency, when your debts get to become many multiples of your revenue. This is something we spend a lot of our time thinking about. When you attempt to inflate yourself out of this problem and your debts are already more than 5, 6, 7 times your revenue, you put yourself into this position where inflation causes the default.
So, in many of these nations, inflation is not an option (and I know your show isn’t long enough) but when you talk about the ECB monetizing all of these debts I think that doesn’t change any of the spending, number one. And what you’ve seen coming out of the Bundesbank and many places in Germany is: that doesn’t change the behaviour of the participants whatsoever – in fact it might encourage their continuing behaviour of the profligacy that’s riddled throughout Southern Europe.
I believe the ECB knows one thing: they have to print money. Whether it’s the ECB or the 17 various central banks at the periphery… they don’t have the money to recap their banks.
So your question should be: do they print before they default or after they default (or both) … and in my opinion they have to just print afterwards, because the number they are going to have to print is so large and that they know this going in…
I know I’ve commented on this video before, you have to watch it – I have watched the second part many times and Kyle Bass’s comments are just intellectual gold dust, in my opinion. It was this interview and a couple of others (which I will show you below) which initially sparked my train of thought on the subject of Germany and the inflation vs deflation pill-choice.
Let’s look at a couple of other poignant comments which were made in the last few days. The first comes from legendary hedge fund manager, Michael Platt – it speaks to the simple arithmetic of the European sovereign debt crisis. In his view, an inflexion point is coming and, as Kyle Bass inferred, there is actually very little authorities can do to prevent it, they can only prepare for the for the type of carnage they wish to endure first. Listen up…
Platt manages one of the biggest hedge funds in the World ($30 billion) and he doesn’t hold any punches. Diving in with both feet he says:
We sort of distill it down to one essential fact that we continue to focus on at BlueCrest Capital Management. That is that, if you look at the debt of, say, Italy, with a debt of 120% of GDP which is increasing at a real rate of 5% (where they have to fund these days) and you look at the GDP, which is now is forecast declining at 0.5% of GDP… arithmetically their debt is going to blow up.
Absolutely it’s about the cultural and political divide. The reality is, there is no willingness within the Eurozone to share wealth. In the United States, money flows between different areas: if California is having a very difficult time the rest of the States will transfer money to California. This is not the case in Europe; there is no willingness to transfer money across the boundaries in a long term and sustainable way.
Lastly I’d like to introduce you to one more interview which continued along the same thought trail this week, it’s a Bloomberg interview with Niall Ferguson, here. And this is the quote I was particularly intrigues by:
The problem here is in Berlin, it’s not a European problem it’s a German problem and the fact of the matter is, the Germans remain more worried about 1923 (i.e. inflation) than about 1931 (i.e. depression) – which is remarkable when you consider what the consequences were for Germany.
You see where I’m going with this don’t you, dear reader? There is a subtle, common theme in all these comments which, I feel, is worth expanding on. Bass, Platt and Ferguson all agree that there is a huge economic inflexion point coming (or, indeed is happening as we speak) and that there is very little policy-makers can do, but make the preparations in ways they feel are most protective to their (highly divergent) societies. The choices they make are largely dependent on cultural issues – Platt remarked directly on this – but Ferguson and Kyle also implied this by drawing attention to the “choice” between invoking inflation (first) or deflation (first).
Red Pill Deflation Or Blue Pill Inflation? That Is Question
To those (e.g. Americans) brought up in a society built almost exclusively upon Modern Monetary Theory, where ubiquitous and extremely “efficient” credit extension is responsible for much higher levels of consumer debt, it is obvious what needs to be done at this inflexion point: INFLATE FIRST, ASK QUESTIONS LATER! Indeed, perhaps Bernanke’s most famous speech was: Deflation Making Sure “It” Doesn’t Happen Here.
Indeed, while Japan has tried to inflate its way out of deflation, it’s quite telling that they were not nearly as pre-emptive or aggressive at the beginning of the deflationary slump. Many (Western Economists) believe this to be a blatant mistake, a “school-boy error” of Monetary Policy. Perhaps it was… or perhaps, collectively Japanese society actually objectively “chose” deflation first and then later tried to inflate their way out of the deflationary debt spiral. Some would say this was a complete disaster, but I’d offer a little more respect for what I believe was actually a cultural choice. It is worth noting that while the economic numbers look horrific to an Anglo-American, Japanese society did not disintegrate into chaos, Japanese unemployment barely rose above 5%, Japanese standards of living and life expectancies continued to rise during this “lost decade”. Deflation did not wreck Japanese society, it only certified it. Could you imagine such a response from American society, faced with a generation of recession and deflation? I think not. This is very much a cultural issue.
There are many reasons why Anglo-Americans were always going to chose to inflate their way out of this crisis.
First, there is a financial argument for this. Due to the massive levels of debt from a (so-called) efficient and extremely loose financial policy, deflation would almost certainly plunge Anglo-American economies straight into deep recession and probably depression. Remember the gargantuan levels of consumer debt in Modern Monetary Theorist economies – the principal value of these debts grow in real terms if inflation is negative. So deflation only exacerbates high levels of this massive mountain of consumer debt – that’s a disaster.
Secondly, a political argument. Because debt is largely held at the consumer level, politicians will always do what is in the interests of the consumer (i.e. their electorate) if they wish to remain in power. Moral hazard plays second fiddle to ensuring that voter debt-burden is softened and votes are protected.
Thirdly, a cultural argument. Democratically diverse and heterogeneous societies with extremely open and liberal media and civil rights culture, like American and the UK are, by design, less stable. In fact, some would say the instability in a political sense, ensures greater long term stability, as societal flaws are exposed very quickly ensuring a faster politically-led evolution. This notion sounds a little flimsy because it is, it’s a psychological equilibrium based heavily on confidence. In a deflationary downturn, confidence evaporates and, the inherent exposed instabilities, which are normally encouraged and embraced by these societies, turn on the economy and obliterate business sentiment, crippling the country into a depression.
But Germany is not an Anglo-American society with a Anglo-American values and an Anglo-American economic model. As I’ve written about before (see my comment: Why The Germans Understandably Hate Inflation) and as Ferguson alluded to in his quote above, the Germans appear to be more petrified of inflation than they are of deflation. Yet for Americans and Brits (who dominate the financial media, let’s face it) to opposite is true.
In many respects Germany is very much more like Japan than it is like America. In fact the cultural similarities between two very different countries are quite striking: socialist democracies, with a general consumer propensity to save rather than borrow, changes the political dynamic considerably and sets the tone for their societal traits. Also relatively cohesive, homogeneous societies with wealth uniformity (a huge middle class) and a ultimate respect and pride for, what I will call, “personal honour, structure and discipline” plays a significant part in their cultural identity. It is no surprise that they both possess the two best education systems in the G7 for Science and Maths and consequently home to the two most sophisticated manufacturing, engineering and export industries.
In this cultural dynamic, deflation is not the monster it is portrayed as in the Anglo-American media. To start with, it is politically less destabilizing in a society which embraces a culture of consumer saving over consumer credit. Indeed the personal wealth of a, saving-rich, populous increases with deflation and, in a more culturally cohesive society with more uniform wealth distribution (both have by far the lowest GINI coefficient of the G7), the prospect of societal disintegration is more applicable to inflation than deflation. Also note that, there is a structural industrial cushion for nations whose economy is absolutely dominated by sophisticated manufacturing exports as wage deflation provides a significant boost to domestic industry via reduction of labour cost on a relative basis.
What Choice Does This Leave Germany With Today?
The bottom line is, if you ask an American or a Brit what the single worst economic period was for their country in the last 100 years, almost unilaterally, the response would be: The (Deflationary) Great Depression of the 1930’s. If you ask a German I’m not sure you get the same answer. I think a German would say: The Hyperinflation of the 1920’s. That’s the psychological difference between Britain and Germany, between David Cameron and “Merkozy”, between the BoE and the ECB, between the US and Japan. Of course, I’m simplifying everything greatly (and I apologize for this) and the economic idiosyncrasies are very different, but their economic positioning and their collective divergent abilities to endure different economic hardships are almost entirely cultural.
Where does this leave us today? Well, it’s not entirely obvious that Germany wants to do everything its power to avoid a Deflationary Depression (that’s an understatement) – this has come to the distress of many highly vocal American and British pundits who think that Germany and the ECB are, quite simply, idiotic not to print the heck out of the Euro. That’s a culturally and politically naïve simplification, I think.
So let’s look at the historic facts: the last time Germany tried to aggressively inflate its way out of a debt trap, disastrous Hyper-inflation ensued, soon followed by a huge Deflationary Depression anyway (oh yeah… and don’t forget the most far-reaching World War in the history of mankind). That’s not a great benchmark. The current facts are that Germany has made it clear that:
The ECB will have a German design – its mandate will be to control inflation and inflation only.
There will be absolutely no participation on the part of the ECB to print money or directly monetize.
It is no secret that the Germans have long been making significant preparations for Euro-wide defaults.
Kyle Bass may be right. The choice is less a case of simply, “do you want inflation or deflation” but rather:
do you want inflation first (and then run the risk of trying to deal with a potential deflationary reaction to default later), or,
do want deflation and default up front (and then try to inflate and grow out of this, potentially chronic, depression later)?
The answer in the UK and the US is, without hesitation: “#1 please” – it’s just how we deal wit this, it’s part of our culture. I know this is a controversial thing to say, but, given both the actions and rhetoric I am observing from Germany, given the cultural and historic backdrop of Central Europe… I’m not sure they would give the same answer.. and, to be honest, in their cultural and historical context, I’m not sure they are wrong to do so. After all, from a cultural perspective, who are we to tell the Germans what is best for their country?
Market Overview
Zzzz…
Pretty dull day and you must be tired reading my macro bit so I’m not going to waffle for the sake of it. I’ll just introduce my Chart of the Day – Greek CDS spreads to defy gravity.
In skating over thin ice our safety is in our speed.
Ralph Wald Emerson (a poetic Keynesian?)
Macro Overview
Presenting A Backdrop To The Motion
I like this devil’s advocate game, let’s put forward a motion we are ambivalent about and then try and argue its case:
Is Germany positioning itself for a European deflationary depression?
Firstly let’s make on thing clear, I have no definitive opinion on this, it is not a statement – it is just a question. But let’s take a step back and examine the backdrop to this. For years and years I had been writing about the then impending Western debt bubble many years before the bubble burst. Of course we know what happened and, since then, much of this bad consumer debt has settled on the balance sheets of the financial sector and much of this debt as been subsequently transferred to sovereign balances.
In January 2008 (before the crisis hit) I wrote that the only real option for Bernanke and that was what I called “Hair of The Dog Monetary Policy” – to force feed us more of the very same poison which had made us sick in the first place. He’d have to cut rates and ease monetary policy so drastically to keep the credit lines open and then to try to inflate his way out of the problem. Using a variety of ingenious methods (aka Quantitative Easing), that’s basically what he did.
In any normal environment this would be extremely risky, if not foolhardy, monetary strategy – never mind social consequences of letting the inflationary predator off the leash, what about the moral hazard? So why was I so convinced that Bernanke would fly his helicopter right in the face of moral hazard and print like a mad man? There are many reasons to be honest: the relative politicization of the Fed and its lack of “Monetary Dominance”, the unknown quantity of the Zero bound of interest rates (the Fed has the tools to fight inflation but not deflation). But the simplest reason to explain arises from the cultural consequences of restructuring (defaulting on) this mountain of debt which was crippling the economy.
Debt doesn’t go away, the debtor must either pay or default – it’s that simple. To cut a long story short, just like Japan in the 1980’s, Western societies had racked up too much debt. Unlike Japan, where much of the leverage emanated from the corporate sector (and then the banking and public debt), The West, after the Enron disaster, had raised corporate balance sheets to much higher standards under the Sarbanes-Oxley act of 2002. So corporations were actually in good shape (thank goodness for Enron), heading into the crisis. Instead a debt bubble was formed on consumer balance sheets. With direct encouragement from central bankers (the original sinners – see my comment: Greenspan prostituted economic HIV), consumer debt in Anglo-American economies was exploding to a size that would dwarf even the Japanese debt bubble of the 1980’s.
Racing Cars and Fiscal Policy
I remember a track day with in a two-seater Formula Jaguar (see photo above – a truly terrifying car!) where I would repeatedly spin on a certain chicane. The instructor (in the other seat) told me I had two options: either brake harder and slow right down or (his way) put your foot on the gas and get enough speed so that the down-force from the aerodynamics stick you to the tarmac. He took the controls and showed me his way … I closed my eyes and screamed like a little girl but not only did we stay on the track we cut a massive chunk out of my personal best lap time.
When debt rises in an uncontrolled manner, there is an political inflexion point, an economic chicane, if you like, which it must be dealt with. Status quo is simply not an option – we’ll spin off track. But there is a “choice” for policy makers, and my opinion is that this choice is determined largely by cultural aspects of an economy. These cultural differences are part of the reason why the, fiscally harmonized, EU is such an ambitious project.
Option 1 is to simply stop spending when we approach the economic chicane, cut the debts, slash the deficits and take the pain up front. In racing terms, this is the “braking option” – in terms of economic “acceleration” it’s a U-turn in policy. It’s bluntly Darwinian, constructive destruction: the strong will survive, the weak will die. This solution tends to be favored by a school of economists who think that the best way for debt to be “worked out” is through clean, hard default – not by using the flawed models of monetarists. This tends to result in a deflationary outcome as capital is sucked from the system violently. This school of economics is actually a Germanic cultural trait – in fact the school originated from the old Austrian Empire – the “Austrian School of Economics”.
Option 2 is to spend more to increase growth and let growth and inflation work its magic on the economy by implicitly reducing the relative value of the debt by increasing the value of everything else (aka “soft default”). This, like my instructor, is the “foot on the gas” option to attacking the chicane and this solution tends to be favoured by Modern Monetary Theorists and Keynesians. This tends to result in an inflationary outcome as capital is typically forcefully infected into the system and, as Keynes himself said; “inflation is always and everywhere a monetary phenomenon”. While the Austrian school emanated from “core Europe” via French, German and Austrian economists, John Maynard Keynes was very much an Anglo Saxon and his political approach to economic management is the framework for much of the Anglo-American (whether Democrat or Republican) economic model and thus response to the crisis.
Am I reading too much into the origins of these two schools of thoughts? Perhaps … but I really do think that cultural issues play a strong part in understanding why different societies are more comfortable enduring one option over the other when they hit that economic chicane.
How does all this play into Europe’s debt crisis? Well… you’ll have to wait until Part 2, in my next comment…
Market Overview
Macro Data Uptick
Believe it or not, the macro data which came out today was actually quite good out of Europe and the US. Especially that jobs number – see Chart of the Day – the biggest drop in Jobless Claims since pre-Lehman.
Chinese Stocks Continue Their Long March Downward
The Chinese stock markets are not for the faint-hearted. Remember at the height of China’s growth spurt, when the economy was growing at 12%, the stock market fell 70%. Yes… a 70%drop from the end of 2007 to the end of 2008. Leading indicator of things to come? I dunno, but there were so many rumours that Bejing would do this and do that to prop up asset prices… what did they do? Nothing – they seemed remarkably Austrian in their approach to deflating asset prices! Chart of the Day, Chinese stocks in Shenzen Composite and China Shipping Graph.
Chart of the Day
Chinese Stocks (Shenzen Composite) (Source: Bloomberg)
China Shipping (Source: Bloomberg)
US Jobless Claims (Source: Bloomberg)
Events
Macro Events:
Update:
US Jobs – 366k Jobless Claims – a great headline number
US Industrial Production – worse than expected
Eurozone Consumer Confidence Number – in line
Brazilian Inflation lower than expected (that’s good news for Brazilian economy)
If you attempt to confiscate the savings of your populous after you’ve sold them bonds to the tune of 227% of GDP you’re going to have a very difficult social scenario on your hands. We’re going to look back at this in two or three years from now and we’re going to say: if you took the time to understand their balance sheet and their income statement as a country, it’s the single most obvious thing I’ve ever seen in my adult life. The reasoning I hear from the other side we keep finding one or two reasons why they might be able to hang on for a little longer and clearly that’s not an investable theme…
Kyle Bass (onJapan)
Macro Overview
Eeerie Silence In The Corridors Of Brussels
It’s easy to tell when someone’s being really naughty in our house: it falls eerily silent.
That said this is far from victorious, all that has happened is a potential path has been cleared toward as solution – Merkel and Sarkozy deserve credit for that part, at least. Whether the European political elite take the right path from here is an entirely different matter – perhaps another time we will examine the potential pitfalls and legislative landmines that EU politicians will have to circumnavigate to make sure this incisive rhetoric is effectively manifested in a fair and transparent political structure which all EU members can feel happy about.
It’s all very well France and Germany uniting to cut out Britain and ensure their dominance in the region but will they now do the right thing by the other 15 states in the Eurozone and the other 24 states in the “new EU”? That’s a monumental question and the questions within the new EU will only become harder.
This was supposed to be one of many steps “The Union” (I don’t know what else to call it) had to take. As I’ve alluded to before, the EU needs to concurrently implement long, medium and short term solutions to fixing their cancer. In many ways they have taken the hardest decision over treaty change, but it would be just like Europe to let egotistical politics get in the way of a good solution. Note, Sarkozy has an election coming in a few months and a black eye for Cameron is not a trophy you can plaster on your campaign bus.
So no news is bad news in Europe at the moment. Right after “Merkozy” pulled the trigger to release their euphoric silver bullet, the microphones fell silent. No more clarity or definition or specifics, not even passionate resounding speeches by the main leaders to their domestic electorates, who all wait with bated breath and twitchy sphincters to hear what their government has signed them up for. It’s left the market thinking that there may indeed be devils in the details.
Make no mistake, Cameron’s approach was poor, even naive, and I’ve already aired this. He could have left with significantly more friends in Europe and still implicitly played the veto card. But history will judge whether this new Germanic States of Europe would ever have been a good thing for the British to be part of.
Kyle Bass Puts China’s “Infinite” Reserves Into Perspective
Great quote from Bass, above. Well I have to say, Bass makes an incredibly logical argument as to whether Japanese Government Bonds are the best looking short in the World. I agree with his logic for shorting Japan… I just daren’t. My appetite has not really changed much since I wrote: I ain’t shorting JGBs ‘til they stop the road works at Roppongi – but I will avoid them.
But Bass’ view on China strikes a few more chords. This is what I wrote a few months ago about the so-called Chinese trump card that is supposed to be able to underwrite the World-economy.
It is not easy to get good access to default rates in China but the FT reports that yields on loans to developers are hitting 20%+, suggesting that “developers are losing access to funding”. My guess default rates will rise exponentially over the next 2 years – if they are not doing so already.
Never-the-less, we hear many reassurances that non-performing loans (NPLs) in China are “contained”, but where have we heard that before and how on earth is it possible to quantify a risk which, as Pettis correctly asserts, by it’s very nature we cannot see? The NPLs we are currently able to observe in China are but the tip of a rather imposing iceberg.
Some of my friends in closer dialogue with Greater China businesses think that magnitude of bank losses due to NPLs may be greater than book equity of the banking sector as a baseline case. Don’t ask what the worst case scenario is, it’s too horrific to put into print.
Bass, while admitting China is an “enigma” to him, he makes some interesting comments on Chinese banking sector too…
In the last two years China has grown their banking sector (their banking assets) 50% of Chinese GDP two years in a row. That’s analogous to theUSlending $14.5 Trillion into our economy last two years. One thing I’m fairly certain of: if we lent $14.5 Trillion into our economy in the last two years, we would grow at more then 8%. So I think it’s very important to think about China’s FX reserves that everyone points to as being the piggy bank for the World at now $3.5 Tillion, but it’s important to understand that Chinese non-performing loans in the banking sector are right around 1.5%. Historically they’ve been 19%. So if you have 13.5/14 Trillion (call it) dollars worth of assets in your banks and your non-performing loans go back to what’s normal in China you can do some quick maths and realize that you could end up losing almost $3 Trillion and that magical pot of money that sits in China goes away…
Interestingly Bass has not real view on China though, because he recognizes (correctly) that China can keep the game going for a lot longer. While Hugh Hendry may have profited from short-China plays, big China bears like Chanos need to be aware that if there is one market which can remain irrational longer than you can remain solvent – it is China.
But sino-pessimism aside let’s be sure, China is pretty much the only large economy which actually possesses any wiggle-room in fiscal and monetary policy. My view is that China can use what economy fire power it has to rotate its economy towards a more service-based, consumption-based economy as part of its 12th 5 year plan – which I have commented about. Be sure about one thing though, even if trend growth in China remains robust, this process will not be seamlessly smooth – volatility in Asian assets is here to stay and with it the fat-tails of default, scandal, fraud and other terrors of the black-swan variety.
Enough talk from me: just listen to Bass for yourself, courtesy of BNN links:
Today nothing went up, the German markets traded down, the French markets traded down, the UK markets traded down, oil traded down… heck even Gold broke through $1600… to the downside. Oh actually, I’ll tell you what went up… the US Dollar! That ought to tell you how bad things are in the World!
Chart of The Day has to be the Euro – breaking the psychologically significant 1.30 mark.
We are increasingly concerned by the combination of high and increasing leverage in China, coupled with an impending peak in China’s working-age population ratio and its level, combined with a rapid ascent in property prices there. Our preliminary work shows this has been a potentially dangerous combination in the past 40 years when and where it has occurred, highly likely followed by a credit and property bust, either brief or prolonged.
Ajay Kapur – DB Asian Equity Strategist
Macro Overview
Making Tail Risk Work For You
Months after I wrote a comment extensively about “Tail Risk” (specifically in Asia – and more recently here), it seems everybody has a word on it. In fact this article, published after mine in The Times of India – reads awfully like mine! Today ZeroHedge publish an extensive report about tails to keep a look out for under the title: Six Tails That Deutsche Bank Are Watching For Next Year. Right at the top of the list is China’s potential growth slump with persistent inflation – which could unleash the dragon’s fat tail… just like I alluded to in my article: The Looming Growth Recession in China.
Today highly respected economist at UBS, George Magnus, said (about 7 mins into the video) that Chinese growth, because it is only reported on YoY basis, may be as low as 6% QoQ. That’s a really good environment for tail risks to propagate in a country which is used to a real growth – inflation spread of 8%+. Couple this withIndia’s horrific Industrial Production number it seems quite likely that China will ease monetary (and potentially fiscal policy, says Magnus) imminently.
Remember, tail risks do not necessarily mean that asset prices go down… it just means the chance of your entire portfolio blowing up spectacularly rises significantly, which, of course, is not the same thing.
On the same day, coincidentally Sino-forest announced that it would indeed default on its convertible bond securities (see FT article) … mind your eye… plenty more where that came from. What recovery rate would I put on these convertible bonds to investors? Errm… pretty darn close to ZERO – you might as well write the entire investment off as one monumental tail-risk swipe.
Hugh Hendry is a controversial figure. He set up a short China investment portfolio and chose to short in liquid, low risk companies outside China which remained exposed to China in a big way. Many people thought he was incredibly fool hardy to short the World’s fastest growing economy … looks like his fund may report being up over 50% this year.
Hendry takes a clever approach which sought to exploit tail-risk concerns without necessarily exposing the portfolio to much tail-risk of its own – purchasing extremely low-level Japanese CDS in companies heavily linked to Chinese growth). If anything it just goes to show, it’s not just the idea that counts, it’s how you implement it that matters…. having said that, having the right idea helps!
Market Overview
Europe Still Soggy
Just to give you an idea of how serious this European crisis has become, S&P seem to be weighing up a downgrade of France AAA rating. And Chart of the Day is Greek CDS… man that is one scary chart!
So much for Black Friday euphoria… sales were rubbish (see this Forbes article) – just ask Best Buy shareholders – stock got mullered today.
The British demand that we use a large amount of firepower to win back credibility for the euro zone is right. But we have to take care that we don’t pretend to have powers we don’t have. Because the markets will figure out very quickly that this won’t work
Angela Merkel
Macro Overview
Merkel and Sarkozy Deserve Credit Where It Is Due
I’m not for one minute suggesting that I’d like to be a Greek under the iron fist of “Merkozy” – the new Franco-German political pact between Merkel and Sarkozy. Indeed, the opposite may be true… rather, I’d like to commend Merkel and Sarkozy on their negotiation strategies. Especially Merkel – like I said yesterday, she’s played her hand very well and, consequently, she has maneuvered a stronger position for the people of her country – that means everyone else’s position is slightly weaker.
Also many commentators are missing the point on why treaty change is such a crucial step forward, “changing the Treaty will not address the crux of the sovereign debt problem”, they say. And yet we and so many investors have already identified the problems in Europe as being political and structural – not liquidity-based. As I suggested months ago; Treaty Change, a politicalrestructuring, actually strikes right at the heart of the problem. Political problems require political solutions: it’s a good first step… but it is only a first step.
However, I have also said, there is no silver bullet, rather a cocktail of solutions is required to allow short, medium and long term actions to be effective. Still, many market participants and strategists suggest that this was the wrong action to take and that what was still needed was the ECB to print money. Unsurprisingly ECB bond purchases at par would significantly improve future bank income statements – which may be why many of the analysts endorsing this strategy seem to be employed by banks. Yet, the average Joe knows that this superficial measure would only succeed in kicking the can down the road. If there is a cancer, the first act should be to remove the cancer, not treat the symptoms – no matter how big the so-called symptom-treating “bazooka”.
The market was asking for a monetary bazooka and Merkel dropped political napalm after taking out Cameron with a sniper. It was a ruthless political ambush, never have I seen two smugger politicians after the event than Merkel and Sarkozy who appeared to agree on one thing: their disdain for the British way. Never-the-less (I cannot believe I’m saying this) but the actions of the EU politicians over the last few days have actually been quite smart and quite logical (including telling Cameron where to shove it)…so far… so far.
For example, few media pundits have taken the time to think through (or perhaps they have they’re just not saying it) the positive follow-through effects of what a treaty change means in fact some say “this is just another piece of paper, who cares?”
Well, ultimately the market may care. We’ll have to see exactly where this is going but a few months ago I felt as though Merkel stood no chance of selling additional funding of the EFSF (or any other body to bail out, say, Greece) because the German public would be seen to gain nothing specific in return. Politically speaking, it would feel like throwing good money after bad, or rather into a black hole.
But, with a new, well-structured treaty, they could get something tangible and very valuable in return for their tax-euros: a power transfer or incremental political leverage over the offending country’s sovereignty. With a power transfer it becomes a much easier thing to sell to the taxpayers of “prudent member states” (like Germany) and, consequently, with a heavily internally collateralized EFSF, it could mean the beginning of a real solution to the current crisis as well as laying a better foundation to the structure of the EU going forward. The bond market specialists may (or may not) foresee this follow-thru and therefore interpret this as a viable solution..?
That said this is far from victorious, all that has happened is a potential path has been cleared toward as solution – Merkel and Sarkozy deserve credit for that part, at least. Whether the European political elite take the right path from here is an entirely different matter – perhaps another time we will examine the potential pitfalls and legislative landmines that EU politicians will have to circumnavigate to make sure this incisive rhetoric is effectively manifested in a fair and transparent political structure which all EU members can feel happy about.
It’s all very well France and Germany uniting to cut out Britain and ensure their dominance in the region but will they now do the right thing by the other 15 states in the Eurozone and the other 24 states in the “new EU”? That’s a monumental question and the questions within the new EU will only become harder.
Market Overview
Tail-Risk Displayed In Market Bifurcation
If you want to know how tail-risks are expressed in the markets it is not an easy thing to do. After all by definition tail-risks are notoriously difficult to identify – never mind predict. But like a patient on a doctors table, the symptoms give us clues… ZeroHedge explain the dichotomy in the credit versus equity markets in Europein this article. Chart of the Day – ZeroHedge’s credit vs equity risk divergence.
Chart of the Day
Sub Financials (light blue) vs Euro Equities (dark blue) ... (Source: ZeroHedge)
Events
Macro Events:
Update:
IndiaIndustrial Production – horrific drop! I’m almost hoping that this was a typo …
