Sage Weekly Letter – 5/28/2012

• Posted by Robert Sinn
• on May 28th, 2012

Last night as we were discussing the euro crisis over dinner and a bottle of Italian white wine my father proclaimed: “In five years we will look back and remember this discussion and wonder how we could have missed the scenarios that led to the eventual outcome. Five years from now what takes place over the coming weeks & months will appear quite obvious but right now, in the moment, the path forward is anything but obvious.” So true, but this doesn’t mean that we should not attempt to understand the problems facing the euro as well as the potential solutions to these problems. After all, in five years there is sure to be another immense challenge facing global economies & financial markets – the more we have experienced and thought through these types of tumultuous periods the better prepared we are to navigate tomorrow’s stormy seas.

To better understand where we are, it is important to at least have some basic understanding of where we have been and how we arrived where we are now. The euro was conceived for multiple reasons, the most prominent of which were:

• Facilitate cross border commerce within Europe
• Create a currency that would rival the dollar for global reserve currency status and challenge the United States’ dominance in global financial markets
• Bind European countries, who have had a long history of tension and war, together in a union that would have little choice but to become further intertwined over time
• To increase Europe’s importance on the global stage: Since the end of World War II no single European country has played a major role on the world stage, however, the concept of a single Europe wields much greater power and importance globally – the euro is a huge step forward in the “European Project”

The euro was welcomed with open arms in its early years as long as it was convenient for all nations involved and it helped to increase wealth and credit availability throughout the euro area. However, as soon as eurozone membership infringed upon national sovereignty and led to financial hardship (through fiscal austerity and by making exports from the weaker member states less competitive) it has become much more controversial and less popular in recent years.

The creation of the euro had too many flaws to mention here, however, the flaws were not emphasized and were little noticed during the credit fueled global economic boom period 2002-2007. Countries such as Ireland and Spain (two of the more prominent examples although all Eurozone countries took advantage of cheap and easy credit to varying extents) experienced massive property booms which quickly turned into bubbles due to the widespread cheap and easy access to credit. Credit which was made much more available thanks to the euro and the increased liquidity and market confidence which the euro provided.

Spain for example underwent a credit boom of biblical proportions which was further exacerbated by political pressures to direct lending from semi-public regional savings banks (Cajas de Ahorro) to the real estate and property construction sector. This concentration and misallocation of credit and resources is largely to blame for the deflationary debt bust which Spain is currently experiencing. The charts below tell a clear story:

Spain M3 vs. euro area M3

Banco Santander ($STD) achieved more than a 600% return for shareholders between its 2002 low and 2007 peak:

 

To put the Spanish real estate bubble into perspective here are a few stats worth pondering:

• At its peak the construction industry accounted for 16% of Spain’s GDP (at the peak of the housing bubble in the US construction accounted for roughly 12% of GDP)
• Between 2001-2005 Spain’s economy created more than half of all the new jobs in the European Union (primarily in the financial services and real estate sectors)
• The average level of household debt tripled in less than a decade

Spain has a massive banking sector which includes Banco Santander (one of the World’s top 20 largest banks by total assets ~$1.7 trillion), however, it is the regional banks (Cajas) and mortgage banks (Bankia) where some of the biggest skeletons are buried. Spain desperately needs a widespread and large scale bank recapitalization in order to flush out the toxic assets and to help trigger the restart of a new economic cycle.

If money goes to where it’s treated best it’s unlikely to find its way into Spain as long as the country’s banks are laden with non-performing property loans amid a backdrop of surging unemployment and negative GDP growth. Spain faces a similar, albeit worse, conundrum to what the US faced in the wake of the US housing bust and Lehman failure: Allow the market to clear at lower prices which will inevitably trigger a large number of banking failures once price transparency leads to balance sheet insolvency OR bail-out/inject more liquidity into insolvent zombie banks who provide a net drag on economic activity due to the fact that they are no longer equipped to perform their primary role as credit providers to the economy. Simply put Spain desperately needs A “Marshall Plan” bank recapitalization even if it means haircuts on senior bondholders – the government debt & economic growth trajectory is so dire that I see no other alternative.

However, there is a small problem which has probably prevented a large scale bank recap from having been enacted already – bank deposits and the potential for large scale bank runs. It is almost unfathomable that the euro has existed for well over a decade and there is still not a eurozone-wide bank deposit insurance fund. Bank runs are the most basic manifestation of economic crisis – the ECB must act to instill confidence in bank deposits even if it means providing a guarantee that is not fully funded currently.

The Path Forward

Europe is already “all-in” on the European Project and the 17 member states that make up the eurozone are for the most part in a similar situation to a group of escaped convicts chained together on a row boat in the middle of the sea – if one jumps overboard it becomes much harder for the others to stay afloat and continue rowing, whereas, if two or three jump overboard the entire boat will quickly capsize.

With so much at stake you can rest assured that eurozone leaders and policymakers will stop at nothing to prevent a meltdown of the European financial system. As high as the stakes currently are (they simply don’t get any greater) I continue to be amazed at the lack of urgency displayed by European leaders and the European Central Bank. One can make a logical argument that surely the President of the ECB must be fully aware of the situation throughout eurozone economies and financial markets; therefore, he stands ready to intervene should things begin to get out of hand. However, one must remember that this is the same central bank that has consistently been reactive rather than proactive – the ECB raised interest rates during the summer of 2008 in response to high oil prices weeks before a global financial meltdown and just last summer the ECB inexplicably raised interest rates once again in response to high oil prices (which had nothing to do with loose monetary policy and everything to do with supply shocks from North Africa) weeks before Italy fell into full blown crisis.

If the ECB were to proclaim that it has done everything it can and the fate of the eurozone were to be left in the hands of political leaders I would bet against the common currency with both hands as its days would be numbered in hours and not in weeks. Therefore, it seems to me that the fate of the euro rests solely in the hands of the ECB: Either the ECB takes extraordinary policy actions (as I outlined two weeks ago) in order to re-instill confidence throughout the eurozone OR an unfortunate fate for the euro could be sealed within weeks.

Market Impact

The ECB appears to have come up with a clever method to help recapitalize Bankia by providing financing through the Spanish government which the ECB still deems to be a fully credit worthy borrower. I expect more of these types of infusions over the coming days & weeks if the ECB is serious about saving Spain from disaster (which I believe it is).

This summer is likely to be roughly analogous to the post-Lehman period in late-2008 during which time the day to day market movements were driven by various news reports of votes in Congress, bailout plans, and Fed/Treasury policy actions. I continue to expect plenty of whipsaws and head fakes with equities ultimately ending not far from the levels which they began. Of course, the risks are to the downside should central bankers and policymakers fumble the ball – I simply believe that the stakes are so high that they will find a “muddle through” path of policy actions that will get us through the next 6-9 months.

Best Ideas

• Euro futures ($6E_F) speculative short interest is at a new all-time high, this combined with extremely one-sided bearish sentiment and oversold technicals make June/July bull put spreads ($FXE) an attractive proposition
• Long gold – gold ($GC_F $GLD) has many ways in which it can work well from current levels and pretty much only one way in which it loses (global deflationary recession with little or no central bank stimulus)
• Long $USDCAD on a pullback to the 1.0150-75 area – this is a good risk hedge
• Short $CRM either outright or via puts/put spreads
• Sell volatility ($VIX) into volatility spikes – $SPY iron condors are a good method of doing this

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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