An excerpt from a recent note that legendary Swiss investor Felix Zulauf wrote to Itau Global Connections newsletter.
Running in Circles
We are all getting tired by how much the world has become hostage to the never-ending Euro drama. While some media reported the recent EU-Summit outcome as Monti’s victory over Merkel, others saw it just the other way around. If the experts don’t see clearly, it must be a very confusing situation indeed. To me it appeared euro-zone members invented a new trick. Instead of trying to bail out bankrupt governments by bankrupt banks, they now turned around trying to bail out bankrupt banks by bankrupt governments. Eureka!
Without going into details about the summit, there were some agreements on principle, but they lacked any detail. The debtor countries are pleased to see ESM/EFSF money helping peripheral banks directly, but be assured that the conditions making Germany agree to this will be very tough. Debtors also applaud the potential purchase of peripheral government bonds without making them senior to others, which prevents putting private investors at a disadvantage. The “growth pact” agreement, however, is a fake and lacks substance, as it is simply an addition of so far unspent but already budgeted expenditures. More importantly, the bargaining about details beginning this week will be decisive, as conditions set for ESM/EFSF money will be tough. Particularly after Monti “persuaded” Merkel with the help of Hollande and in particular the German Social Democrats – although the latter were probably not fully aware of what they were doing.
The rift I expected with a French Socialist as president is growing bigger between the debtor and the creditor countries. German media complain about Merkel agreeing to direct financing of Spanish banks without any control. In fact, sentiment in Germany, which has been broad-based in favor of the euro and some solidarity help in recent years, has turned decisively against any further help. A group of 160 leading economists have even launched a manifesto requesting that the German government step back from recent agreements of a banking union, as it would become so costly it could destroy German prosperity in the long run. As parliamentary elections will be held in September 2013, Merkel must stand tough if she wants to be reelected. Because she holds a doctorate in physics and is a natural scientist by training, the hope is she can think a problem through to the end with logic. Moreover, she has lived in communist Germany and knows what socialism on a grand scale means, namely the opposite of freedom and prosperity. On the other hand, she always said no first to say yes later. Europe is moving closer to the key decision about how the continent should look in the long run.
The ESM/EFSF vehicle is supposed to have a capital of €700 billion, of which €80 billion will be paid-in capital by the different governments according to their ECB share. So far only €32 billion has been paid in. Further capital can be called from governments according to their share. What is unclear is whether a member country asking for help will not be subject to those calls, which would increase the burden for the remaining others. That was the case so far because the whole vehicle was set up only to help the small countries! The lending capacity should reach a maximum of €500 billion. Of this €500 billion, €192 billion has already been lent to Ireland, Portugal and Greece, and another €100 billion has been promised to Spain, which leaves approximately €200 billion for future purchases of government bonds or lending to finance banks. This is only a drop in the bucket, of course.
Just have a look at the Spanish situation to understand that borrowers need much more money than the financial umbrella can provide. Total Spanish bank assets amount to €3.7 trillion. The tangible book value of the Spanish banking system is about 4%, or about €150 billion. With the multi-year recession and home prices realistically down 40%-50%, I would estimate that write-offs amount to 20% plus, totaling at least €700 billion.
Just by looking at the Spanish numbers, it is obvious that current lending facilities of the ESM/EFSF are far too small to help Spain, not to mention the others. Now, if Spain cannot contribute anymore to the financing vehicles and Italy follows Spain and France follows Italy due to the deflationary downward spiral in those economies, the ball lands in Germany’s court. Merkel and her team must have figured out that it is simply too big for Germany to become the paymaster. Germany’s government debt already amounts to €2 trillion, and adding current guarantees, loans and TARGET2 money in reality pushes it easily to over €3 trillion, which means Germany’s government debt/GDP ratio is in reality already far above 100%. As Reinhart and Rogoff explained in their book, This Time Is Different, governments past 90% usually face major growth restraint going forward.
Germany is realizing what a fatal trap the euro has become for her in terms of potential financing requests from debtor countries. And the debtor countries are waking up to the fatal deflationary trap that the euro has created for them. It is an untenable situation. What cannot be, will not. Merkel’s words that there won’t be any eurobonds as long as she lives makes it clear that Germany will act in solidarity, but she will not risk Germany’s own financial situation. The Club Med countries are burdened by an aggregate government debt of €3.4 trillion, and their banks have an aggregate debt of €9 trillion. Germany’s annual tax revenues total approximately €0.6 trillion, which is simply a drop in the bucket. The dimension of the problem is such that Germany simply cannot solve it. Hence, it would be absolutely suicidal to enter debt mutualization. What cannot be, will not be.
The European dilemma is quite simple. The debtor nations (in terms of external accounts) have become uncompetitive and are trapped in an overvalued currency. As a result, external accounts keep deteriorating, which calls for some austerity, which in turn weakens the economy further. The deflationary spiral is getting enforced by an undercapitalized banking system that funded the government to a large extent and is now bust. Hence, funding for government deficits has dried up, and interest rates have risen due to fears of default or a euro breakup and corresponding currency devaluation. As a result, banks continue to lose deposits in a slow-motion bank run and in turn, those banking systems go bust.
We know the procedure when a company goes bust, and even when a government goes bust. But when several governments and their corresponding banking systems go bust within a monetary union, this is new and unique. The best way to solve it would be to stop throwing money at the problem and to nationalize the banks and protect the savers, but not the creditors and shareholders. A default by the government and ensuing restructuring would follow. It would be painful but it would end this drama and create a platform for future growth down the road. But more money will be spent and lost if policymakers continue their current path.
Increasing Lending Facilities Does Not Solve the Problem
Nonetheless, many voices are calling for more union and more help because the costs of a break up are too big for all, including Germany. Even George Soros, who has generously spent billions of his wealth to support the Foundation for an Open Society, a movement for freedom, is calling for Germany to step in. It is true, a breakup would initially lead to chaos, crisis and economic hardship, but at the same time eventually improve the economic situation for the whole region. Further lending facilities cannot solve this problem. The ECB may postpone a final break up by stepping in to finance the uncompetitive economies and thereby print so many euros that the currency will weaken against all other currencies. This may postpone the inevitable for a while but not for ever. At the end of this road, Europe must either function as a political union with a centralized government with full sovereignty, or the euro must break up. I simply don’t see any other solution. My hope is that preparations are made behind the scene to manage such a break up in an orderly fashion because I personally cannot see the political union happening within my lifetime. With Italian 10-year government bonds trading near 6% and Spanish bonds near 7%, markets are sending a clear message. At these yields, both governments will not be able to fund themselves for long without dire economic consequences.
When trying to compare the costs for Germany of a breakup of the euro versus the costs to save the euro, many mention all the time that a breakup is too costly. Is that really true? While some simple arithmetic may show that saving the euro is less costly at first glance compared with a breakup, we should not forget that a mutualization of debt would push Germany into the paymaster position forever. It would destroy the German economic success model once and for all because Germany’s benefits would to a large degree end up in other nations’ pockets.
Let individual nations decide what they want: more work and prosperity or less work and less prosperity, retirement at 60, 65, or even 70 years, and so on. Each nation can decide but also must bear the responsibility for its decisions in full. Each nation can decide whether to have a strong or a weak currency, with all its consequences. The alternative to sovereign nations in a democracy is a United States of Europe, which will be far from what the United States of America is. There are different languages, cultures, ancestors and ways of life, not to speak of the differences in economic matters. A centrally managed Europe by one multi-state central government in Brussels would lead to horrible misallocations of resources and transfer payments on a grand scale simply to fulfill the European political left’s dream since the French Revolution of 1848, namely to make everybody equal. This is the dream of the 1968 radicals who were Socialists, Marxists and Maoists and ended up as bureaucrats in today’s governments throughout the Western world, including key positions in Brussels. It would make everybody a lot poorer (except the few in power) and less free. The people of the USSR did not embrace Communism/Socialism but for several decades were forced to do so or pay with their lives – until the USSR was bankrupt and fell apart and each nation went its own way again, but much poorer than before the Communists had taken over. And those who think my comparison is far-fetched may study the former Yugoslavia, which was also held together with an iron fist against the desire of the different ethnic groups but eventually exploded in a bloody war. Have our politicians who want the United States of Europe at virtually all costs really learned anything from history?
Slowing World Economy
The PMI indicators in virtually all major economies are pointing downwards, with the vast majority even below 50. The world economy is slowing, in all regions. While I doubt the US will fall into recession anytime soon, the slow creeping fashion of the economy is hardly pleasing households, businesses or the current administration. While some parts of the economy and some regions seem to be doing okay, and actually better than what indicators suggest, others are not doing well. Quite frankly, I don’t see any major improvement soon, as corporate profits are now beginning to be impacted by the stronger dollar and the slowdown overseas.
In China, the central bank has cut rates again to support the economy. This unexpected rate cut by the investment community probably shows best how concerned the Chinese government is about the lack of credit demand and the pronounced slowdown of the economy. While the hard landing has already occurred, best demonstrated by the decline in base metal prices of between 30%-45% over the last 15 months, it is possible to see some stabilization at current lower growth levels soon, particularly if investment projects by the public sector will be forthcoming. However, it is difficult to see a sustainable economic improvement because the biggest credit and construction boom on record has gone bust, and no interest rate cut will bring it back. Moreover, the Chinese corporate sector already carries debt on its balance sheet equivalent to the cash-flow of a full decade. The world may actually find out that China is subject to the same economic laws as everybody else. Expectations for another growth miracle out of the land of the dragon will be disappointed, in my view. I am afraid the commodity bulls may get very disappointed, as the peaks of 2008-2011 smell like a secular peak to me (see the chart below).
The biggest malaise is in Europe, and it is beginning to affect growth in Asia and in the Americas. While Germany is stagnating at a high level, I doubt a further weakening will be prevented. Other economies belonging to the core are all clearly weakening, some even meaningfully. France, despite its new socialist leader’s campaign rhetoric, is even announcing cuts of government expenditures, which will in the short run weaken the economy further. Italy is weak and getting weaker, and it is hard to see how it could turn around with an uncompetitive industrial sector and consumer confidence at multi-year lows. Industrial production is back to near the lows of 2009, fully 25% below the level of 2007. Spain is even worse, with industrial production decidedly below the lows of 2009 and almost down 30% from the business cycle peak of 2007. And Greece trumps all others, as it is in a full-fledged depression, probably worse than the US experience in the early 1930s. It is obvious that budget deficits are growing again everywhere despite cuts of expenditures, as tax revenues are breaking away. This is the environment for a severe banking crisis, particularly when banks are as undercapitalized as is the case in Europe. These trends in Europe must encourage those who want to terminate the euro project and go back to national currency sovereignty again. And I simply wonder how long the euro bureaucrats can remain in denial about the total failure of their grand project. As there will be no improvement into later this year, be prepared for the people to begin expressing their dissatisfaction in a more pronounced way.
It is no surprise to see investors positioned cautiously in view of the fundamental environment and uncertainties. While many corporations are doing well, investors do not fully trust that it will continue in view of the macro landscape. And fixed-income investments do not really offer an attractive alternative to equities after yields have plunged to historically low levels (for example, a 500-year low for 10-year Dutch government bond yields!), whereby an annual coupon can be lost by the normal volatility of one trading day. Dividend yields are higher than quality bond yields for a high number of stocks. And while those dividend yields are attractive teasers, if stocks decline in bear market fashion, the dividend return evaporates in a single day of trading losses. Some may therefore turn to alternative investments, but who guarantees they will not fail. We have had many casualties, even among what used to be the best in recent years.
In this return-scarce and risk-prone environment, US large cap equities, particularly the bluest of the blue chips, seem to attract a lot of the risk-averse investment money. At present, a firm currency – best horse in the glue factory – and decent earnings and dividends combined with time-tested business models is attracting money from all over the world. It appears to be leading to a new nifty-fifty theme with members from Healthcare, Retail, Consumer Staples, and Telecom. In the meantime, the US market has been and still is performing the best due to this flow of funds, and its valuation is now already 40% more expensive than Europe or Japan and 10% more than emerging markets, which have more robust long-term fundamentals beyond this cycle. Usually, a theme goes to an extreme before it crests, and this one could also later in the year. I detect growing bullishness among investors due to medium-term oscillators being in oversold territory and the excellent performance of a selected group of US stocks in particular. Market analysts differentiate between good and bad oversold. Good oversold is an oversold situation within a defined bull trend, while bad oversold is just the opposite. My hunch is that we are dealing with the latter rather than the former here.
On the other side of the spectrum, we have cheap and oversold European equities but unattractive macro fundamentals, to say the least. And that’s why investors are holding off or diverting funds to the US. Europe needs to see the Gordian Knot of the euro being cut so as to attract investment funds to its equity markets. And as explained above, this is not possible for political reasons.
We have seen some timid central bank easing. Only the Bank of England continues its massive quantitative easing despite a complete lack of any positive result for the real economy. Most central banks seem unwilling to risk their silver bullet too early. If the global economy weakens further into this fall, which appears very likely, I expect central banks to act once again, forcing some money from the sidelines into the markets again. And that may produce more pops from the coming short-term oversold expected for later this month.
So far we have seen the first pop, or upside attempt, in global equity markets I mentioned in my last report. While the leading US blue chips mentioned above are overbought, US cyclicals as well as European and emerging markets just bounced from oversold. Hence, markets are vulnerable to further losses in the short term. Most likely we will enter a more choppy territory now, leading to another low later this month.
Given the fragile fundamental backdrop, I would assume more testing of previous lows will take place. As central banks are on guard and investors are already cautiously positioned, the downside may be limited, although new lows in selected markets are possible. Only a big unexpected shock could lead to serious breaks of recent lows.
Despite the already low yields on a historical basis, bonds may have another and possibly final attempt toward the lows or marginal new lows in yields, but it may present a good selling opportunity for bonds sometime during this quarter.
Oversold base metals are bouncing after a severe decline since early 2011. But so far it is not more than a bounce within a still bearish trend. China’s economy is much weaker than published statistics suggest, and interest rate cuts do not revive a credit and housing boom of historic proportions gone bust, as many other economies have found out over recent years.
The one standout in the commodity complex is grains and soybeans, where severe heat leads to constant cuts in harvest forecast. Moreover, the Chinese have shown up as big buyers because they also seem to have a poor harvest. While they say their inventories are plenty, it is strange to see them buying front-month futures that trade at a premium to longer-dated contracts. It may be indicative of a much more serious inventory/consumption problem that they have. In fact, this harvest is on its way to being the poorest since 1988, and the inventory situation on a global basis is getting to be one of tightest ever seen. One doesn’t have to be a rocket scientist, but a glance at long-term price charts of the grain/soybean complex suggests the potential for a very powerful move to historic new highs. Unlike equities, new supply in commodities cannot be readily generated. That’s why commodities usually end a big bull market in a parabolic fashion. This one has all the earmarks of such an outcome.
Gold remains locked in a tight trading range. It needs to break out of the $1,520-1,670 range for its next important move. While longer cycle patterns suggest an important low in the third quarter, I am still not sure whether the recent and third test of the lower side has already completed the cyclical correction from last summer’s high of $1,920. If not — and that is my gut feeling — a quick shakeout would still be possible but at the same time offer a great opportunity to add to gold holdings. On the upside, a break of $1,670 is necessary to confirm a cyclical turn for the better. It is most likely that this important decision will come up during the current quarter. Stay alert.
The US dollar has become the preferred currency in view of the problems in Europe and the pronounced slowdown in emerging market countries. But foreign-exchange traders are already positioned long the greenback and short the European unit. I do expect the euro to weaken considerably over the next two years due to my expectation of tremendous efforts by the ECB to hold the currency together by injecting large quantities of newly created liquidity into the European banking system to prevent an implosion. However, until we see those efforts for real, the euro’s decline resembles more an erosion than a slump. Moreover, the US currency does not have the classic characteristics of a strong currency, like a structural current account surplus or monetary authorities who are time-tested guardians of stable money.
Source: Itau Global Connections