Risk taking is back with a vengeance this morning after a spectacular bailout of the Eurozone was announced prior to markets opening in Asia. As such, we felt it was important to share a few pieces of thoughtful commentary regarding Items Nine and Ten of our recent Ten Reasons to Buy Bonds post:
Our friends at Research Edge referred to this weekend’s announcement as The Keynesian Elixir. Wikipedia defines an elixir as “a sweet flavored liquid used in compounding medicines to be taken orally in order to mask an unpleasant taste and intended to cure one’s ills. Elixir in the noun form means a drink which makes people last forever.” In this case, the Euro Elixir is masking the unpleasant aftertaste of unintended consequences. The cure will buy some time, but will emphatically, not last forever. Per John Hussman this AM:
Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.
Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.
“Failure” and “restructuring” mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.
And the skeptical David Rosenberg raises the following concerns in his morning commentary:
Beyond today’s knee-jerk reaction, there are issues left on the table. The emergency measures just announced buys some time but should help take some of the fear and illiquidity out of the market over the near-term. However, what were not addressed are the intense structural fiscal problems plaguing much of the Eurozone.
In the final analysis, if the EU lends money to Greece or to any other problem country in the zone, debt ratios (including contingent liabilities) in the region will only rise further. It will be interesting to see how the rating agencies end up handling this. It cannot be lost on them, or the global investment community, that while loans, guarantees and central bank provisioning can deal effectively with liquidity issues, they are ineffective in addressing what’s really at stake here, which are structural fiscal issues. So the deal over the weekend is only going to be successful insofar as they are backed up by meaningful reforms (it must be emphasized that the rescue package critically hinges on the Club Med countries accepting deep budgetary retrenchment notwithstanding their weak economic structures. Indeed, it will be interesting to see how Spain can manage to meet EMU deficit requirements at a time when the unemployment rate is currently at 20%, just as one example.)
Since the ECB has come out and said that it will buy both government and corporate bonds, then what is clear is that any rally in the Euro should be faded because the lines between fiscal and monetary policy has just become blurred. The cost of the ECB helping drive long-term yields in the periphery lower is jeopardizing the sanctity of the central bank balance sheet. And, just as the Fed has ceased in expanding its balance sheet, the ECB is set to expand its balance sheet, and this is a Euro-negative. Of all the knee-jerk bounces today, the Euro is the one most vulnerable to reversal.
Although the measures will help mitigate the growing dangers of contagion in the Euro area, the IMF/EU loans come with a “strong conditionality” with respect to intense budgetary restraint and structural fiscal reforms. The massive package of loans and guarantees buys time, but the issue of whether the austerity package for Greece will be accepted by the public (almost half do not approve) is still up in the air. Portugal and Spain are in need of credible packages to cut their deficits. This will exert an enormous fiscal squeeze across wide swaths of the Eurozone and require a weaker Euro as an antidote.
Against this backdrop, the threat of default and concerns over the future of the Euro will not dissipate entirely. The region, especially the Club Med partners, will be in for a long period of extremely weak economic growth.
Obviously, we agree. The Euro dropped from about 1.33 to 1.25 since we suggested that investors Remain Calm – “the Euro still has a ways to go before reaching fair value on a purchasing-power-parity basis. Given the prospects for an extended deflationary period ahead, we think the odds of a downside overshoot are “strong to very strong.” We are not there yet. Sell the bounce.
Disclosure: At the time of publication, the author was short the Euro, although positions may change at any time.