Greed And Fear's Chris Wood On The Timing Of The Euro Endgame

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From CLSA's Greed and Fear, by Chris Wood, December 23 edition.

The S&P500 remains at post-Lehman highs and GREED & fear remains nervous about a correction. But GREED & fear will also have to admit that the short-term technical indicators long followed here are not sending warning signals. Rather the message is bullish which is one reason why GREED & fear is not reducing the beta of the long-only portfolios.

It is also the case that the US continues to be cut relative slack because of the problems in Euroland. Here the ongoing noise from Brussels makes it clear that the final crescendo of this particular drama lies in the future. With Frau Merkel continuing to talk tough about the need for fiscal discipline, and rejecting euro bonds, it appears that there will have to be more market turmoil before the inevitable decisions are taken. GREED & fear says inevitable because it still seems likely that the end game will involve some form of German acceptance of collective fiscal responsibility and debt restructuring. This is partly because the German establishment is so committed to the euro and partly because of the practical fact that German banks have such big exposure to the debt of the European periphery countries.

The past week have seen further signals that the above will be the end game. Thus, an article in the pinko paper by Peer Steinbru?ck and Frank-Walter Steinmeier, the former minister of finance and former foreign minister in the last SPD government, proposed debt haircuts as well as the limited introduction of European-wide bonds (see Financial Times: “Germany must lead fightback”, 15 December 2010). Second, the ECB announced on 16 December that it decided to almost double its subscribed capital base from €5.76bn to €10.76bn, with effect from 29 December.

This suggests that there is an understanding, despite the official rhetoric, that there are losses that will need to be taken. Still it also seems clear that there needs to be more market panic for such decisions to be forced on the relevant authorities, most particularly Frau Merkel. All this suggests an opportunity for macro investors since it seems increasingly likely to GREED & fear that this drama is going to come to a head in the first half of 2011 and not in 2013 or later.

Moreover the moment some form of credible debt restructuring is agreed, in the form of a European version of the Brady Plan, a bid should come in for the euro against the US dollar and indeed against the Swiss franc which has been the major beneficiary of the systemic surrounding the euro to the chagrin of the Swiss National Bank. But all this lies in the future. For the moment the issue for investors is what will be the catalyst to precipitate the next wave of market turmoil. Will it be Portugal, will it be Spanish banks’ property exposure or will it be a new Irish Government’s desire to walk away from the massively costly bank guarantees committed to by its predecessor? GREED & fear has no idea which will be the precise catalyst. Indeed it could be all of them. But more turmoil is coming which is why the best hedge for those owning Asian equities remains shorting European bank stocks

Meanwhile, the risk to the above view remains that Frau Merkel remains hard line to the end and that German public opinion revolts against taking on any of the periphery’s debts. Clearly, this is possible. But it seems unlikely to GREED & fear given that all the empirical evidence thus far is that when push comes to shove, the Germans capitulate to the political mantra of maintaining the euro.

What about the Chinese inflation story? GREED & fear will not repeat the relatively sanguine view already articulated here. But what is worth re-iterating here is that mainland policymakers are not concerned. The past week has seen more evidence of this. Thus, the Chinese government announced on Tuesday another increase in gasoline and diesel prices. As noted by CLSA China macro strategist Andy Rothman, this is not a signal that the PRC is particularly worried about inflation. Second, the chairman of the China Banking Regulatory Commission (CBRC), Liu Mingkang, made a speech at a financial forum in Beijing last Friday stating specifically that inflation was not a problem because of China’s continuing excess capacity. Thus, Liu said that there remains overcapacity for most industrial goods in China and that it is difficult for upstream inflation to be transmitted downstream.

Clearly, the PRC policymakers could always be wrong. But in GREED & fear’s view the empirical evidence of the past ten years and more suggests they deserve to be given the benefit of the doubt. Still it is also the case that markets are likely to spend the first quarter of 2011 continuing to worry about inflation in China. This is because the mainland authorities are themselves now expecting inflation to peak at about 6% in the second quarter, primarily because of weather related seasonal pattern. Thus, January and February traditionally show strong month-on-month inflation pressures.

Still the longer investors want to look into 2011, the less likely they are to be worrying about inflation in China or the rest of Asia and the more likely they are again to be worrying about renewed deflationary pressures in the West. As for developed market equities, the best place to be remains in those companies whose revenue streams are geared to the emerging markets. This is certainly how GREED & fear’s Japan long-only portfolio is positioned. On that point, the Nikkei published last week an interesting survey of 420 nonfinancial companies that found that 36% of Japanese listed companies’ earning last fiscal year (ended 31 March) came from emerging markets, up from just 9% a decade earlier. The same story applies in the US and European stock markets. But the only domestic story GREED & fear really likes in the West remains Germany and even there the final drama of Euroland’s crisis has the potential to hit resurgent consumer confidence, at least for a while.

There have been interesting developments in the Korean peninsula in recent days. GREED & fear refers to South Korea’s so-called “live-fire drill” on Monday on Yeonpyeong Island and North Korea’s subsequent statement that the exercise was not worth reacting to. This suggests the North is hoping for a resumption of the six-party pantomime, or some variation of it, after the recent flurry of diplomatic activity. Thus, China’s leading diplomat, State Bingguo, has visited Pyongyang and Seoul in recent weeks while an unofficial US envoy, Governor Bill Richardson of New Mexico, also visited Pyongyang last week.

Still if Washington and Seoul decline to be pressured into more talks, the risk to GREED & fear remains of further escalation from the North. For the failure of the South to do anything to stop the death of four South Koreans on South Korean soil, as a result of the violent attack in November, has led to a long overdue wake-up call in terms of South Korean public opinion. The support for the so-called “sunshine policy” has now all but evaporated. Instead there has been rising popular demand, in response to the South’s evident lack of military preparation for the North’s November attack, that Seoul makes it clear to Pyongyang that the next time such an incident occurs there will be a more aggressive retaliation. Hence this week’s military drills.

This is why investors should understand that the risk of military escalation in the Korean peninsula has increased since the government of President Lee Myung-bak has now made it clear to the North Korean regime, via communications with the North’s main ally, namely China, that it has changed the rules of engagement. The message is that if the North launches another attack the response will be to retaliate by launching an attack on pre-targeted strategic assets such as missile sites in the North. The question then becomes the risk of escalation if the North responds in turn to such an attack. In this respect the ability of China, or the lack of it, will become a critical variable given the fact that Beijing was clearly not pleased with the North’s November provocation which put it in a difficult position diplomatically.

Still so long as China is willing to shore up the North, and it is estimated to supply about three quarters of North Korea’s food and oil, it is not clear to GREED & fear if Beijing really has any control over the North’s behaviour. For the Kim Jong il regime presumably calculates that China will continue to prop it up because the alternative is a collapse of the Pyongyang regime which would likely mean a united Korean peninsula coming under the control of a pro-American alliance.

Meanwhile the North Korean interest in launching the November attack was clearly to gain America’s attention. The ultimate goal is US acceptance of the North’s nuclear weapons programme. Hence the not coincidentally close timing in November of the shelling of the island and the decision to show the world the uranium enrichment facility. As for the investment implications, North Korea remains an impossible issue for markets to discount. It either does not matter at all or it is the only issue that counts.