We traditionally enjoy the periodic letters by Guggenheim's CIO Scott Minderd. His latest piece, "The Opening Act to the Broader Crisis" is no exception. In it, the strategist dissects the European crisis, compares it to the subprime debacle and sees it as the precursor to the eventual downfall of the euro, a surge in the dollar, the "federalization" of Europe and the adoption of QE by the ECB. The key must read item in the current report is Minerd thought experiment of what a wholesale bank run, first in Ireland, and then everywhere else in Europe, would look like. This is especially important as one could, as Scott claims, start at any moment. What does this mean for investments? "If we are on the brink of crisis in Europe, which I believe we are, then there are several expectations we can draw about the investment landscape. First and foremost, the dollar will strengthen rapidly against the euro; U.S. Treasuries will rally; equity prices in Europe will fall; and credit spreads will widen, at least temporarily. In general, risk assets will experience choppier waters, especially as the crisis intensifies." Yet somehow this is a disconnect with the Guggenheimer's recent Barron's round table bullish statements on stocks and high yield bonds: "Let me be clear, I am not changing my mind on any of these investment theses, but a crisis in Europe will likely interrupt, but not derail, certain bullish trends at some point in 2011." It is ironic that Minerd brings up subprime as an analogy to Europe: after all his response is precisely the same that everyone else who appreciated the gravity of the subprime contagtion used at the time, starting with The Chairman. To wit "it is contained." All else equal, and it never is, we fail to see how a surge in the world's funding currency, the USD, will not generate an all our rout in every single risk asset, The Chairman's gushing liquidity notwithdtanding, due to trillions in short dollar funding positions.
Here is how Minerd, who obviously realizes this dichotomy, attempts to resolve this glaring irony:
To understand what this might look like, I use the analogy of the stock market in 1987. During the stock market crash of October 1987, the Dow Jones Industrial Average plunged 31 percent. For six trading days, it appeared that everything in the world blew up. Despite its crash that October, the Dow still ended 1987 up 2.26 percent for the year. Annual returns were 12.6 percent during the 1980s, and they surged even higher (15.1 percent) in the decade following 1987. From a historical perspective it doesn’t look like there was much of a crisis in 1987 after all. In 2011, I think the markets will face something similar with the pending crisis in Europe. At least for the U.S. market, at some point in the next year there will be a dramatic disruption that will adversely affect prices. In spite of this, I still believe equity returns will average 7 to 9 percent for the next decade.
So let's get this straight: the unwinding of the biggest political and socio-economic experiment of the last century, and the collapse of the world's largest economy (which is what the EU is), together with surging bond spreads, trillions in FX flows, an explosion in the dollar, the collapse of European trade is the same as a... one-time stock market event?
That said, Minerd does have some pertinent observations on how the imminent pan-European bank run will eventually look like.
‘Imagine You’re Irish’
To help explain why I believe a broader financial crisis is coming to Europe, let me start with a quick story. Imagine for a moment that you’re an Irish citizen. Needless to say, you have many concerns about your country’s economic situation. The unemployment rate is 13.7 percent and climbing, your economy continues to contract, your nation’s debt-to-GDP ratio is 97 percent and rising (up from 44 percent just two years ago), your national deficit has ballooned to a whopping 30 percent of GDP, your government is caught in a debt trap, and its borrowing costs have increased 75 percent year-to-date. If expressed in current market rates, the interest payments on your government’s debt obligations could easily account for 7 percent of GDP, or roughly one third of annual tax revenues. To put this into perspective, the situation facing the Irish government is akin to waking up everyday only to realize that one-third of your salary is gone before you even think about paying for the necessities of life.
Fiscally, everything is heading in the wrong direction in Ireland. However bad it may be, the country’s solvency is a secondary concern. If you’re an Irish citizen, the more pressing issue is what you’re going to do about your banking deposits. Your domestic Irish bank posted a 2.4 billion euro net operating loss in 2009 and is projected to nearly double its losses in 2010. The entire domestic Irish banking system has essentially failed, but the government wants you to believe that everything is fine. After all, the International Monetary Fund, the European Central Bank, and the European Union member countries have cobbled together an 85 billion-euro rescue package of which approximately 35 billion euros is set aside for the banking system.
In addition to the bailout, the Irish government has assured you that it will guarantee your deposits, therefore, there’s no need to worry.
Then you get a hold of the Central Bank of Ireland’s most recent Credit, Money, and Banking report (publicly available on the internet). You see that total deposits for Ireland’s dwindling base of domestic credit institutions were roughly 496 billion euros as of October 2010. Some quick math tells you that this is more than three times Ireland’s GDP, and 14 times the scope of the current banking system bailout package. You start to wonder, “If I try to get my money from the bank at the same time everyone else does, where is the government going to get the euros to pay everyone?” You can’t think of an answer. Then you start to feel silly. “Why am I even bothering with all this worry?” you ask yourself. “I’ll just go down to the bank and take my money out now before things get worse. I can give it to a multi-national bank and sleep better at night.”
It seems trite, but this little scenario is essentially what’s happening today. The Irish banking system is literally experiencing a run on its banks. According to the most recent banking update from the Central Bank of Ireland, total deposits in Irish banks declined more than 5 percent (28 billion euros) between August and October alone.
Year-over-year, deposits declined 10.5 percent, and foreign investors are pulling their money out at an even faster rate of just over 20 percent per year. If the October data was that brutal, I cringe at the thought of what the November and December numbers may reveal. Even more disconcerting, domestic deposits have begun to contract. It’s one thing for foreign depositors to lose confidence, but now even the domestic deposit base is losing faith.
Facing facts like these, each morning when I wake up I have to wonder, “Why is today not a good day for a wholesale run on the Irish banking system?” And if there is a wholesale run on the Irish banking system, then what stops the same scenario from cascading into Portugal, Greece, Italy, and most importantly, Spain?
So is there any hope at all for Europe? Yes...but to plagiarize from Goldman, with huge risks:
‘Where’s My Printing Press?’
Someone recently asked me, why doesn’t Ireland drop out of the EU and do what the United States has done with quantitative easing (i.e., run the printing press)? The problem in Ireland, Spain, Portugal, etc. is that they can’t print money – they surrendered the sovereignty of their printing press to the European Central Bank (ECB) long ago.
The next logical question is, why doesn’t the ECB just run the printing press for them? Can’t the ECB create a flood of euros to alleviate any concerns over illiquidity in the banking system and the toxicity of certain sovereign debt obligations? Technically they can, but practically they won’t. The psychology behind this is something that I hope to address in a future commentary. But for now, suffice it to say that dropping out of the EU is not a viable option for Ireland or any of the other debt-plagued peripheral countries. Benefiting from aggressive monetary policy is equally unlikely, at least to the extent necessary to stave off further crisis.
If Ireland and the peripherals can’t drop out of the euro, and the ECB won’t paper their way out, then what is the alternative? The answer most likely lies with the Germans. Since Germany is not willing to let the troubled economies secede from the euro, and they’re not interested in outright bail outs, the only option left is for the nations of the European Union to somehow share the burden. This would require greater fiscal union and ultimately translate into European federalization. Federalization may not seem very palatable at the moment, but the debate is certainly gaining steam. Once the crisis comes to a head, I could see the German people looking much more favorably upon playing a historic role in organizing the fiscal union of the sovereign states of Europe.
In simple terms, federalization means that the EU would issue pan-European bonds and begin the process of expanding the role of its central governing body over time (the EU already has a governing body with a formal president, currently Herman van Rompuy). This is what the United States did when it ratified the Constitution and established the U.S. Treasury, which in turn consolidated and absorbed the various debts incurred by colonies during the Revolutionary War.
I believe the federalization of Europe is the most viable solution and will be the ultimate outcome. As German Finance Minister Wolfgang Schäuble said recently, “Sometimes it takes a crisis so that Europe moves forward. In this crisis, Europe will find steps toward further unification.” As Schäuble subtly foreshadows, to get from here to there, the crisis will need to intensify. As sovereign credit downgrades continue to flow in and deposits in Europe’s weakened banking system flow out, a broader crisis in Europe appears to be imminent in 2011.
What this means is that the final lap in the great currency debasement race will start in earnest some time in 2011 as the last lever available to the EU has to be pulled:
With the great debaser, Dr. Bernanke, leading the way, the European Central Bank will eventually have to join the charge and print money in order to save the European financial system. As Hyman Minsky once postulated, central banks ostensibly say that their job is to maintain stable prices and sound monetary policy, but at the end of the day, the role of any central bank is to save the financial system at all costs. This includes the cost of the value of the currency and price stability. There’s nothing that cannot be sacrificed if the entire financial system is at risk. Practically, I believe this means that the euro will head to parity with the dollar and then ultimately below parity.
According to Minerd this means that a short EUR trade is a no brainer. That and going long core European CDS, a trade which we ourselves have been pushing for a long time:
The main theatre where the events in Europe play out will be in the foreign exchange (FX) market, where the primary opportunity is to short the euro. Outside of FX, I believe there are opportunities to buy gold and invest in U.S. Treasuries (but not just yet), as both will benefit from their safe-haven status once crisis erupts. In addition, there is opportunity to go long credit protection in the CDS of the countries that haven’t blown up yet, namely Italy, Germany, and France.
We disagree that a plunge in the EUR, which means a surge in the USD, can coexist with rising risk assets. It can't. There are literally trillions in USD funded carry positions whose unwind will result in a market correction that will obliterate the 666 lows on the S&P. There is simply no way that a drop in the Euro does not impair risk.
We end with Minerd's closing observations on that "other" most important topic - interest rates:
In December 2009, the yield on the 10-year Treasury increased 64 basis points to close out the year, primarily on the back of robust expectations for economic recovery (fourth quarter 2009 GDP eventually registered 5 percent annualized growth). Following the rise in rates in late 2009, the first quarter of 2010 saw rates go sideways. Then, after pushing upward to 4 percent in early April 2010, the yield on the 10-year proceeded to fall precipitously by 160 basis points over the next six months. Most recently, yields have mimicked 2009 year-end by climbing 80 plus basis points off the lows as positive economic expectations are taking root once again.
Although it would appear I’m describing significant fluctuation in rates over the past 12 months, at no point in this story did rates break out of the long-term down trend established over the past 30 years. In fact, even at the nadir of 2.21 percent on December 31, 2008, the yield on the 10-year note remained completely within trend. Even as we end the year with yields rising to what seem to be a relative high, the 10-year Treasury remains completely within the trend channel of declining longterm interest rates.
I’ve already gone on the record saying that the bull market in bonds is long in the tooth, but it’s also important to note that bull markets don’t just roll over and die – they either break trend and continue into a parabolic blow off, or they break the trend and move sideways for long periods of time. To me, the most important point is that the recent rise in interest rates has yet to break out of the downward secular trend in bonds. This event would be the first indicator to watch for before anyone should be concerned about rates rising in a meaningful way, and it has yet to materialize. I suspect that in the near term we’ll see continued upward pressure on rates, but I would be surprised if they reached much higher than 3.80 on the 10-year note before declining again. The moral of the story is that as we near year-end, the 10-year note remains approximately 45 basis points below where it started the year.
After a tumultuous 2010 filled with rising-rate speculation, the case for an extended period of low interest rates remains faithfully intact.
Full report here.
h/t momo "I am hiding a sock in my pants" trader