Monday, December 12, 2011
TMM have lost track of which particular version of the Europlan this is, but would guess it is probably something like Plan K (plus or minus a letter or three). Having now digested the events of last week, TMM will attempt below to decipher what it all means.
But first, we cannot resist commenting upon the UK veto and the press reaction in the UK to it. As we have often noted before, the UK press are prone to covering geopolitical events in a self-doubting way, as if the country were losing influence, power and prestige. Well, tell us something new - it is not 1904. However, the uniform broadsheet reaction was one of UK isolation within Europe given that supposedly the other 26 nations are likely to sign up to the new agreement. Well, maybe they will, maybe they won't - there are plenty of reasons to suggest the Finns, Irish & Swedes will not. But does it really matter? This was a treaty that was, essentially, a power grab by the Germans. Clearly, it is not in the interests of the UK to sign up to something that goes further with transferring financial regulation to Brussels & imposes a financial transaction tax EU wide. Let's be honest, and call it the "UK Tax" and before you label us as Tea Party-ers, TMM are not against taxes full stop. If France & Germany were not willing to remove the FTT and provide assurances on financial regulation, then in TMM's view, it was quite right to use the veto. The reality of the situation is that, despite annoying a few civil service types & journos (who will have less jaunts to Brussels) and some disgruntled Eurocrats in Brussels, the EU still needs the very large contribution the UK provides to its budget. Rumours of the UK's demise have been greatly exaggerated for at least the twentieth time in TMM's careers.
But what TMM found exceptionally amusing was that the left-wing press in the UK (the BBC, Guardian & Independent etc), along with the Labour Party - a function of having to argue against the Tories - have been forced into arguing for more European integration (not a position an opposition party in the UK ever wants to be in, seeing the post-veto polls painting broad-based support for the use of the veto). But not only that. They have also found themselves arguing in favour of a treaty that would have capped the structural deficit at 0.5% of GDP and also triggered automatic sanctions for breaching a 3% budget deficit and a debt brake requiring fiscal consolidation. In essence, they have found themselves arguing for a fiscal policy going forward that is far tighter than the current government's and one that would tie Labour's hands permanently going forward. If that is not irony, TMM do not know what is.
But we digress. Back to Europlan K...
Over the weekend the press, blogosphere and emails that TMM received were uniformly critical of last week's summit and the ECB's actions, with the word "failure" bandied about in many places. And certainly, relative to even the lowered expectations it seems to be something of a disappointment given the ECB dugs its heels in further with respect to government bond purchases. TMM were also disappointed, but must admit that this has been somewhat an emotional response. After digesting both the ECB's actions and the result of the EU summit they cast their minds back to February 2009, and it all seems very familiar... in recession, markets and policymakers searching for "the bazooka", and the frequent refrain that TARP was not big enough etc...
And that got us thinking. Because it wasn't a single silver bullet that led to the rebound in the US and final acceptance that the policy response had been enough. It was a combination of a multitude of policy actions, ranging from TARP to the TALF, to ARRA, to liquidity guarantees for bank funding and eventually to Ben Bernanke's "Greenshoots" fireside chat. Note that these all occurred and the stock market had bottomed well before the FOMC began buying USTs under QE1. Readers may recall TMM have thought along these lines before, but it turned out that the numbers were not big enough.
So, in place of the standard "Mickey Mouse" analysis TMM found in their mail boxes from most places, we are actually going to have a go at seeing if the measures in place are big enough to cover the conditions necessary to end the crisis, which TMM believe are:
(i) A large enough amount of cash to cover Spain & Italy's financing needs for the next two years,
(ii) Incentives to longer term investors to buy Eurozone government bonds,
(iii) Structural reform measures aimed at rebalancing within the Eurozone and, lastly,
(iv) Clarity on the growth outlook.
In TMM's view, clarity on the first three of these conditions is enough of a firewall for the rest of the world to chug along, and the last of these would be enough to unwind at least some of the under-performance of European assets and loosen financial conditions significantly.
First let's get the bad news about growth [condition (iv)] out of the way. While the Composite Eurozone PMI has bounced from its November low and economic surprises have turned less-negative, it is too late to avoid a recession in Europe. Should financial conditions stabilise, TMM's view is that the current US reacceleration should result in a new global inventory cycle which will aid Europe's stabilisation. Q1 thus seems a reasonable expectation for the cycle low though, of course, this is a difficult view to have any confidence in but should the next batch of PMIs confirm last month's base, TMM would be encouraged.
Now, onto the other three conditions.
(i) The funding of Spain & Italy. This has been, in particular, the problem that has to be fixed "Now" in the view of markets, not unreasonably. But in demanding a bazooka - similar to early-2009 - TMM reckon both commentators & markets have missed the wood for the trees. To see this, consider the following European battalions:
- EFSF: About EUR 250bn left in its unleveraged form (and call it 750bn if they can leverage it 3x).
- ESM: Now to be operational from July 2012, size EUR 500bn.
- ECB: Currently purchasing around EUR 5bn/week which adds up to about 250bn/year.- EU/IMF Bilateral loans: The Summit-announced EUR 200bn of bilateral loans to the IMF to increase its firepower.
- IMF: Current space capacity sits at about EUR 300bn.
Totalling that up gives EUR 1.75trn over the next two years. Include the EFSF leveraging and that number starts with a EUR 2trn-handle. Even stripping out the ECB and not leveraging the EFSF in this case would proved EUR 1.25trn, an amount TMM believe sufficient to finance Spain & Italy and more. And even if the IMF is not able to lend its full capacity to Europe for political reasons, there is still well over EUR 1trn of firepower.
Now before anyone starts pointing out that core Europe is about to lose its AAA rating, and thus the lending capacity of the EFSF etc is diminished, TMM would say that this is not new news. What is important to medium/long term investors is a clear institutional framework, not necessarily the presence of a AAA-rating (after all, there aren't many places sporting such a rating these days...). In short, TMM do not think that it really matters that much.
(ii) Incentives to purchase Eurozone bonds. One of the most difficult problems to balance in any crisis is moral hazard - something discussed at length in many places. With respect to the Eurozone, the Greek PSI undoubtedly spooked many long term holders of Eurozone government bonds, with the subordination to the ECB resulting in larger losses upon banks than would otherwise have been necessary to return Greek to solvency. Additionally, the way Eurocrats went out of their way in order to avoid triggering Sovereign CDS (and one of the key reasons TMM reckon it is an ex-product), further reduced confidence both in policymakers and the rights of bondholders within Europe. TMM thus think it is particularly interesting the lengths the A-Team have now gone to in order to reverse from the PSI stance in ESM to that more of the IMF. Now, cynics would obviously point out that the IMF has often been in favour of PSI in the past, but the softening of the position to being on a "case by case" basis, is certainly one that will lessen the view from the bondholder perspective that they are subordinated. This is key to restoring long term confidence in Spain & Italy, nations that appear to TMM to be illiquid but still solvent.
Related to incentives to purchase Eurozone bonds, TMM move to the ECB's exceptionally generous liquidity facilities that were dramatically loosened on Thursday. Banks can now post collateral on LTRO for 3yrs, and hedge their duration risk vs. EONIA for just 0.73%. As Sarko pointed out:
"Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate."
Given the ECB cut its reserve ratio, freeing up capital, posting short-medium term BTPs yielding 6-7% to the LTRO (with just a 1.5% haircut) with funding locked up for the entirety looks like a particularly good trade for Italian banks that are essentially screwed if Italy goes bust anyway. This not only takes a good chunk of Italian funding, but also results in building capital at Italian banks (reducing the need for the State to inject equity). This is the Bank/Sovereign feedback loop working in a positive way.
Note also that EU banks in general are now likely a large buyer of EFSF paper which can be used as collateral at the ECB. TMM would also note that banks can help achieve their new capital targets by purchasing these types of assets and taking the RWA improvement. TMM note that insolvent but liquid banks do not go "bang".
(iii) Structural measures. The EU Summit clearly went a long way to addressing the problems with EMU in terms of aligning fiscal policy, implementing national debt brakes and structural deficit constraints. Additionally, Italy is enacting more broad-based structural reforms. These types of things take years to have an effect, but eventually they will. And it seems that Super Mario is pretty happy with them. That doesn't necessarily mean the ECB will step up, but it is certainly a necessary condition to preventing these problems from arising in the future. The agreement is now like a pre-nuptial, and it is certainly vulnerable to difficulties in being passed. But TMM would view the only countries that matter here as Germany, France & Italy. Monti's package that is being voted upon on Wednesday already contains the debt brake legislation, leaving only France to pass it. No doubt this will be difficult, given that the Socialists are against the package and an election is shortly coming. But there is now a convenient guy to give the blame to - David Cameron & the UK. TMM are optimistic on this front as it also furthers Sarko's wish for Eurozone-17 integration at the (supposed) expense of the UK.
To sum up, TMM reckon markets have misread the events of the past week. Sufficient firepower does actually appear to exist, with many of the other perquisites for the end of the crisis. TMM reckon looking for a bazooka is the wrong approach, and have just noticed the infantry columns marching from several directions. The above is probably just about sufficient to remove the systemic effects of the crisis globally, making TMM more optimistic broadly on global growth. But at the end of the day, it will be clarity on Europe's growth outlook that finally puts the issue in Europe to bed.
Simply said, the World isn't ending just yet, friends.