A Macroeconomic Conversation on the EU Crisis

• June 27, 2012 • Uncategorized

This is a conversation between me and a stock analyst who prefers to stay anonymous on the European crisis. The stock analyst’s thoughts are in italics. Mine are in block quotes. I thought our conversation deserved posting:

I have been writing for six years that we would have to endure the reversal of globalization… populism, protectionism, a peak in labour productivity and previously unhallucinatable levels of indebtedness.

Off each bubble peak, a new bubble, a new focal point for speculative excess develops and I have wondered what that new bubble would be in the aftermath of the commodity-boom-bust. There is a good case that it was growth momentum where investors understandably were prepared to pay anything for growth in a low growth world (provided it is accompanied by low rates justified by the Fed Model – inverse of the 10-year yield).

However, we have now reached a position where too many important countries sustain public debt above 90% of their GDP. The result, till now, has been growth rates which continue to disappoint regardless of the intensity of the stimulus – monetary or fiscal…Private debt was transferred to public debt in 2007/8 in rapid effect and subsequently it has grown. It has been easy to become complacent about low rates as a green light to use credit to solve the problem of debt.

I agree with ALL of the above 100%. In fact I could use it as the introduction to my thesis. In the 2000s, in the aftermath of the implosion of the Internet bubble, the developed world turned to leverage to create the illusion of growth. This came in the form of housing, which we incorrectly classified as investment rather than consumption – which it clearly is when you are talking about moving families from the 1,500 ft² homes of the 70s to the 5,000 ft² McMansions of the 2000s (despite a reduction in average family size). It also came in the form of home equity loans used to finance traditional consumption – multiple plasma TVs, multiple SUVs and multiple PCs per household. Finally it came in the ridiculous promises made by governments and corporations to their constituents. Frolic in school pursuing an undergraduate degree in Human Sexuality until you are 21-25, work 40 hours a week / 46 weeks a year until you are 65 (30, 40 and 50, respectively, if you work for the government) and then retire for another 30 years regardless of demographic trends, with healthcare that will pay millions of dollars a year to keep you alive in your last 6 months….

This was financed (illusorily) by 2 things. First, the unconscionably long period of unbelievably low interest rates thanks to Greenspan and his apprentice Bernanke. And secondly, the emergence of a new, massive group of savers in the Middle East and Asia.

The latter turned out to be extraordinarily risk adverse, desiring only high rated guaranteed bonds, while the developed world was forced to seek risk to fund the insatiable requirements of its pensions and guarantees. The answer was securitization. We took the traditional 20% down payment and turned it into 5%. The remaining 15% we turned into 75% investment grade paper and 25% equity. The theory was sound. If home prices fell 5% ONLY — the home owner would suffer. If they fell an unheard of 10%, the home owner and the equity would be wiped out, while the investment grade paper would suffer only an 11% hit. The banks were still safe. It was only when home prices fell 30%, wiping out the home owner, the equity, the fabricated investment grade paper and 13% of the bank note – that we had a problem. Our banks were levered 30:1, and their equity was wiped out 3x over. Private debt was transferred to public debt that had already ballooned to unfathomable levels thanks to pensions and guarantees…

2010/11 was about the experimentation of austerity… The experiment is now over. Austerity cannot work and not even Germany debates this. It might have worked if implemented earlier but the debt has become too large… Economic growth is lower than new debt growth. Austerity sharply slows the former causing the gap between the two to widen not shrink…

We must inflate away the debt by inflating wages and nominal GDP. We will, of course, arrive at a point where long rates rise, perhaps uncontrollably. At such time, the burden of financing this debt (which admittedly will not have expanded as fast the nominal economy) will cause a severe recession. To be clear, the other theoretical solutions for the burden of debt are default and economic growth. Once we reconcile the fact that high indebtedness slows economic growth, we know that the latter is not a realistic option. Default by the US and the ECB, I suppose, are options but it is an easy bet that this is not this year’s or perhaps not this decade’s business.

The developed world has made promises to its populace that are untenable (to be generous). You cannot be idle for 20-25 years at the beginning of life and 20-25 years at the end of life, while working for only 30-40 years in the middle. This works for a brief period of time when a society has a huge proportion of its population between 25 and 50 – but not thereafter. Having reached this untenable phase – we agree that the 2 options are default and devaluation or print and inflate.

The print and inflate thesis relies on the principals of FEAR and GROUPTHINK. IE The Powers That Be are so afraid of what happens should Default and Deflation kick in that they are willing to do ANYTHING to avoid it. It also assumes they are all willing to work together to achieve a common goal. Everyone must print and everyone must inflate.

The Default and Deflate trade relies on the principals of GREED, SELF SERVICE and ANGER. IE the opposition to The Powers That Be are greedy for power. They see an opportunity to tear down the status quo and assume power in the current situation. By throwing a wrench into the process, they can assume power. For example, Syriza or the Republicans in the US. By simply objecting to and blocking everything The Powers That Be try to do… they are likely to assume control. And let’s not forget the time frame. The FEAR principal assumes The Powers That Be are maximizing for an outcome at an indeterminable date in the future, when things will be better. The GREED principal assumes you are maximizing for the next election. Thus the Self Interest.

The Anger comes from the constituency or The Street. The Tea Party, OWS, The Arab Spring… all of them feel that The Powers That Be are not only NOT serving their interests – but The Powers That Be are looting the scene of a crime. Greece and Spain have 50% unemployment of young males – any surprise grenades were found at 4 polling stations in Greece? As a converted EMPLOYED “young male” I know it’s easy to be roused to mischief. But this time THEY ARE IN THE RIGHT!

So let’s examine the motivation of the street. It’s easy to say that in the case of austerity and the status quo that the youth are on the hook for the promises made to the elderly. But this ignores the opportunity for default. With a simple default ALL obligations are wiped out. Meanwhile a print and inflate scenario if highly destructive to the youth which see their earnings power wiped out by hyperinflation, while the elderly’s equity investments accrete with inflation.

Lets be clear, there is no option of CONTROLLED inflation. The US has $15 trillion of debt and $15 trillion of GDP. To make a difference we must print TRILLIONS of dollars. And M1/M2 is only $1-$2 trillion. We are talking 100%+ inflation ONCE THE VELOCITY OF MONEY STOPS GOING DOWN!

By the time of the letter, that China was slowing was no longer controversial.. we expect China to continue to slow breaking the 7%-11% band to which economists were tethered…

China isn’t just going to slow to 7%, they are going to go NEGATIVE. There has NEVER been an example of double digit to high single digit REAL GDP growth for this long without a single recession. WHY THE HELL DO WE PUT SUCH FAITH IN A EXPORT ORIENTED, COMMUNIST MODEL THAT HAS FAILED SO MANY TIMES??? Look at electricity production! China growth might already be negative. Don’t tell me about government BS stats… This is the black swan combined with US fiscal cliff.

Finally, most controversially, we felt lonely in predicting a steady slow deceleration in the US economy through the first half of this year. We highlighted the concept of pulled-forward demand as the main reason including warm weather, accelerated depreciation and the effects of the Japanese economic rebuilds as key components..

Not TOO lonely. I was with you!  Those of us that are paying attention over the last 3 years knew that all the growth in the fall/winter was BS. I told a friend of mine at Fidelity that US unemployment would start missing 3 months ago due to WARM WEATHER and BS SEASONAL ADJUSTMENTS!!! Every intelligent person KNEW THIS. And going into a depression in Europe, a HARD landing in China and the fiscal cliff… the US is either already ina recession or heading to one in Q4!!!

Act II is the aggregate response to this combined with the learned behaviour that the only solution is the inflation of nominal GDP and debt. The last month has seen Germany wriggle with ever decreasing physical power against impending reality. Depending on the outcome of the Greek elections, it may or not be able to struggle a little longer but the end game result is in the mail…

No.. Germany has ALREADY said no to any easement of the terms for Greece. 60%+ of the population wants them out of the Euro. We have a war between Greek newspapers portraying Germans as Natzis and German newspapers portraying the Greeks as Commie Bums.

Germany’s expansion of its balance sheet via Target 2 means that it is now fully committed and any negotiation leverage has no credibility. To invest in the German Bund at this point embeds two impossibly bad bets. The first is obvious. With rates so low, there is no realistic return available with the realization that inflation is the only way out. Much worse, however, is the fact that if Germany were to stand strong and refuse to bail out its poorer European friends, it would sustain truly horrific losses. Spain and Italy are hours or days away from losing access to capital markets – these large nations will not be able to fund themselves. With Target 2 at 1 trillion Euros (and with the German economy at 3 trillion Euros), allowing them to default would be like creating an economy with a 30% non-performing loan. Equally, to issue Eurobonds (or QE or deposit guarantee – it’s all the same and will end up in the same place, except that the shock and awe can be lost) will be to embrace the bad debts of a financially broken continent. Germany’s debt will “peripheralize”.

NO NO NO. You don’t get it. I’ve seen the BS math of the cost to keep the EU ALIVE vs Germany withdrawing… IT’S BS!!! The problem is that it assumes if Germany just lends a bit more to already broke economies… that they will ultimately get repaid! If Germany relent the faucet is left open, and the water keeps flowing. At some point you cut your losses. If a business that is loosing $10mm on revenues of $100mm has $100mm of debt, does the bank keep lending?? NO!!! Germany has some losses to take, and they are HUGE! But to fund the losses of French banks (which are FAR higher) and to fund the next 3 years of deficits and debt refinancing only makes the ultimate losses FAR LARGER!
Let’s look at the Spanish Bank bailout. The Spanish have E1bbn of debt (really E1.5bbn but going through the math to prove it isn’t worth it). So the Germans come in with E100bbn of SUPER SENIOR SECURED debt isn’t a big risk. They take the first and best E100bnn of collateral. But as that amount grows, they slowly put themselves in the same position as a public bond holder (while making the public bonds worth $0 – which is why the Spanish yield is rising – collateral seizure). If Germany stops here, IT GETS ITS MONEY BACK. The further they go the worse it ends up!

The Fed is now widely expected to do what we thought and on time by announcing QE3.

WHAT? ARE YOU KIDDING ME??? Fed’s Raison D’entre for QE3 went out the window with the ND/PASOK win. S&P at 1,340, GDP growth and employment both positive. There is NO REASON for QE3!! Interest rates are already at all time lows! What will QE3 actually do for the economy? Meanwhile, the FED needs to keep its powder dry for a real European crisis. QE3 WILL HELP in a bank run scenario. It does not foster GDP growth or employment! And Mitt just said NO MONEY FOR EUROPE. The political gauntlet is thrown. QE3 means unemployment for Ben if the Repubs win! QE3 is not happening till 2013! Maybe you get an extension of “Twist” which does NOTHING for the markets – except transfer wealth from 1 party to the other.

Japan, I sense, is days away from a truly massive QE program..

You better hope so! People far smarter then you (name rhymes with “ass”) think Japan is the next domino…

and then there is China. If creating more money to buy back old debt sounds like a chapter narrated by Yossarian in Joseph Heller’s Catch 22, perhaps China re-incentivising fixed asset investment when there is already way, way, way too much capacity isn’t quite so silly.

This is Act II.


Having been neutral to short from the end of January, we got opportunistically long based on our expectation of a significant policy response. We effectively got long the “market” and short the “economy”, retaining our highest conviction industrial and cyclical short themes but adding to less economically sensitive businesses with a positive rate of change. We also bought back into the global financials that we had sold at the end of LTRO and added to precious metal equities.

As we await the too-close-to-call Greek elections, we, in fact, flattened out our bullish position on Friday. In periods when the market fears that the stimulus is over, growth dominates value. The opposite occurs in the anticipation of “help” on the horizon. Talented growth investors will scream out loud at this point that growth always wins in the end and this is true but we are trying to answer a different exam question. Aside from the rally in stocks that has occurred, stylistically we can easily observe that value has outperformed into this weekend. There were two things that could happen next week. First, Syriza could win and Greece could actually leave the Euro. I think few people understand how bad this would really be. Second, there might be no policy response immediately essentially allowing the market to crash parachute-free.

By Thursday evening, consensus was clear that the New Democrats would win and second, with that classic knack of neutering the shock and awe, the ECB announced that it was ready with cavalry in the event of “Grexit”. For us then, there is suddenly no positive delta because good is already expected and bad is apparently provisioned for.

Worse still, to maintain an increasingly structural bullish view, we need a lot of bad because a lot of bad will finally cause Germany to stop wriggling and give in. We need Europe to print Euros and use those very Euros to buy unlimited amounts of French, Spanish and Italian paper. Anything less is not good enough and to the extent that the Greek elections go “well”, we have a small delay in this final step.

Friday was a significant derivative expiry and the market will inevitably find itself less protected than it has been. A sell-the-news or bad outcome could easily cause funds to re-initiate futures positions, new puts or simply sell stocks. This would bid up the VIX and cause VAR-related selling.

The Fed has made it clear that it wants to convey its policy guidance via the Fed Minutes not the FOMC. We intend to gently buy any weakness next week on the assumption the Fed is ready. Should QE3 not be announced (again it is too well telegraphed for us with both Goldman and Morgan predicting it), we would more aggressively increase long exposure in the anticipation of a clear “guide” via the Minutes a few days later and in the knowledge that Europe has just days left before it blows up.

In other words, we don’t want to fight coordinated policy but between now and the official birth of Act II, there may be a few false starts requiring flexibility.

There are three final points to note about the market and Act II:

On the negative side, we believe we are in an earnings downcycle. Corporate profits, as a percentage of GDP, have peaked and with it goes productivity. With or without QE, with or without low rates and lower gasoline, the US is in a weak economic position, not helped by the debt cliff overhang. The top line is a hindrance not a help for earnings and the margin is at risk too. Companies are going to miss and some people will feel awfully hurt when management teams they have come to trust let them down. It will be difficult to capture alpha the traditional way in such an environment.

On the positive side, I have for many years, sneered at the idea that you have to own stocks because there is nowhere else to put your money. Now, after so many years of rates being manipulated to zero, I think it is a fair statement. Bonds (again, I am a new short advocate) are un-ownable. Cash, as governments overtly attempt to create inflation and undertake hardcore drug abuse, is a really poor place to be. Gold should have a position in any portfolio until such time as rates begin to dislocate higher. Cheap stocks offer an inflation hedge and at least a goddamned chance.

Volumes on the NYSE have been in decline ever since the peak of the last bull market in 2000..

Maybe cause people don’t trust this FED manipulated MKT anymore…

There is a bubble – it has been in government long dated bonds that offer massive credit risk and no return. What is more stupid – Yahoo on 500x in 2000 or that?

Err…BOTH? I’d rather just short..Is that not an option?

The 3-way fight between falling earnings, massive global QE and low investor equity positioning is a difficult one but after 12 years without a new high in the S&P, I am for the first time less inclined to see the cup half empty.


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One Response to “A Macroeconomic Conversation on the EU Crisis”

  1. Adrian on October 19th, 2012 3:03 pm

    To Whom it May Concern,
    I have started a democracy website and I am wondering if there is any way that I can use my website to promote your website a bit better.  Is there someone I can talk to who can speak to ways that we can promote your website?  My website is Democracy Chronicles and we are looking for better coverage of election reform in the US and I think your organization is on the good side of the fight. Some ideas I have considered for ways to connect with your website are articles about people or initiatives, better display of your fundraising efforts on our charity page and even interviews (through email) with key people.  I would love to talk with someone regarding this type of coordination.  Thank you very much for your time.
    Kind regards,
    Adrian Tawfik

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