“Would you live with ease, do what you ought, and not what you please.” – Benjamin Franklin, Poor Richard’s Almanack
That may seem like an odd thing to say in the face of a turkey of a Thanksgiving week, the worst one since records began in 1942. But it’s true. Last month at this time, this space warned that the equity markets had floated up on little but momentum and the warm air of a few days of late-season sunshine and optimism. Six days later prices peaked at a multi-month high, and have come off ten percent since.
That’s exactly why things are looking up. The essential feature of our European saga – like most crises of their ilk – is the reluctance to make hard choices. Especially ones that cost money, and even more especially ones that might cost votes. In this respect, benign markets are the enemy of action. So long as prices stay broadly stable, or even rally, we could expect nothing more than meetings and their attendant theatre: lots of posturing, quibbling and tap-dancing. Real action needs real crises.
Now we’re closing in on a big one. Last week’s European bond auctions went from bad to worse. Yields on new Italian notes (financial-speak for bonds of less than a year’s maturity) soared, a German note auction went poorly, and Belgium and Hungary were downgraded again, the latter to junk status. There is another heavy schedule set for next week, with the Italian (Monday, Tuesday) and Spanish (Thursday) auctions looming large. If they go badly, a lot of alarms are going to go off.
There are some good reasons for confidence in the EU system to be faltering. To begin with, there’s all that bad debt around, most of it held on the books at fictional prices. After the size itself of the debt, the biggest problem may be the persistent approach of hoping to solve everything on the cheap. The EU started out with solemn pronouncements (words are free): we shall not let the euro fail. Then it moved on to trading short-term bailouts for ruinous austerity measures (Portugal, Ireland, Greece). One would think bankers would know better than to lend short and ruin long.
The announcements have gotten ever more serious (this time we really, really mean it) but practical measures haven’t moved beyond the one too-small stabilization fund that has already been half-used up on the mini-bailouts. The comic peak was reached a couple of weeks ago when with one wave of the wand, EU leaders proclaimed that bond insurance wouldn’t work for Greek sovereign bonds (they made the banks an offer they couldn’t refuse), then with a counter-wave offered to sell investors the solution to all their problems: insured bonds! Only twenty percent insured, but hey, we’re talking leverage here (too bad that they didn’t think of only insuring the first five percent – then they could have announced that the package was four trillion instead of one). Swish, swish, went the magical wand, who wants to be first?
Not that many, it seems. Since that frabjous day, which saw European equities soar to a peak that has been rapidly receding in the distance ever since, it has gradually dawned upon the gods in their Alpine lair (the Olympian digs being for sale at foreclosure) that investors burnt with defective insurance might not want to buy more. On Friday, the word was quietly percolating that the Corleone-like offer of a “voluntary” fifty-percent haircut might be withdrawn.
The insurance restructuring (better known in the bond trade as a “swindle”) was accompanied by the ecstatic announcement that somebody else could foot the bill for Europe to restructure itself. When French Prime Minister Nicolas Sarkozy came up with the brilliant suggestion of allowing the Chinese to pay for it, German Chancellor Angela Merkel magnanimously consented: we Germans will put aside our inflation fears and desire to ceaselessly bash the Greeks over the head with a stick, if the BRIC countries will guarantee their debts. Sarkozy ran off to deliver the good news to the lucky donors.
Alas, the BRICs failed to appreciate their good fortune. Some spoilsports got into the press with a lot of chitchat about BRIC per-capita income being multiples less than that of their heretofore-wealthy cousins, and the pitch was ruined. Saboteurs! Now we are back to where we always were: too much debt to wave away. Either bite the bullet, agree to pay for a restructuring and move on to a brighter future, or look the other way and wait for the fire at your neighbor’s house to be checked by the wall of moral superiority around your own home. For those thinking of the latter, you may wish to have a little sit-down with your local fire department first.
Forget merits and politics: focus on the debt. So far, it’s been Chancellor Merkel’s job to keep saying “no” until she has no choice but to say yes. That’s the way of such things. But the no-exit option could come very soon.
It will mean steering a middle way between two false polemics. The first is the age-old domestic trap of thinking that it’s not our problem, so why should we get involved? So said the first-class passengers on the Titanic. The other springs from the inevitable hysteria that comes with every crisis: it’s too big to be solved. But restructuring is never about paying back every nickel ever borrowed, it’s about reducing loads to a manageable level and maintaining a level of systemic confidence. That can be done. Instant turnaround, no; panacea, not hardly. Road to recovery, yes.
Germany is in a unique position: its expansionism in the twentieth century led to two devastating European wars, with the latter one spreading to most of the globe. Now it has a chance to lead Europe back from the brink and preserve the newly integrated system. We think it won’t give up on European unity. But investors should take out some insurance (the kind that pays off), because it’s a political decision, and sometimes politicians make mistakes – e.g., Lehman Brothers. Take out some of the other kind of insurance too – this market is ready to rip higher on any excuse. It won’t be long now.
The Economic Beat (in holiday time)
Durable goods, GDP revisions and personal spending made it clear that we are in another caution-induced slowdown episode. The Chicago Fed’s activity index – a good measure of economic health – remains negative. Home sales show a slowly clearing market and tighter-than-ever credit.
The keys to next week look like Thursday and Friday. The former has the European Purchasing Manager Index (PMI) and Spanish bond auctions, followed by the US PMI (ISM). The all-important jobs report comes out Friday. Recent weekly jobless claims have improved while benefiting from seasonal adjustment, so we expect neither a clunker nor a home run. The ADP report Wednesday will give the usual clue.