The technical and fundamentals both supported this forecast, but I completely underestimated the degree to which the Central Banks and EU would attempt to prop up the market.
These verbal interventions coincided with coordinated monetary interventions between the Federal Reserve and other world Central Banks: first on September 15 2011 and again on November 30 2011.
The effects of both coordinated moves were short-lived in terms of equity prices, but they did send a message that the Central Banks were willing to intervene in a big way to maintain the financial system. This in turn helped to ease interbank liquidity problems in Europe (more on this in a moment) and maintain the belief that the Fed backstop or “Bernanke Put” was still in effect.
Regarding this factor, I also underestimated the extent to which leaders would push to hold things together. After all, Greece had already received bailouts in excess of 150% of its GDP and still posted a GDP loss of 6.8% in 2011. It’s hard to believe they’d want to accept more austerity measures and more debt.
Moreover, political tensions between Greece and Germany had reached the point that Greeks were openly comparing German Chancellor Angela Merkel and Finance Minister Wolfgang Schauble as Nazis while the Germans referred to Greece as a “bottomless hole” into which money was being tossed.
Looking back on it, the clear reality was that Germany wanted to force Greece out of the EU but didn’t want to do it explicitly: instead they opted to offer Greece aid provided Greece accepted austerity measures so onerous that there was no chance Greece would go for it.
Well, Greece surprised many, including myself, and went for it. And so the EU experiment continues to exist today. However, before the end of this issue I will make it clear precisely why this will not be the case for much longer and why we are on the verge of a systemic collapse in Europe.
For starters, unemployment in Greece as a whole is now over 20%. For Greek youth (aged 15-24) it’s over 50%. The country is in nothing short of a Depression.
Indeed, Greece has now experienced five straight years of contraction bringing the total contraction of Greece’s GDP to 17%. To provide some historical perspective here, when Argentina collapsed in 2001 its total GDP collapse was 20% and this was accompanied by full-scale defaults as well as systemic collapse and open riots.
With new austerity measures now in place there is little doubt Greece will see a GDP contraction of 20%, if not more. I expect we’ll see other “Argentina-esque” developments in the country as well. Put mildly, the Greek issue is not resolved.
The one thing that would stop me here would be if Greece staged a full-scale default. While the political leaders and others view a total default as a nightmare (and it would be for Greek pensions, retirees, and many EU banks), it is only a total default that could possibly solve Greece’s debt problems and allow it to return to growth.
Defaults are akin to forest fires; they wipe out all the dead wood and set the stage for a new period of growth. We’ve just witnessed this in Iceland, which did the following between 2008 and 2011:
- Had its banks default on $85 billion in debt (the country’s GDP is just $13 billion).
- Jailed the bankers responsible for committing fraud during the bubble.
- Gave Icelandic citizens debt forgiveness equal to 13% of GD.
Today, just a few years later, Iceland is posting GDP growth of 2.9%: above that of both the EU and the developed world in general. In plain terms, the short-term pain combined with moves that reestablished trust in the financial system (holding those who broke the law accountable) created a solid foundation for Iceland’s recovery.
Now, compare this to Greece which has “kicked the can” i.e. put off a default, for two years now, dragging its economy into one of the worst Depressions of the last 20 years, while actually increasing its debt load (this latest bailout added €130 billion in debt in return for €100 billion in debt forgiveness).
Iceland staged a REAL default, and has returned to growth within 2-3 years. Greece and the Eurozone in general have done everything they can to put off a REAL default with miserable results. I’ll let the numbers talk for themselves:
2011 GDP Growth
2012 GDP Growth Forecast
EU (all 27 countries)
17 EU countries using Euro
* Data from EuroStat
The point I’m trying to make here is that defaults can in fact be positive in the sense that they deleverage the system and set a sound foundation for growth. The short-term pain is acute (Iceland saw its economy collapse 6.7% in 2009 when it defaulted). However, a combination of defaulting and debt forgiveness (for households) can restructure an economy enough for it to begin growing again.
However, EU leaders refuse to accept this even though the facts are staring them right in the face. The reason is due to one of my old adages: politics drives Europe, NOT economics.
And thanks to the Second Greek Bailout (not to mention the talk of a potential Third Bailout which has already sprung up), we now know that EU leaders have chosen to go “all in” on the EU experiment.
Put another way, EU leaders will continue on their current path of more bailouts until one of two things happens:
1) The political consequences of maintaining this strategy outweigh the benefits
2) The European markets force EU leaders’ hands (hyper-inflation or widespread defaults and the break up the EU).
Regarding #1, this process is already well underway for those countries needing bailouts. Investors must be aware that the Governments of Ireland, Portugal, Spain, and Italy have all watched/are watching the Greece situation closely.
Moreover we can safely assume that the topic of defaulting vs. asking for bailouts in return for austerity measures has been discussed at the highest levels of these countries’ respective Governments (more on this in a moment).
These discussions are also underway at those countries that are providing bailout funds. German politicians have won major political points with German voters for playing hardball with Greece. As I’ve stated before Germany may in fact be the country that ends up walking if EU continues down its current path of bailout madness.
With that in mind, there are three key political developments coming up.
1) Ireland’s upcoming referendum
2) Greece’s upcoming election
3) France’s upcoming elections (April and May)
Regarding #1, Ireland will be staging a referendum regarding the new fiscal requirements of the EU sometime before October. While the actual date has yet to be set, Ireland will likely stage its referendum after the French elections in (April and/or May… more on this in a moment).
Ireland has already staged two referendums which Irish citizens voted AGAINST until various concessions were made. This time around the primary concession being discussed is potential debt forgiveness (the country definitely needs it). Indeed, according the Boston Consulting Group, Ireland needs to write-off some €340 billion in debt just to make its debt levels “sustainable.”
So Ireland could easily be a wildcard here. The country is already in recession. So we need to monitor developments there as this referendum could go very, very wrong for the EU.
However, the BIG election of note is that of France where the current frontrunners are Nicolas Sarkozy (Angela Merkel’s right hand man in trying to take control of the EU) and super-socialist François Hollande.
A few facts about Hollande:
1) He just proposed raising tax rates on high-income earners from 41% to 75%.
2) He wants to lower the retirement age to 60.
3) He completely goes against the recent new EU fiscal requirements Merkel just convinced 17 EU members to agree to and has promised to try and renegotiate them to be looser.
Currently polls have Sarkozy and Hollande securing the top slots in the first round of the election on April 22. This would then lead to a second election in May which current polls show Hollande winning (this has been the case in all polls for over two months).
However, there’s now another leftist wildcard coming into the mix: communist Jean-Luc Mélenchon who is now taking 11% in the polls (he was at 5% last month). And Mélenchon’s primary campaign message? Rejecting austerity measures completely via “civic uprising.”
Now, Mélenchon could end up taking votes away from Hollande therby allowing Sarkozy to win. It’s difficult to say how this will play out. But if Sarkozy loses to either of these candidates, then the EU in its current form will crumble as Germany loses its principle ally in pushing for fiscal reform and austerity measures.
Finally, let’s not forget Greece where politicians are now pushing for an election on April 29 or May 6 (the Second Bailout was passed based on new parliamentary elections being held soon after).
This could be yet another wildcard as it is around the time of the French elections, which Greek politicians will be watching closely. Remember, the key data points regarding Greece’s economy:
1) A 20% economic contraction over the last five years
2) Unemployment north of 20% and youth unemployment over 50%
3) Unfunded liabilities equal to 800% of GDP courtesy of an aging population and shrinking working population (which is shrinking all the time as youth leave the country in search of jobs)
These facts will not play out in a victory for “pro-bailout” politicians. So the Greece deal, which is supposed to solve Greece’s problems, could actually be in danger based on a change in politics.
Remember, as stated before, politics rule Europe, not economics. And Europe now appears to be shifting towards a more leftist/ anti-austerity measure political environment. If this shift is cemented in the coming Greek, French, and Irish elections/ referendums, then things could get ugly in the Eurozone VERY quickly.
That’s the political analysis of Europe. Now let’s take a look at what the various EU economies/ markets are telling us.
Spain’s current economic condition matches that of Greece… and it hasn’t even begun to implement aggressive austerity measures. Unemployment is already 20+% without any major austerity measures having been put in place.
Anecdotal reports show Spain to be an absolute disaster. Spanish banks GREATLY underplay their exposure to the Spanish housing market (“officially” prices are down 20% but most likely it’s a lot more than that).
In simple terms, things are getting worse and worse in Spain… and the market knows it. Indeed, the charts of most EU indexes, particularly Spain, are telling us in no uncertain terms that the markets are expecting a truly horrific collapse sometime in the not so distant future. Timing this precisely is difficult but the window between May-June is the most likely time, as it will coincide with:
1) The end of seasonal buying (November-May)
2) The French, Greek, and Irish elections/ referendums all of which could go very wrong for the EU (April-May)
3) The end of the Fed’s Operation Twist 2 Program (June).
Now, having said all of this I have to admit I have been very early on my call for a Crash. I’m fine with admitting that. Calling a crash is difficult under normal conditions, let alone in a market that is as centrally controlled as this one.
Indeed, going back to March 2009, it is clear that the Fed has been the ONLY prop under the markets as QE 1, QE lite & QE 2, and now Operation Twist 2 have all been announced any time stocks staged a sizable correction (15+%).
In fact, on a weekly chart of the S&P 500 going back four years, we find two items of note:
1) The Fed will only tolerate a 15% drop or so in stocks before it announces a new monetary program:
2) Each successive Fed program has had a smaller and smaller impact on stock prices:
Aside from these monetary interventions, we also have to deal with the Fed’s verbal interventions: every time stocks start to break down some Fed official (usually Charles Evans or Bill Dudley) steps forward and promises more easing… or the Fed releases some statement that it will maintain ZIRP an additional year… and VOOM! stocks are off to the races again.
With that in mind, I will admit I’ve been caught into believing a Crash was coming several times in the last few years. In some ways I was right: we got sizable corrections of 15+%. But we never got the REAL CRASH I thought we would because the Fed stepped in.
So what makes this time different?
1) The Crisis coming from Europe will be far, far larger in scope than anything the Fed has dealt with before.
2) The Fed is now politically toxic and cannot engage in aggressive monetary policy without experiencing severe political backlash (this is an election year).
3) The Fed’s resources are spent to the point that the only thing the Fed could do would be to announce an ENORMOUS monetary program which would cause a Crisis in of itself.
Let me walk through each of these one at a time.
Regarding #1, we have several facts that we need to remember. They are:
1) According to the IMF, European banks as a whole are leveraged at 26 to 1 (this data point is based on reported loans… the real leverage levels are likely much, much higher.) These are a Lehman Brothers leverage levels.
2) The European Banking system is over $46 trillion in size (nearly 3X total EU GDP).
3) The European Central Bank’s (ECB) balance sheet is now nearly $4 trillion in size (larger than Germany’s economy and roughly 1/3 the size of the ENTIRE EU’s GDP). Aside from the inflationary and systemic risks this poses (the ECB is now leveraged at over 36 to 1).
4) Over a quarter of the ECB’s balance sheet is PIIGS debt which the ECB will dump any and all losses from onto national Central Banks (read: Germany)
So we’re talking about a banking system that is nearly four times that of the US ($46 trillion vs. $12 trillion) with at least twice the amount of leverage (26 to 1 for the EU vs. 13 to 1 for the US), and a Central Bank that has stuffed its balance sheet with loads of garbage debts, giving it a leverage level of 36 to 1.
And all of this is occurring in a region of 17 different countries none of which have a great history of getting along… at a time when old political tensions are rapidly heating up.