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To ensure the European sovereign debt
crisis doesn't go to waste, the markets have kept policy makers and bankers
on their toes. The naysayers of a European turnaround have become so
overwhelming that it is stunning Europe hasn't submerged into the Atlantic
Ocean yet. It appears that German Chancellor Angela Merkel, the cautious woman
with the checkbook, is about to turn the tide.
First off, Greece would likely
default, possibly within weeks, if it were not for the efforts being made to
postpone the inevitable until next spring. The driving force behind the Greek
drama and its potential fallout has primarily been played out in the bond
markets. Indeed, it appears the only language policy makers understand is
that of the bond market. In this context, it's quite astonishing how much
progress has been made. Italy, for example, passed substantial reforms three
times this year. And for those who worry that the politics of austerity
measures may topple governments, and thus the reform process itself, fear
not: in Spain, for example, early elections in November will likely have the
current opposition sweep to power. The main implication in Spain will be that
the new government will own the same old problem, but may have a stronger
majority to engage in reform. In Germany, where many fear the junior
coalition partner will at some point cause the government to collapse, note
that the major opposition parties favor Eurobonds and possibly a Marshall
Plan for Greece; both such plans would likely appease bond markets.
When it comes to banks, it's again
the market calling the shots. While banks had ample opportunity to bolster
their balance sheets - and in all fairness some have done so - bank boards
have been hiding behind their regulators. Bank regulation is deeply flawed,
as it favors holding domestic sovereign debt and discourages marking
positions to market. In Europe, a strong pan-European regulator is urgently
needed to put a meaningful dent into this culture. Fear not: the markets
haven't waited for regulators to get their act together. The latest round of
European stress tests was most meaningful, because it provided transparency
on the sovereign debt exposures of European banks. As a result, the market
provided "encouragement" to weak banks to raise more capital. In a
strange way, that process has been working wonderfully, culminating in German
chancellor Merkel throwing her weight - and checkbook - behind the
initiative.
Although the debate should be playing
out mostly in the spreads in the bond markets, i.e. the difference between
the cost of borrowing between the stronger and weaker Eurozone countries
(with respect to banks, both their debt portfolio and stock market valuations
have been guides in assessing their perceived health), the Euro tends to also
be the focus of attention. As the Euro was plummeting towards 1.18 versus the
U.S. dollar in 2010, we became outspoken 'euro bulls', arguing that issues in
the Eurozone should primarily be reflected in the spreads in the bond market;
the Euro was sold - in our view - mostly because of its great liquidity: it's
easier to sell the Euro rather than short peripheral country bonds. Indeed,
the Euro since recovered substantially, while periphery nation spreads have widened.
Market volatility is the friend of
strong hands. Momentum players are attracted by a market that goes up (or
down) in what approximates a straight line, be that
the stock market, gold, the Swiss franc or euro. When such a trade is no
longer perceived to be risk free, volatility returns to the market; those
trend chasers run for the exit, often causing sharp corrections. Volatile
markets force investors to think for themselves: is blood on the streets a
unique opportunity for the contrarian investor or an omen for even more
extreme conditions?
Just about a month ago, we turned
cautious on the euro, as the tail risks became evermore
likely to unfold. However, in a world where policy makers are throwing
billions and trillions at the problems, market fundamentals can quickly
change. And so it is that our assessment of the likely outcome for the euro
has changed. Last Wednesday, Olli Rehn, EU
commissioner on monetary affairs, suggested bank recapitalizations ought to
take a high priority. When the woman with the checkbook echoed his
assessment, we decided that major progress had been made. German chancellor
Angela Merkel has come to the realization that bolstering bank balance sheets
may be the most effective way to build the "ring of fire" around
Greece's impending default. Over the weekend, French President Sarkozy has
fallen in line with Merkel's new agenda; unlike the German Chancellor,
Sarkozy wants to rely on the European Financial Stability Facility (EFSF) as
a primary, rather than last, resort; his different perspective is not
surprising given the substantial exposure of the French banking system to
Greece.
In 2008, the infamous TARP program
put in place to rescue the U.S. financial system opted to inject money into
the banking system rather than buy "toxic assets." As politically
painful as it may seem to "bail out the banks", this is where
capital is most effectively deployed, for the very simple reason that banks
can leverage the capital. A Euro spent on buying Italian debt is a Euro
spent; a Euro injected into a bank can support ten times as much capital, or
more. We are not advocating to increase bank leverage, but to regain market
confidence, banks must have adequate cushions to allow for
"haircuts" of debt held by the banks; in the case of U.S. banks, it
was mortgage backed securities, amongst others; in Europe, it's sovereign
debt holdings of "peripheral" Eurozone countries.
After the current short squeeze in
the Euro has run its course, investors may be surprised to see the rally
continue on the backdrop of more positive scenarios being priced into the
markets. Ironically, the biggest risk to a positive outcome is market
complacency. As soon as market pressures abate, policy makers tend to lose
their enthusiasm to make tough decisions. Fortunately, there are plenty of
minefields along the way, ensuring that policy makers should remain on alert.
Axel Merk
Manager, Merk Hard Currency Fund
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