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The Broken Euro Club Bailout, Calling All Martians

Interest-Rates / Global Debt Crisis May 29, 2010 - 07:01 AM GMT

By: Jonathan_Pain


Best Financial Markets Analysis ArticleWhen the due diligence team from the IMF arrived in Athens to determine how much money was needed, they were not surprised by what they found. They had for many years been watching events in Europe and had wondered how long it would take the Germans to find out how the Greeks had not been playing by the rules of the Euro club. In fact the citizens of Mars had been watching the reality show, „Euro club‟ for many years. What concerned them most was that the last time they had seen the Europeans get so angry with each other, many horrible, horrible things had happened.

They knew that the underlying problem in Greece, Spain, Portugal, Ireland and Italy was that they had too much debt. They knew too that the German people were very angry and would soon prevent their leader from giving any more German money. They knew that if a country went further and further into debt to pay off existing debt, the situation was simply unsustainable. They also knew, given their extra-terrestrial powers, what happened at the week-end meeting of European leaders. They had seen Sarkozy banging the table and threatening to leave the Euro and Merkel fidgeting awkwardly. They heard the phone call made by the President of the European Commission, Jose Manuel Barroso, to the German Chancellor Angela Merkel, when he said, “It was a moment of truth and I‟m asking you to save the Euro.” The IMF team, however, knew full well that the great majority of Germans did not want to give any money to the Greeks. They knew all these things and be-lieved that the riots in Athens, the birthplace of democracy on earth, were just the beginning and that the new reality of fiscal austerity had the potential to tear Europe apart.

The Intergalactic Monetary Fund decided they needed to launch a massive rescue package and agreed to make an

inter-galactic transfer of 1,000,000,000,000,000,000 Eura-nians. When asked why they had saved Europe, they re-plied, “We have seen the future,” and then left.

On their return trip to Mars the IMF team felt a sense of relief that they had helped solve one of earth‟s problems. However, they also knew that they would have to return soon and perform another inter-galactic bailout of the na-tion that was the leader of the submerging world. All they wanted in return was for Jerry Springer and Fox News to be taken off the air.

For some years, the citizens of Mars, had watched in amazement how this great nation of innovation had lived beyond its means, but it was when they saw the creation of the NINJA mortgage that they knew The Day of Reckoning was soon to arrive.

These were just some of the thoughts on the minds of the IMF team as they raced through space on the way home to watch the next episode of „The New Reality‟ show, starring the submerging versus the emerging nations.

Coming back to earth and the present.....

The debt paradox is plainly and painfully evident for all to see. It was too much debt that got us into trouble in the first place and now governments are going further and further into debt to get us and them out of debt. We have in effect seen the „mother of all debt swaps‟ from the private sector to the public sector, and the problem is who is going to bail out the governments. In essence, there is no gov-ernment to save governments, hence the need for an ex-tra-terrestrial bail out.

The Euro 750 billion rescue package was impressive in its size, but is no more than a short term liquidity solution and does not solve the long term solvency problem. It therefore looks increasingly likely that Greece will need to see a restructuring of its debt, which will lead to significant losses in the European banking system, particularly in France and Germany. Europe‟s banks had U.S $ 2.29 trillion at risk in Greece, Italy, Portugal and Spain at the end of 2009, ac-cording to figures from the Bank for International Settle-ments. French banks had the most claims, at U.S $ 843 billion, followed by Germany at U.S $520 billion.

Greece now faces the reality of a prolonged period of fiscal austerity which will further depress economic growth, lead-ing to even higher debt levels. Moving forward it would appear that Greece needs to exit the Euro and restructure its debt. This is not inevitable but, looking at the numbers, increasingly probable.

All of the events in Europe over the last several weeks have strengthened my conviction that we are likely to see the submerging nations spend less and save more in the decade ahead.

Markets are now frantically re-pricing for the possibility of a systemic sovereign debt crisis in the submerging world. It wasn‟t meant to happen this way as most economists and analysts, who are domiciled in the submerging world, have been raised in a world divided between the developed and developing, with the former being less risky than the latter. The events of the last 2 years have turned conventional wisdom on its head as the fiscal ratios in the emerging world now look so much better than their counterparts in the so-called developed world. To make matters much worse a majority of money managers still invest most of their clients money in portfolios which slavishly follow eq-uity indices such as the MSCI index, which are heavily exposed to the submerging nations of America, Britain, Japan and also to a lesser extent to Spain, Ireland and Greece. This could very easily be resolved if the money management industry used the cash rate as their bench-mark, but I hear you yawning so I shall move on, as this inconvenient truth is perhaps too much to digest at a time such as this. We have enough problems at present, I hear you say, without trying to reform the entire money manage-ment industry.

The bears have come charging out of hibernation and they are angry.„ I told you so,‟ they snarl, through gritted teeth. We have now seen a fundamental shift in investor senti-ment, from buy on weakness to sell on strength, and there is no doubt that enormous damage has been done to the „technical‟s‟ of the market. Virtually every major equity mar-ket is now trading beneath its 200 day moving average, and the speed of the declines has been brutal with the 7 day RSI (Relative Strength Index) at Crash 08 type levels. Such depressed RSI levels clearly suggest we are over-sold in the short term and the VIX index (a measure of the implied volatility of the S&P 500, sometimes known as the Fear Index) has risen exponentially since mid April. All of this suggests that the market is pricing in a lot of bad news.

As most of you know, in December 2009 I said, “The first quarter will see a nasty correction and its magnitude should be between 10% to 20%.” Markets fell approximately 9% in February and then rallied to new highs. Since mid-April eq-uity markets have fallen very sharply, with declines between 10% to 20% for the major markets. I also downgraded my China GDP forecast which I outlined in my last report, „The Chongqing Express‟ and continue to believe that we will see growth of around 7% in 2011 rather than the 10% numbers analysts were forecasting a few months ago. I suspect, how-ever, most economists are now quietly lowering their China forecasts.

My positive view on BHP, that it would reach A$ 50 in the months ahead, has been blown way off course by a number of factors, not the least of which is due to our own Prime Minister. The „super tax‟ gob-smacked investors in every respect and one leading analyst from overseas said, “We expect such nonsense out of Hugo Chavez in Vene-zuela...but never did we expect such nonsense from Austra-lia.” The analyst then went on to add that, “we will be adjust-ing positions accordingly as a result of this idiocy.” Not sure what I can add to that.

For the record, despite Mr Rudd‟s best efforts, I remain a long term believer in BHP.

I have recommended gold since March 2009 and we had a stunning run to new highs of U.S $ 1249.40, which we reached on 14th May. It too has recently sold off sharply, but it remains an attractive insurance policy against all kinds of possible nasties.

In the longer term I remain committed to my view that one should be underweight the submerging world and overweight the emerging world.

We are currently witnessing phase two of the financial crisis which began with shameful and predatory lending practises and excessive leverage, which in turn gave birth to the NINJA mortgage. Wall Street then neatly packaged, secu-ritised and sanitised, with the help of the rating agencies, their dirty little secret and it travelled like a virus around the world. The governments around the world then engaged in „shock and awe‟ fiscal and monetary intervention to save the world and in so doing amassed unprecedented levels of debt. The private sector balance sheet crisis has morphed into a public sector balance sheet crisis and in Europe the Euro 750 billion rescue package was intended to stop the threat of a sovereign debt contagion sweeping through Europe. It has bought much needed time and helped the short term liquidity crisis, but has perhaps inflamed the long term solvency problem, as it adds even greater debt to an existing mountain of debt.

At times such as these, when my eyes are sore from looking at all the fiscal data and my brain is spinning with every defi-cit and debt ratio in the submerging world, it does in many ways remind me of 2006 and 2007. At that time, however, I was looking at sub-prime debt, U.S mortgage equity with-drawals data, house prices and household debt and thinking that it was all simply unsustainable. The big difference be-tween now and then, and it is a very big difference, is every-one knows about Greece, Portugal, Spain etc and the markets have re-priced accordingly. It is on the front page of newspapers across the world. I also know, however, that there is a fundamental flaw at the heart of the Euro club, namely, that whilst they have a monetary union they have no fiscal union. In many ways the Euro club is a „fiscally challenged‟ fiction and all the rules of club membership have now been broken and, in time, some members will be expelled so as to allow the club to survive. I am not there-fore, for a moment, suggesting that we don‟t have serious problems in Europe, but what I am saying is that the mar-kets have priced in much of the bad news.

It also helps, at a time such as this, to remind myself of how I feel when I visit nations such as Vietnam. I remem-ber the sense of vibrancy and optimism, the remarkable passion for advancement and I see 3 billion people in Asia all moving ahead. The rise of Vietnam, Phoenix- like, from the ashes of a truly brutal history serves to illuminate the remarkable potential of nations in developing Asia.

I then remember how depressed I felt when I saw, sitting in a New York hotel room, my first NINJA mortgage adver-tisement, which I brought back to Australia. I recall having lunch with a close friend in London In July 2005 who man-aged CDOs for one of the biggest CDO firms in the world. I talked to him about „my‟ NINJA mortgage advertisement and my view on the American housing market. I showed him the Robert Shiller chart on U.S house prices and said I think the bubble is about to burst. I begged him to run the numbers and see what impact a 20% decline in U.S house prices would have on his CDOs. He looked at me as if I was from Mars. This chapter is most fortunately behind us.

Fast forward to May 22nd 2010, as I write these concluding words, I am not as fearful as I was in 2007 or 2008. I am neither a perma bear nor a perma bull and I would like to think I am a realist.

Events in Europe, over the last several months, are a chapter in a story called; „The New Reality‟ and the grow-ing divide between the submerging and the emerging. The markets are finally beginning to understand the profound and tectonic shift in the global economic landscape and, in characteristic fashion, they are having to adjust to a dec-ade of frugality in the submerging world.

All the very best,

Jonathan Pain

The Pain Report is for the exclusive use of subscribers only. No forwarding, reprinting, publication or any other redistribution of The Pain Report is permissible without the prior consent of JP Consulting (NSW) Pty. Ltd.

Disclaimer: The information and material presented in the newsletter The Pain Report are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to buy or sell securities, investment products or other finan-cial instruments, nor is it advice or a recommendation to enter into any transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. It does not have regard to the specific investment objec-tives, financial situation and the particular needs of any specific person who may receive this information. Any and all information provided in The Pain Report is for general information purposes and JP Consulting (NSW) Pty Ltd do not warrant the accuracy, timeliness or suitability of any information provided. The general information contained in this material should not be acted upon without obtaining specific investment advice from a financial adviser.

© Copyright 2009 by J.P. Consulting (NSW) Pty. Limited - All rights reserved.

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