April 11, 2012 By gpc1981 http://gainspainscapital.com
{ The
following is an excerpt from a recent issue of Private Wealth Advisory. In it, I
explain why exactly
‘Starting back in August, I began
suggesting that we were approaching a Systemic Crisis/ Crash scenario in the
markets.
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.
At that time, I thought it likely we’d
see a Crash, which would then be met with another round of stimulus, which
would push the economy temporarily into the green. It seemed the most logical
outcome given that we were heading into an election year with a President whose
ratings were at record lows.
Instead, the Federal Reserve,
particularly those Fed Presidents from Financial Centers (Charles Evans of
Chicago and Bill Dudley of New York) began a coordinated campaign of verbal
intervention, hinting that more easing or QE was just around the corner.
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
Another issue that served to push the
markets higher was European leaders’ decision to go “all in” on the EU –bail
out project. I’ve tracked those developments closely in previous articles.
Regarding this factor, I also
underestimated the extent to which leaders would push to hold things together.
After all,
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,
For starters, unemployment in
Indeed,
With new austerity measures now in
place there is little doubt
The one thing that would stop me here
would be if
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
Today, just a few years later,
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).
|
Country |
2011 GDP Growth |
2012 GDP Growth
Forecast |
|
|
2.9% |
2.4% |
|
EU (all 27
countries) |
1.5% |
0.0% |
|
17 EU countries
using Euro |
1.4% |
-0.3% |
* 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 (
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
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
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
With that in mind, there are three
key political developments coming up.
1)
2)
3)
Regarding #1,
So
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
Finally, let’s not forget
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
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
Remember, as stated before, politics
rule
That’s the political analysis of
Anecdotal reports show
In simple terms, things are getting
worse and worse in
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 (QE 1: 44%, QE
2 and QE lite: 33%, Operation Twist 2: 22%).
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?
Several items:
1) The Crisis coming from
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
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:
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…’