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.
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.
For starters, unemployment in
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).
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 (
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.
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.”
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
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?
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…’