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The Euro is Dead.
Long Live the Euro Axel
Merk, Portfolio Manager, Merk
Funds October
12, 2011 www.merkfunds.com/merk-perspective/insights/2011-10-12.html 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. Manager
of the Merk Hard, Asian and Absolute Currency
Funds, www.merkfunds.com Axel
Merk, President & CIO of Merk
Investments, LLC, is an expert on hard money, macro trends and international
investing. He is considered an authority on currencies. This report was prepared by Merk Investments LLC, and reflects the current opinion of
the authors. It is based upon sources and data believed to be accurate and
reliable. Opinions and forward-looking statements expressed are subject to
change without notice. This information does not constitute investment
advice. Foreside Fund Services, LLC, distributor. |
