Mamma Mia!
Europe Needs a Super Mario to Help Fix Europe’s Plumbing
On November 3rd the European Central Bank (ECB) will meet to set Eurozone interest rate policy with new President Mario Draghi taking over for Jean-Claude Trichet. This meeting will be the first in an eight year term for the Italian Draghi, whose resume includes heading the Italian Central bank and a brief stint working for Goldman Sachs (are you really surprised?). What does all this mean to us? The Eurozone economy is nearly the size of the U.S. economy, and in an interconnected world, outcomes in Europe will have a profound effect (good or bad) on the global economy.
Last week’s grandiose “Solution” to the European Sovereign debt crisis made a splash headline, but was sorely lacking in detail. Yet, the stock markets surged. We mentioned in our prior posting that we were looking for more participation from the BRICs or the U.S. central bank, in order to feel more comfortable about the sustainability of a stock market rally. The Chinese have stockpiled $3.2 trillion in reserves including $400 billion in sovereign wealth investments. Some of this outside money would have really helped. This has not happened, but we remain hopeful. Were the French repulsed by the idea of the Mona Lisa hanging in a Chinese museum, or maybe the Chinese were still snake bitten by investments in Morgan Stanley and Blackstone prior to the 2008 crisis. The cuddly relationship between France and the Dalai Lama must not have helped either.
Last week’s bail out did not even include involvement from the ECB. It relied on an abstruse levering of the EFSB to €1 trillion and “voluntary” Greek debt haircuts of 50%.
The Greek problem has not been quarantined and is potentially spreading to Italy and Spain. Italy is too large to save. With $1.6 trillion government debt outstanding Italy is the 3rd largest issuer of debt in the world behind only Japan and the U.S. Since June of this year yields (funding costs) for two-year Italian bonds have increase by a whopping 70%, to 5.2% from 3.06%. For example, if Italy had to roll over all of its debt, the interest cost in this period would have increased by approximately $34 billion dollars (5.2%-3.06%=2.14% of $1.6 trillion). Of course Italy doesn’t have to roll over all of its debt at once, but you get the point. Since October 27th these same yields have increased 81 basis points. To put into perspective, the two-year German Bund yield is only 40 basis points! Here is a chart, courtesy of Bloomberg, on the interest rate of two-year Italian Bonds.
Given this unprecedented backdrop, what will the new ECB president do? The ECB’s sole mandate is to promote price stability, and with the Eurozone inflation number at 3% (well above the target of 2%) the overwhelming consensus is for Mr. Draghi and the ECB to keep the fixed rate at 1.5%. In fact, the ECB has increased the fixed rate twice this year already (April 13 & July 13). The ECBs obsessive focus with managing inflation is deeply rooted in European history plagued with inflation (Weimar Republic for example). There will be incredible pressure for Mr. Draghi to show a strong willingness to fight inflation, and being Italian (as opposed to German) will only add to this pressure.
We believe it is likely that on November 3rd, the ECB will lower rates between 25-50 basis points. This reversal of policy would come as a shock to most. We must however consider that the Eurozone growth outlook for 2012 has already been revised downward to .3% from 2% just five months ago*. The ECB and Mr. Draghi cannot wait any longer to change direction. Remember, the ECB under Mr. Trichet was raising interest rates to combat high oil prices as late as July of 2008, a couple months before the Lehman crisis. Mr. Draghi would not want to make that same mistake, especially this time with the crisis brewing in his backyard. Voluntary departures of key ECB members Jürgen Stark and Axel Weber, who were both staunch inflation “hawks”, is already a leading signal to a possible change in policy direction. This change in policy would begin with interest rate reductions and would more than likely continue with further involvement by the ECB in sovereign bond purchases, something the ECB has already grudgingly acquiesced to, before the EFSF was up and running (think EURO QE). Our assumption is that the ECB will behave more like the U.S. central bank and start to blur the lines of monetary and fiscal policy.
What are the implications? In the short term, the euro debt and stock markets could react favorably (euro would sell off) to this scenario of ECB backstopping. Longer term, however, it would alienate the Germans and other Northern European nations (ex-Irish) and further divide the region. Regardless, it is unlikely that the Euro can survive in its current state so now is the time for change in policy if there is a time. This would also mean that the last major central bank has thrown in the towel and is embarking on money printing, joining the U.S, U.K., and Japan.
These different outcomes will help shape our investment strategy, always with an emphasis on vigilance and protection of capital.
The Vigilare Management Team
*Source OECD