NEWS

Viewpoints Update (Europe)

on October 25, 2011

The markets have been in a trading range for almost the past three months. For example we have seen a 1000 point range on the Dow from 10,650 to 11,650. We just broke the upper end of the range last week on speculation of Europe reaching a near term resolution with restructuring Greece, re-capitalizing European banks, and ring fencing the larger country sovereigns (and curing cancer). This upward market trend could continue if we see even a short term solution to Euro problems, however, valuations still look rich considering the potential for earnings deceleration based on renewed economic weakness and a political mood for fiscal tightening, not just in Europe but around the world. The BRIC countries may not be able to support global growth as they did in 2008.

All eyes are still on Europe because a disorderly shock there would tip an already fragile global economic environment to recession or worse. We believe that Europe alone cannot fix its problems, because it does not have the economic firepower to address the capital needs of the weaker nations or undercapitalized banks, without entertaining the restructuring solution path.  Restructuring conversations (except for Greek) among policy makers and government leaders have been taboo and this outcome will most likely be forced upon them only by the markets.

The only solution out of this week’s Summit that would make us much more bullish in the short term would be a coordinated effort involving BRICs and U.S., in which BRICs provided recapitalization funds through the IMF and the U.S. Fed followed through with telegraphing statements considering another round of QE.  Germans are reluctant to lever up the EFSF* (French are in favor) because ultimately those guarantees would fall on the German taxpayer, but we believe that with a healthy infusion of funds from BRIC countries and support from the U.S, Germans would be willing to accept their role. All the other Euro countries would fall in line. Naturally, U.S. Congress would vehemently object, but this would be inconsequential in the moment. A move like this would nudge the structural global imbalances involving debtor-developed countries and emerging-creditor countries in the right direction, albeit small and forced, instead of organic. It would also invoke more speculation and with newly injected liquidity, the market could surge.

Conversely, if we do not see a “bring the house” solution, the equity markets could have an awakening, which is already the reality of the credit markets. LIBOR-OIS spreads, sovereign yields, CDS spreads, and a variety of leading indicators are signaling extreme caution, yet equity markets myopically focus on the lagging indicators such as earnings, or unfounded hope of a European solution.  In either outcome, we continue to be patient and will look to invest further based either on lower prices (based on equity capitulation) or on a European solution that gives us enough liquidity to generate another short lived equity melt up. Additionally, in each of these scenarios the investments choices would be different based on what would be driving the markets.

The Vigilare Management Team

*About EFSF

The European Financial Stability Facility (EFSF) was created by the euro area Member States following the decisions taken on 9 May 2010 within the framework of the Ecofin Council.