Season Investments


It's An Upside Down World

Posted on June 19, 2012


“What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does.” Reinhart & Rogoff from This Time is Different

In John Mauldin’s “upside down world” capital markets are not driven by finance and economics – they are instead driven by public policy. This is the world we have lived in for nearly four years now, and current price action in capital markets continues to bear this out. Elections in Greece this past weekend produced another leg in the ongoing “CRIC” (Crisis, Response, Improvement, Complacency) cycle that has been ongoing the past several years in Europe. Pro-Euro leaders edged out a victory over the anti-bailout party of the far left ensuring that ongoing bailout negotiations would be conducted in the name of cooperation and forward progress for Europe. This result, along with tepid anticipation of another round of stimulus (if you can call it that) from the US Fed has led to good performance in risk assets thus far this week.

National Character trumps Regional Unity
We originally thought Southern and Northern Europe would be compelled to compromise, meet in the middle and sacrifice sacred cows for the sake of a united Europe. However, as we’ve watched the dynamics change over the past several months we’re now convinced the monetary union will not be preserved in its current form. National character is just too strong, and ultimately if you are a German you want what’s best for Germany and likewise if you are a Spaniard or a Greek. Too much is required to make the Eurozone in its current form continue to work. This would imply an enormous financial burden for German tax payers in return for a ceding of national sovereignty by the peripheral countries. The Greeks are clearly not on board with this, and the rest of Europe is getting weary of dealing with them. 

“Grexit” is Inevitable
Greece simply can’t survive in the Euro, and the elections do nothing to change that fact. New leadership is already promising to go back to the troika and negotiate more favorable terms on their bailout provisions. While this may increase the liquidity runway, it will do nothing to address the underlying insolvency of the country and its banking system. There are so many problems with the Greek economy (and economic culture) it’s hard to even know where to start. Tax evasion, fraud and corruption are rampant, and entitlements are crippling any chance the country has at competing against European counterparts. There are over 600 categories of workers who receive full pension benefits to retire at age 50. Unemployment is at 25% (twice that for the country’s youth), and after five years of recession their economy is likely to shed another 7%+ this year alone. Forcing austerity on the country will not do any good unless there is a wholesale shift in entitlement attitudes within Greek culture. As Niels Jensen of Absolute Return Partners recently stated, “An overdose of austerity will do to European economic growth what fertilizer does to my lawn if not accompanied by ample supplies of water.” In this case the water that is needed is the willpower to become more competitive and productive.

The only viable option at this point is to redenominate back to the Drachma and default fully on public debt – a strategy which has a strong historical precedent. The table below from the Center for Economic and Policy Research shows results for a number of countries who have devalued over the past twenty years. Not only has economic growth resumed within a reasonable period in most cases, but these countries also regained access to debt markets in fairly short order.


Amazingly, if the Greeks defaulted on 100% of their debt they would still have a budget deficit even after saving all that principal and interest. They would still be forced to implement austerity!

The Ensuing Bank Trot
Some call it a bank run, some call it a jog – we think it’s more of a trot at this point. The bottom line is that cash is being withdrawn from Greek banks and re-deposited outside the country (Germany). Financial historian Niall Ferguson recently said, “A Euro in a Greek bank really is not equivalent to a Euro in a German bank.” Roughly 2% of banking system deposits are leaving the Greek system each week. In order to meet these deposit requests Greek banks are tapping something called the Emergency Lending Assistance (ELA) program. The ELA allows for national central banks to extend emergency loans to banks that become cash-strapped. This is Europe’s solution to not having any type of deposit insurance. Banking system regulation is tasked to each individual country within the Eurozone rather than being handled at the regional level, and as a result if banks become under-funded and require recapitalization it is the country’s problem, not Europe’s (or so they thought). So here’s the cycle…

  • The sovereign nation of Greece is becoming more and more insolvent.
  • Depositors withdraw cash from Greek banks and move their Euros into Germany and other northern European banks.
  • Greek banks fund withdrawal requests from their own cash holdings or sell other assets to raise cash.
  • Greek banks quickly become cash-strapped and tap the Greek central bank (via the ELA program) for a loan.
  • The Greek central bank prints Euros and lends them to the Greek banks.
  • The ELA loans are guaranteed by none other than the sovereign nation of Greece, which further compounds the problem!
  • Wash, rinse and repeat.

Do you see the viscous cycle? The chart below shows the explosion of “other claims” as listed on the European Central Bank’s balance sheet (which is an aggregation of all the national central bank balance sheets in the Eurozone). The ECB doesn’t report ELA balances on their own line item and instead simply rolls them into “other claims”. However, the recent spike in the chart below is clearly a result of the dynamic explained above. Interestingly, when questioned about why ELA balances are not shown more clearly the central bank governor of Belgium said, “You don’t say when you are in an emergency situation, because then you make the situation worse. So I really don’t see the usefulness of being more transparent.” 


Suffice it to say that this trot could turn into an all out sprint fairly easily, and the pressing question would then be whether or not a similar trend starts in Spain, Ireland, Portugal, Italy, etc. 

If By “Bailout” You Mean “Loan”
The recent €100 billion “bailout” of Spanish banks was really just another loan that will eventually need to be paid back by Spain. The detailed terms have yet to be finalized, but there is a chance that the source of funds for this loan could be from the European Stability Mechanism (ESM) which would fall into a senior position ahead of all other outstanding Spanish government bonds. It’s no wonder that since the bailout was trumpeted, yields on 10-year Spanish bonds have continued to march upward towards the critical 7% level. By the way, JP Morgan estimates the amount needed to fully recapitalize Spanish banks is actually closer to €350 billion.

It appears to us that each and every new announcement made by European policy makers comes with a bit less impact. Europe is marching towards the inevitability of allowing Greece and perhaps certain other countries to exit in as orderly a fashion as possible. This will require enormous losses being realized by the remaining countries in the Eurozone (writing off bad debt), capital controls and regional deposit insurance (similar to our FDIC) to prevent more cash from fleeing troubled countries and a much more proactive stance from the ECB in providing emergency funding to regional banks. Sound fun? It won’t be, but at this point this option is the “cleanest dirty shirt” in the closet. Even German bonds are beginning to reflect this reality in that CDS (basically insurance against a future default) are trading near all-time highs. 


Central Banks Standing By
We can’t count the number of headlines we’ve seen over the past week that include some derivative of the phrase “central banks are standing by.” Whether it be the Fed, the ECB, the Bank of Japan or the Peoples Bank of China, the markets are clearly thirsty for more monetary stimulus to combat the ugly realities underlying the global economy. We realize that this is the primary difference between the current environment and mid-2008. Heading into the credit crisis the world was still “right side up” and a true crisis was allowed to fully develop before policy makers stepped in. Now the precedent has been set that whatever may come policy makers will have an answer to it. As such, one of the most important aspects of the job we do for our clients is to monitor and understand the policy landscape and correctly anticipate how it will impact fundamentals, sentiment and ultimately asset prices. On this front, the Fed will conclude its two-day meeting tomorrow afternoon at which point it will tell the market what it plans to do from here. It’s current program called Operation Twist is set to expire at the end of this month so there is a lot of speculation as to what program, if any, will take its place. For the first time in a while there is no consensus view on what the Fed will announce, and as such we expect the market reaction to be strong in one direction or the other as it begins to adjust for the new information regardless of what it may be.

In our view the Fed really has no power over the two primary headwinds facing growth – Europe and the US Fiscal Cliff. If the Fed chooses not to embark on any additional stimulus this year, it may put some additional pressure on Washington to address the fiscal side of the equation and on the ECB to take the lead with proactive monetary intervention in Europe, both of which would be a long term positive in our view. However, we wouldn’t be surprised to see the Fed announce some sort of monetary stimulus as Bernanke would rather be seen as doing too much than too little. We will certainly be monitoring this closely and assessing our positioning in light of any new information we receive. In the meantime we remain underweight our long-term targets in risk assets per MarketVANE’s positioning.

Season Investments, LLC
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