Whipsaw Markets

The desperation is palpable - yesterday's price action in European equities indicates a market completely unhinged. The clear message after witnessing another failed EU trial balloon - a non-starter bank union plan this time - is that we are now into a stage of exceptionalism. As with the days following the Lehman collapse, similarly drastic measures are now required from the ECB. Treaties, philosophical differences and principles will have to be set aside for the largest liquidity dump the world has ever seen.

Unfortunately more pain will occur to jolt the European bureaucrats into action. Perhaps it will take Spanish 10 year yields to 8%. However, the only thing that will save Greek and Spanish banks now is a wholesale deposit guarantee. Until then the pace of withdrawals and currency shortages will increase. Already the Greek Public Gas Corporation (DEPA) is predicting an early June blackouts as utilities have failed to pay their bills to tune of €300m. A lack of bank guarantees means that Greece is now buying their oil from the charitable people at Glencore at an additional cost of €2.2m a month. When a commodities trader is applying pariah-state financing methods to member of the EU, it signals a need for drastic action. 

JFDI

Lemmings

Short covering rallies don't usually take much to ignite, even less when "China" is the propellant. The ASX 200 has given back all the points it stole yesterday, and AUDUSD has coughed up over 100bp.

China is not going to save Europe, the USA, or much less Australia. China is currently struggling to through a rocky leadership transition, a political purge, and clear signs that the economic miracle might just be the work of  mere mortals committed to making age-old mistakes. However, the prevailing belief in Australia is that the Chinese economic leadership is omniscience.

Speaking of stereotypes, here is how Europeans see each-other. It provides a glimmer of comic relief in an otherwise depressing PEW survey of European [dis]unity:

Will the Spanish Coalition of Cultures Hold in a Time of Austerity??

Spain has maintained a working relationship between Castilians, Basques, Galicians and Catalans. The transition to democracy in 1978 allowed for autonomous regions under a Statute of Autonomy. This devolved power means that the regions are responsible for the administration of schools, universities, health, and social services. Basically that is all the stuff that costs the most. This was great in the good times, when financing was plentiful. With Spain now in the grips of pro-cyclical fiscal tightening, the autonomous regions are starting to feel the pain of austerity.

The tenets of austerity, as originated in Brussels and the Bundeathstar, will now bind these autonomous regions together in  away that will force the strong to carry the weak. Does this sound familiar?

There is a nasty game of brinkmanship already under-way. Just last week, the President of Catalonia announced that his fiefdom would be out of money in weeks. Catalonia has an economy equal to that of Portugal, and is a major source of income for Madrid.

And then there are the banks. Enquiring minds would like to know where the €23bn for the Bankia bailout is going to come from. Incidentally, how did this bailout go from €4 to €23bn in the space of 10 days? Ibid. Spain only has just over €5bn left in its Fund for Orderly Bank Restructuring. This comes at a time when there is a growing awareness that Spain is only just starting to realise massive property losses. This from Ambrose Evans-Pritchard:

Barclays Capital says Spain's housing crash is only half way through. Home prices will have to fall at least 20pc more to clear the 1m overhang of excess properties. If so, the banking costs for the Spanish state are going to be huge. 

The Centre for European Policy Studies in Brussels puts likely write-offs at €270bn. We could see Spain's public debt surge into triple digits in short order.

Prime Minister Rajoy has insisted that no help is needed for the Bankia bailout nor aid to the regions. By implication he is stating his confidence in Spain's access to international debt markets. However, widening yields on Spanish debt suggest that nothing but pain lies at the end of that road.

The Spanish state and its fractured democracy stands as a proxy for pan-European disharmony. The strong will not acquiesce to carry the weak, just as Germany will not concede its fiscal sovereignty for the sake of the eurozone's survival. The plain truth is that there is no muddle-along option any more.

Further reading here, here and here.

A Back of the Envelope Eurozone Crisis Solution

I've been thinking about a cure-all solution for the eurozone - not very much, mind, so don't expect anything wonkish.

I would like to see the following statement from the EU next week (prior to the Greek elections: 

On the 1st of January 2013, Greece, Portugal, Ireland and Spain will leave the Eurozone. It has become clear that the rigid nature of eurozone monetary policy and the failure of austerity to calm markets and achieve better deficit outcomes, has made those countries' membership of the common currency no longer tenable 

Futhermore, starting from 9am this morning, currency controls will be placed on the financial systems of the aforementioned countries. There will be no bank runs, no flight of capital. In addition to exchange controls, the ECB will become a lender of last resort with respect to current and future stock of debt issuance of the aforementioned countries. The ECB and the Eurozone will set maximum yield values on the bonds of the departing and remaining countries and these values will be maintained at all costs. 

The ECB will also provide trade financing via the central banks of the departing countries. With the measures already mentioned, this will ensure the economies of the departing countries to not grind to a halt. 

And so on, and so forth.

The Europeans need to understand the value of surprise. They also need to grasp that the crisis is a much about the stock of sovereign debt as the flow. Like the Swiss National Bank, who have dared anyone to challenge their 1.20 peg to the euro, the Europeans will need to send a stark message that anyone attempting to challenge their maximum yield levels will get the cold steel treatment.

Equity markets will be left to their own devices, but ultimately investors will see through the panic and realise that cheap financing and the potential foreign currency to earned by exporters in the departing countries have value in the price of their shares.

I can assure you that this idea has not been subject to any rigorous interrogation, but it is merely illustrative of the kinds of wild ideas that are now urgently required. The Greek election is a binary outcome for the crisis, and my fear is that the EU is betting on the wrong outcome without preparing for the other. However, even if a troika-friendly government is formed, we are still condemned to roll from one crisis inflection point to the next. Some drastic action is needed.

Fragility

The sell-side always maintains a firm belief secular growth in emerging markets. Indeed in Australia, it underpins just about every investment thesis presented by stock-brokers and analysts. Worried about Australia's overall private indebtedness, property bubble, retail weakness, or manufacturing collapse? Fear not, the insatiable demand for resources from China, India etc. will pick up the slack. Worried about fiscal consolidation and pro-cyclical policy from the hopeless crowd in Canberra? Fear not, the mining boom will fill government coffers and the RBA will boost aggregate demand through rate cuts.

With Europe and the US relying generous financing schemes from central banks, and quantitative easing, there is the inescapable sense that economic growth in every case depends entirely on a panacea that can be elusive and overwhelming depending on the circumstances. An by circumstances I primarily mean the equally abstruse constructs of sentiment and expectations.

And, as previously explored, the global investment community is as interconnected as the neurons in your brain. Information and sentiment travels at the speed of light. Hubris and panic move exponentially, and yet we all buy tickets knowing that theatre has a misunderstood risk of fire. Relying on invalidated VaR models, and "hedged" trades, market participants blithely risk other people's money, and too-big-to-fail banks sit on huge deposits bases whilst frugally lending money to the real economy. And yet, we still get outsized failures of risk management, most recently at JP Morgan (now possibly $7bn loss). Felix Salmon nicely illustrates my point:

It’s easy for JP Morgan to bring in huge amounts of deposits, of course: corporate balance sheets are bloated with cash, and those corporations want to deposit their funds with a too-big-to-fail institution. But if those deposits are being attracted by JP Morgan’s implicit government backstop, then it’s incumbent upon JP Morgan to lend them out into the US economy, to get it moving again. Rather than sending them off to London to be gambled away by the likes of Bruno Iksil, even as JP Morgan’s total loan base remains lower today than it was in 2008.

On the other hand you have the banks of the European periphery, which are bleeding deposits into the core, like a mountain climber suffering from hypothermia. This slow-motion bank run has led to furtive attempts by the ECB to prop up banks via the ELA mechanism. The deposit flight is effectively about mitigating exchange rate risk, not the fear of bank failure. Should Greece leave the euro, nobody wants to be holding new-drachma. However, with these flows the buck ultimately stops with Germany (TARGET 2 liabilities) and the ECB (ELA risk). The TARGET 2 chart demonstrated both the bank run and the huge problem Germany faces.

Returning, then, to this Australian narrative about China. By way of linked stories, here is the bearish case:

• Chinese buyers are defaulting on coal and iron ore shipments.
• Chinese real estate is unravelling.
• Money is fleeing China.
• China is short of dollars and therefore short of liquidity due to subdued trade.
• BHP has slashed planned infrastructure spend.
• Chinese commodity stockpiles, including copper used for financing are out of control.
• China's electrivity production plunges in April.

I won't elaborate too much on India, save to say that recent anti-business moves by the government may potentially ruin their growth story. Here is the FT for better insight. Between regulatory risks, corruption, and the failure of the government to reform, growth has stalled. Realisation about India's woes has spread to such an extent that even Michael Pascoe has written something sensible about India.

As a sometime rational long-term investor, my overriding mode of thought should reflect contentiousness rather than acquiescence. I believe that time to make money in commodities was when they were unloved back in 2003. The current climate suggests we are in the last days rather than midway on some fantastic trajectory. The bulk of evidence tells me that that those going long commodities are fighting for seats at a funeral.

The fragility of markets, the dependence of government largess and tenuous growth stories, is not an indication of a global economy in robust health. Look through the noise and you'll find that the forces of debt deleveraging, structural unemployment, and sovereign risk still firmly have the upper hand.  

A German, a Frenchman and an Italian walk into a bar

Well, there's a joke in there somewhere about old grudges, asceticism, outrage and paying the bill. The reality, however, is that it will require a subversion of stereotypes to save the Eurozone, and potentially the EU.

The most pressing, and perhaps the biggest challenge, is for the ECB to target a higher lever of inflation. Actually, it would be great if they aimed at their current target. The insistence in using CPI rather than the GDP deflator means that monetary policy has failed because it is too tight. The GDP inflator is not used because it excludes import prices, and obviously commodity price inflation wouldn't be accounted for. However, the panic tightening by the ECB in April 2011 shows the potentially ruinous effects of responding to what might be a temporary blip in import prices.

The fear of inflation seems culturally manifested in the ECB; and a change to using the GDP deflator, which also excludes non-monetary factors like indirect taxes, would involve a significant easing in monetary policy. If this miracle were to occur in conjunction with a marked effort to increase German aggregate demand, we might have the makings of a European recovery. Here is a chart from the Market Monetarist that nicely shows the divergence when CPI is favoured over the GDP deflator:

For further subversion of national stereotypes I'll leave it to the Economist:

Like some dreadful joke, the euro needs French reform, German extravagance and Italian political maturity.

JP Morgan, Jamie Dimon, and the unchecked hubris of Wall Street

Hubris always catches my eye, and especially when the should-be-meek heads of large US banks show great disdain governments and muppets alike. And so it went back in April when Bloomberg ran with a story that specualted on the activities of JP Morgan's chief investment office (CIO), and in particular the mammoth trades of Bruno Iksil a.k.a the London Whale.

Jamie Dimon reacted with a sadly predictable mix of indignation and condescension when quizzed about positions like the $100 billion notional on one of the Markit CDX indices. This is what Dimon said last mnonth:

"It's a complete tempest on a teapot" and, "Every bank has a major portfolio. Obviously it's a big portfolio; we’re a large company, and we try to run it - it’s sophisticated, obviously with complex things, but at the end of the day, that’s our job is to invest that portfolio wisely and intelligently over a long period of time to earn income and to offset other exposures we have."

I will allow myself a bit of Schadenfreude today after JPM announced a $2 billion dollar loss from the "hedging" activities of its CIO. Now, according to Dimon, Iksil's activities are an "economic hedge", but it is quiet clear that this was a monumental failure of risk management. Basis trades can be spectacular when they blow up, just as was the case in 4Q 2008 when Merrill Lynch lost nearly $16 billion in one quarter. Jamie Dimon was quick to apologise in the JPM's conference 5pm call yesterday, however:

"These were egregious mistakes," Mr Dimon said. "They were self inflicted, we were accountable and we happened to violate our own standards and principles by how we want to operate the company. This is not how we want to run a business."

This event quite clearly demonstrates that the Volcker Rule is toothless, and that banks can't be relied upon to regulate themselves. The Obama Administration has shown little heart in the fight for better regulation of Wall Street and, in an election year, it is not about to start now. As Felix Salmon put it:

"JP Morgan more or less invented risk management. If they can’t do it, no bank can."

I doubt that this is the last we will hear on this issue, losses could quite easily get out of hand now that there's blood in the water.