Sunday, July 17, 2011

Critical juncture - Euro & USD

Dear all, I was preparing the new blog article on a completely separate topic when I started to pick up from the press the convergence of a series of issues that require immediate attention.
I will therefore leave on this occasion the general analysis of the emerging market economies to focus on the impending "perfect storm" that is brewing across Europe and the USA.

We are in fact fast approaching a series of events that if not carefully thread could have a profound impact on the global economy the way we know it, more specifically:

  1. the Euro crisis is spreading and it has INEVITABLY included Italy;
  2. the USA is about to vote on a structural piece of their economic system and its timing is indicative of a very fragile system; 
Let's briefly analyze each item separately and then try to make sense of what is happening.

The Eurozone debt crisis
In talks with friends and clients we have sustained for the past 2 years two fundamental claims: the Euro was an experiment that unless strong political changes supported couldn't be supported long term.
We also claimed that the critical moments in which the crisis would have accelerated was the moment in which Italy was going to become the focal point of the crisis, or the tipping point. The issue is a matter of size: while Greece barely represents the GDP of a German Land, the Italian economy is the 4th largest economy in Europe and the 8th largest economy in the World. An Italian bailout is bound to create significant ripple effects both politically and financially.

Please note how the debate on the global media with regards to the Eurozone crisis has started to include Italy no more than a month ago. Nowadays all newscast globally, other than the one in Italy of course, seem to have recognized the size of the problem looming.

For the first time I have noticed going "mainstream" some of the "what-if" scenarios that we have been kicking around for quite some time now: the idea of multiple euro currencies: a "core euro" and a "peripheric" euro. I think that the fact that these scenarios are reaching mainstream talk is a sign that time is maturing for some bigger event. For additional information about scenarios like the one mentioned above please follow this posting by Izabella Kaminska of July 15.

As predicted earlier the list of "endangered" countries now comprises:
- Greece
- Spain
- Portugal
- Ireland
- Italy

Long before than the media investors have started moving, please look at the latest spreads.
From Bloomberg:

"Italian two-year note yields surged the most in over a year, as the nation’s borrowing costs rose at a debt sale and contagion from Greece’s debt crisis spread across the 17-nation euro region.
Yields on notes from Ireland, Portugal and Greece soared to euro-era records, while German bunds advanced for the fifth time in six weeks as Europe’s politicians clashed over how to craft a new rescue plan for Greece involving private bondholders. Spanish and Italian 10-year bonds slumped, sending yields to the most since the euro’s inception in 1999, as borrowing costs rose to a three-year high at a sale of five-year Italian securities. France, Spain and Germany plan to sell debt next week."

Italy’s two-year yield climbed 75 basis points over the week to 4.26 percent as of 4:40 p.m. in London yesterday. That’s the biggest weekly increase since the five trading days ending May 7, 2010, the week before Europe’s leaders announced a $1 trillion backstop for the euro. Yields on 10-year notes advanced 48 basis points to 5.75 percent. They reached 6.02 percent on July 12, the most since 1997.

Ireland’s two-year bonds plunged after Moody’s Investors Service cut the nation to Ba1 from Baa3 on June 12, saying it is likely to need a second bailout. The country’s two-year yields climbed 6.9 percentage points to a record 23.12 percent, while its 10-year bond yields advanced 1.13 percentage points.

Greek 10-year yields climbed 71 basis points over the week, while the nation’s two-year bond yields soared 2.69 percentage points. Fitch Ratings slashed Greece’s credit rating on July 13 to CCC, its lowest grade, and said that a default is a “real possibility.”

Spain’s 10-year bonds dropped, pushing the yield up 39 basis points to 6.06 percent. Spanish debt may continue to fall next week as the nation prepares to auction 5.5 percent securities maturing in 2021 and 2026 on July 21. It will also sell 12- and 18-month bills on July 19.

What does it mean the trending of the spreads for Italians? It means that the 40B Euro in economic cuts and additional taxes will be all but wiped out by higher borrowing costs that the country will need to face in the future. More corrections will be required. 

Let's take additional data from Italy: the money supply over the past 6 months has fallen drastically. M1 and cash deposits over the last 6 months has contracted at an annual rate of 7%. To put this in perspective: this is faster than the build up leading to the great recession of 2008. Such dramatic figures typically indicate an economic contraction approximately 6 to 10 months away. What is also important to report is that the numbers in the core eurozone has started to deteriorate as well, and in spite of this ECB has recently increased interest rate. It does seem that the leadership of the ECB is battling political and financial issues but the end result is that there is still a fundamental denial about the gravity of the situation that is building up.

Remember: once the situation will be mature, we will require a small event to unravel the euro and send shockwaves across the global economy. Will China commit to save the Euro? Please remember that China has been one of the supporters of the Euro note over the past year.
My prediction is that the "endangered" countries of the Euro will turn the issue political sooner rather than later and that economic matters may take a backseat.

Now let's briefly take a look at what is happening on the other side of the Atlantic.

US debt ceiling debate
Raging right now in the US is the debate to change the debt amendment and raise the current deficit ceiling. In essence Congress must raise the $14.3 trillion limit on US borrowing by Aug. 2nd. If that doesn't happen the US may face a downgrade in his credit rating and send significant shockwaves across the the financial system, or at least many believe so. 
President Obama and the Republican opposition have been fiercely fighting over two fundamentally different approaches towards this matter.

I personally believe that like the ex chairman of the Federal Reserve Paul Volker: "reason will prevail" and the politicians will find a compromise. In fact history leads us to believe that it will be so: in the past 30 years the limit has been raised already a significant amount of times.

The real important issue for me is timing and the fact that uncertainty at this time in the global economy, and especially uncertainty surrounding its largest economy, is adding onto very negative investor sentiments. The message here is economical as much as political: the transition between a world dominated by the G7++ economies into a world led by China & India is fast in the making. While the trends are undeniable the transition is froth of peril for such an interconnected world and the aftershocks of a new order may excerpt sacrifice on many parties.

Again, pragmatically: what does it mean for the investors right now?
My advice in the short term is to stay liquid, please look at currencies like the Swiss Franc and the UK Pound. Leave the equity market to its woes and play out some of the uncertainty unless you are a good trader. 

In the long run evaluate different type of investments altogether: food commodities are a sure bet in the long run but you need to brace yourself for a bit of a roller coaster ride. In some of the most uncertain countries or where financial instruments are limited, focus on building business ventures that satisfy local needs.

Related posts on this blog that explained the fundamentals of what is happening:
Geopolitical & economic shift eastbound: underlying trends fueling long term growth in an economy - December 19, 2009
- emerging markets: by choice or mandatory evolution? - December 27, 2009

Related posts from other sources:
Italy money supply plunge flashes red warning signals - The Telegraph, July 14, 2011
U.K. Pound Approaches One-Month High Versus Euro Before Bank Stress Tests - Bloomberg, July 15, 2011
Barack Obama’s extravagant Ancien RĂ©gime tells the American people: let them eat taxes - The Telegraph, July 15, 2011
Moody's: U.S. faces default on debt payments not 'technical', - Reuters Video
Volcker: Common sense must prevail in U.S. debt debate - Reuters Video