Forget The Details, The End Of The European Crisis Is In Sight

Winston Churchill

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Team Macro Man apologise for the lack of service recently. Last week saw their technical pullback first get Apple’d and then FED’d. And though there were glimmers of the technical turn, it looks as though it has morphed into a “technical pause”. Despite the fizzling out of yesterday’s Euro summit there has been little sell-off which leaves TMM thinking that there is a chance of the European “Policy by Sloth” may work.TMM wrote back in December about what they believed the necessary conditions were to bring about an end to the crisis. The classic Anglo-Saxon view (TMM cannot resist the French line) is that the only way out of the crisis is fiscal union. But TMM believe it is far more nuanced than that – strictly, that measures that confirm the path to some sort of fiscal union in the medium term are in place. Specifically, as we wrote back in December, TMM reckon we need to see the following:

(i) A large enough amount of cash to cover Spain & Italy’s financing needs for the next two years,

(ii) Incentives to longer term investors to buy Eurozone government bonds,

(iii) Structural reform measures aimed at rebalancing within the Eurozone and, lastly,

(iv) Clarity on the growth outlook.

In TMM’s view, clarity on the first three of these conditions is enough of a firewall for the rest of the world to chug along, and the last of these would be enough to unwind at least some of the under-performance of European assets and loosen financial conditions significantly.

TMM also highlighted the Silver Bullet Fallacy: there rarely exist simple solutions to solve complex problems. The alphabet soup thrown by US policymakers at the the 2008/9 GFC is point in case. What is more important for markets, is to be able to see the exit. And, as many have noted over the past couple of years, the exit can only come with growth, and that is why the last of the above conditions is arguably the most important.

The Street was generally surprised at how strong the take-up at the December 3yr LTRO was, and this morning’s FT report that several banks are likely to double or triple their request for 3yr money at February’s LTRO seems to slot nicely in the framework of providing adequate liquidity both for the banking system and Spain & Italy in particular – conditions (i) above. Putting this in the context of the EFSF and ESM and the seeming probability that the March summit will confirm ESM and EFSF to run alongside and the numbers have begun to add up. It is only the end of January, yet Spain has already funded about a fifth of its 2012 funding needs. The expanded collateral pool similarly means that French banks will be able to fund a large amount of their balance sheets with the ECB, incidentally, reducing the power that the Germans have over France going forward. The private sector money that would have funded these banks but has now been crowded out will have to go somewhere.

The second point, of providing incentives to longer term investors to buy Eurozone government bonds is not there yet. The treatment of the ECB in the Greek PSI is particularly important here, to avoid markets confirming the suspicions they already have regarding de facto subordination. While the ECB’s LTRO provides time, and the promises of “No More Greeces” with respect to the approach to PSI which is supposed to be “over” evokes the post-Lehman policymaker consensus, only actions (in the form of ECB participation, or an explicit lack of PSI in the upcoming second Portuguese EU/IMF programme) will convince longer term investors.

The Fiscal Compact, while rightly criticised as being too centred on austerity, is a structural reform (iii). Additionally, the measures in Greece and Italy in particular will raise medium/long-term potential growth and aid rebalancing. More needs to be delivered here, but each incremental measure will help. By far the most important, in TMM’s view, is the enactment of structural debt brakes in national legislation, to cement the credibilty of fiscal restraint in the future. In particular, TMM would regard the French enactment of this as the most important structural measure that lays the groundwork for future fiscal union. Of course, Sarkozy has delayed this until after the April election and, with the Socialist Francois Hollande ahead in the polls stating that he would renegotiate the fiscal pact such that France would not cede sovereignty, this is a significant hurdle for markets. TMM cannot get BOLIVIAN bullish until this is passed, but it does seem like much of the plan is coming together.

Finally, the growth outlook (iv). Markets are discounting machines, and they have already discounted fiscal austerity in Europe. The PMIs have begun to move higher which shows the exit… Greenshoots 2.0, the fabled second derivative. Late last year, the Squid published an excellent piece of research comparing Asia in 1998 with the current situation. TMM found particularly interesting the conclusions they came to, which were that market underestimated significantly the degree of demand weakness in those countries at the epicentre (ASEAN). However, the market also significantly overestimated the impact of the crisis upon the rest of the world, resulting in a grab for risk assets in late 1998 and especially in 1999. This is all of a sudden seeming all too familiar… the economic performance in the Euro-periphery has continued to disappoint, while that in Germany & France, the US and increasingly the rest of the World has exceeded expectations.

To sum up, while TMM expect the new month to bring a new bear attack on Portugal, they fear that they have been too cautious on the risk front. The strength in US equities, despite a relatively tepid earnings season, speaks volumes. And if the liquidity emitted from the upcoming 3yr LTRO is indeed large enough to restart animal spirits, then it is not hard to imagine equities finishing the year a lot higher.

TMM will finish by noting that GDP fell in most countries in 2009, yet equity markets and risk assets in general put in an incredible performance. It is not about what is happening *now*, it is about where markets can see we are going. And it increasingly looks like they can see the exit. TMM think that while just about anything US cycle linked looks cheap (Spoos, Korea, SGD, TWD, you name it) there are some things that have run on just about nothing – spec longs in AUD being case in point. TMM wouldn’t advocate going BOLIVIAN but we think the equity perma-bears are in for a rough couple of months.