Stinky Cheese

This note was originally published at 8am on May 02, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“For every complex problem there is an answer that is clear, simple, and wrong.”

- H.L. Mencken

 

While they’re not the only ones in the business, the French are rightfully proud of their “stinky” cheeses.  Yet stinky is for the consumer to judge and when it comes to pungent cheese, aroma and taste can run the spectrum from intense pleasure to pain, or alternatively as a pleasure from the pain.

 

A similar broad spectrum on the handling of the Eurozone’s sovereign debt and banking “crisis” is enjoyed by investors, strategists, journalists, and European citizens alike: abolish it, rescue it, or structure some hybrid of the two.  So what’s the update on the region as we find ourselves in May with the stink currently in Spain?

 

We continue to throw the abolishment camp out the window on four main factors:

  1. Eurocrats will tote the line to save their job
  2. Fear of the contagion effect from the default of countries and banks on the rest of the continent
  3. Belief in the Union’s economic benefit (namely through open trade and travel)
  4. Belief in the formation of a European identity (including the continental strength to balance the closest geographic spheres of influence in the U.S. and Russia)

While we could argue until we’re blue in the face that Europe needs its own Lehman-like event, to let weaker countries default and/or exit the Union, and that one monetary policy for a collection of joined states growing at uneven rates will continue to compromise the Union because it handcuffs nations from manipulating currencies and interest rates to encourage competitiveness, we think the above factors will justify the maintenance of the existing Eurozone fabric over at least the next 12 months.

 

So the task is to play an incredibly-challenged environment ahead as Eurocrats try to find a balance between fiscal consolidation, while not obliterating future growth in the process. One key factor to monitor, which we’ll hit on later in the note, is the deterioration of Merkozy, or relations between Germany and France on Eurozone policy.

 

So what’s so wrong with Europe?


The existing rub in directing European policy to improve the fiscal health of countries is that European leadership is inherently compromised: on one hand they have to answer to their citizenry that is largely voting against fiscal consolidation (and rioting on the street to bout), yet on the other they must answer to the markets, and a larger Brussels “authority”. Given that the markets are pricing in slow growth across Europe in 2012 and such threats as the inability of governments to meets consolidation targets, sovereign yields should remain elevated, which in turn increases the cost to raise capital and sets the “non-virtuous” cycle of raising debt and deficits levels. 

 

With 10YR yields trading at 20.4% in Greece; 10.5% in Portugal; 5.8% in Spain; and 5.6% in Italy; vs 1.6% in Germany, it comes with no great surprise that Germany is not interested in issuing Eurobonds.

 

But now the stakes in reducing risk have elevated, as Spain has taken the sovereign spotlight after a lengthy focus on Greece!  (Note: Spain’s economy = 5x Greece’s.)

 

And while Eurocrats have set up a number of firewalls to ease investor concern that the Eurozone is going away—including funding programs such as the EFSF, ESM, and enhanced commitments to the IMF earmarked for Europe, to liquidity programs such as the two 36M- LTROs and the SMP—these programs do little to bind Europe under a growth strategy.  As of recent weeks, it’s growth that has been given more attention by Eurocrats.

 

More Conflicts Ahead


But how do you manufacture growth? Simply by setting up more funding through the European Investment Bank or earmarking more lending from the IMF?  But who’s paying for it? Importantly, Germany hasn’t put up her hand, and who’s left?

 

Again, the uneven and compromised nature of Europe (and the Eurozone specifically) cannot be overlooked.  Simply throwing money at “problems” won’t cure structural drags like high unemployment rates, low labor productivity, vulnerable banks, and further risks from declines in housing and property prices ahead.

 

To highlight a few imbalances: Spain’s unemployment rate is 24.4% vs Germany’s at 6.8%, or Spain has a monster deficit reduction target of 5.3% (of GDP) for 2012 versus 8.5% last year vs the German deficit forecast to fall to 0.6%.  Or consider Portugal’s average annual growth rate over the last 10 years of 0.03% vs 1.07% for Germany, or recall that we forecast house and property prices could fall another 30% from here in Spain! 

 

It’s such structural mismatches (to name a few) that suggest that even if Europe finds a united path, it won’t come next week, next month, or next year. Uncompetitive countries like a Portugal or a Greece are going to stay uncompetitive. Europe’s stronger nations will simply have to decide how long they want to subsidize them.  Is this a realistic long-term strategy? We think not, but we still must play the likelihood that Eurocrats fight to support the whole.

 

Of note is that in some cases expectation are just grossly misaligned. For example, the European Commission targeted all member nations to have deficits at or below 3% by 2013. That’s surely not realistic for Portugal, Ireland, Spain, or Greece! Further, the Fiscal Compact, which is really an amended version of the Stability and Growth Pact (aimed at deficit reduction to 3% and debt reduction to 60%), stands to fall short as Brussels wrongly assumes members will give up their fiscal sovereignty.

 

French Inflections


Returning to stinky cheese, the likely victory of the Socialist candidate Francois Hollande in this Sunday’s presidential elections spells the likely end of a strong working relationship between France’s Sarkozy and Germany’s Merkel. Hollande’s very socialist agenda (increase spending by €20 MM over five years, reduce the retirement age from 62 to 60, raise income tax on earners over €1 MM to 75%, capping gasoline prices for a number of months and a pledge to block corporate job cuts) along with such positions as pro Eurobonds (which Germany vehemently opposes) and opposition to the Fiscal Compact, portend great disunity at a time when the Eurozone needs its two largest economies to pull jointly on the loose strings and direct solutions to its sovereign and banking ills.

 

Returning to H.L. Mencken’s quote that started the note, it’s clear Europe has a very complex suite of problems. And if expectations are the root of all heartache, it’s the market’s expectation that Europe will be “fixed” tomorrow that needs amendment.   While there is no simple solution, without better coordination through both appropriate targets for fiscal consolidation alongside strategies for growth, we do not see any hope for material improvement across the region over the next 12 months.

 

The immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1630-1656, $119.07-121.06, $78.55-79.32, and 1391-1415, respectively.

 

Matthew Hedrick

Senior Analyst

 

Stinky Cheese - EL CHART

 

Stinky Cheese - el VP


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