The T Report: From European Bull to Bear

Summer 2012 in Europe

I have clearly had another change in sentiment on the outlook for assets in Europe. At the height of the crisis I was an unabashed bull. The timing of this Bloomberg TV interview couldn’t have been better, but in general the bull case was based on 3 things

• Not doing anything was risking catastrophe and a Eurozone wide banking run, followed by a freeze in economic activity
• That the Spanish bank bailout deal would progress and had been designed to get banks up and running in a timely manner
• Prices already reflected much of the risk and little of the upside

From the moment of the “whatever it takes” speech, where Draghi clearly answered my How Dumb is Draghi question, European markets rallied.

The Spanish bank bailout seemed to be running slower than I would have liked, nothing was getting done in Greece, but at least Draghi seemed determined to follow up on his promise (or threat if you were short). His first ECB after the big pronouncement was a bit of a dud, but he said enough to keep the markets happy.

Too many people focused on the German “Nein Nein Nein” when in reality, Nein didn’t mean No. So the markets remained underwhelmed by the prospects, but Draghi surprised many by launching OMT.

My initial reaction to the program and the press conference was that while it didn’t go far enough, it had demonstrated a big change in attitude. The plan was comprehensive, well thought out, and most importantly, ACTIONABLE. Everything about the plan showed that it was designed to be implemented within the existing scope and framework of the ECB and the EFSF and would only benefit from ESM approval. It went to great lengths to address investor concerns (allegedly pari passu for example) while pushing the envelope so that Germany couldn’t stop it, as it was “within the ECB’s mandate”.

I had three reasons to be long, each of those has been dialed back significantly, if not outright removed.

Prices Now Reflect Balanced Risk Reward

In Spain, the IBEX went from 6,000 to 8,150, 5 year bond yields went from 7.5% to 4.2% and CDS went from 650 to 350.

In Italy, the MIB went from 12,500 to 17,000, 5 year bond yields went from 6.3% to 3.8%, and CDS went from 580 to 310.

So my view that prices already reflected much of the risk no longer makes sense. The markets performed incredibly well. We saw “re-coupling” of epic proportions. Greek, Portuguese and Irish debt went along for the ride. Greek PSI bonds have almost doubled off their lows. The returns have been great, but now represent a much more balanced risk/reward than before. Even in OMT goes into effect

Bank Bailouts Delayed and Economies Suffer

There is a clear link between banking health and economic activity. Whether it is as simple as loan availability impacting car sales (from Nick Colas at Convergex) to bigger projects, economies cannot function well, while their banks are struggling. The U.S. learned that during the crisis. The Greeks should have, yet NBG and other Greek banks continue to live on in some cruel zombie purgatory. Yet, Spain and the EU still don’t seem to get it.

Bankia should have received capital already. Other banks should have been in the midst of the restructuring. Instead, we have a pretty MOU, and more committees. Europe continues to act as though the “promise” of money acts the same as “actual” money. While the stock market may react well to promises, the real economy tends not to. Yes, the nature of all these diffusion indices means we will likely see some bounces in the data (it really is almost physically impossible for each month to be worse, or “worser” than the month before) but the real economy has limited hope of improvement when the banks are a total mess.

I was willing to play along that the delays made sense, but at this stage I cannot see any justification for the delays, which indicates something deeper is going on behind the scenes.

The focus on a pan-European bank regulator or something seems like a pure smokescreen. Nothing like that would have prevented the crisis and nothing like that will help their current balance sheets. Would it possibly ease the way, down the road for some sort of kind of maybe possible deposit insurance? Sure, I’ll give that, but there is no immediate tangible benefit, this is once again Europe trying to create an aura of co-operation and support, without any real support.

I think there is a growing risk that longer dated bond holders get punished with some form of PSI. It’s just a feeling, a perception, but it feels like some European leaders are going to demand “their pound of flesh” in the form of PSI for longer dated bondholders. They have sympathy for “shorter dated bond holders” since they themselves encouraged purchases of those bonds, and even enabled it with ECB money. Any PSI is unlikely to be rational or fair, since the intent is to punish and show a strong hand to the public. Unlike sovereign PSI, I would expect many more legal challenges. Again, this is out there, and new to my thinking, but isn’t inconsistent with various comments and interpretations of comments.

So Europe doesn’t have the willingness to truly support banks, and now that it is obvious, it is hard to see a dramatic improvement in the economies, which is needed to support valuations here.

The Window on OMT is Closing

OMT was a stretch. Draghi looked for loopholes and seemed to have found them. Merkel could pretend to be surprised and the Bundesbank could complain, but in the end they could shrug their shoulders and say that the ECB was acting “independently” as it should.

I have argued repeatedly, that Draghi is desperate to get pregnant. He wants to start OMT NOW!!!! He knows he stretched the mandate. He knew some countries (Finland) and some National Central Banks (Bundesbank) would be opposed from the start. He knows that in each and every country within Europe there is growing disagreement over the direction that the EU and ECB have been going. He knows that while the ESM was only be challenged in the German courts, there is risk of other challenges.

He wanted to launch a program, buy bonds, “get pregnant” so that he could continue to grow the balance sheet to the point that the dissenters would get more scared of losses from existing positions than of growing the positions. That has been a key element of all European policies. They have been “slippery slope” policies, where once they started on small or even temporary policies, the fear of being exposed as having been wrong, has lead them to expand their policies.

Draghi needs that on OMT. Every day that goes by, increases the risk that the deal is challenged.

I also strongly believe that the IMF could have made the terms of OMT relatively favorable for Spain and Italy. They could have gone along the lines of the “Fiscal Compact” which both countries have already agreed to. That would have caused some screams in German and even Greece, but they probably could have pushed it through in the confusion.

But now opposition has had time to organize. If the ECB’s plan is really within its mandate (and growing risk of investigations into that), then the other way to stop it, is to make terms harsh, with regular check-ups.

The ability to sneak through an agreement with few obligations on the part of Spain or Italy, and relatively few ongoing checks and balances is diminishing. There will now be strong opposition to this, and that opposition has recovered from the initial shock when they could possibly have been railroaded.

Finally, Mme Lagarde’s latest attempt to become involved in the money throwing party is unlikely to give anyone, including the U.S., a sense that she is performing her duties in an unbiased way. She is rapidly losing trust, as more people see her going out of her way to support her beloved Europe without representing her constituents (U.S., China, Japan, etc.). She seems left out as not being in the top 5 most important people in the world (along with fellow unelected bankers Ben and Mario).

So there is growing distrust of the IMF, at least outside of Europe, and even within Europe, reports that some countries are unhappy with their policies and monitoring in existing recipient countries.

On the other side, you have Rajoy. Enough said. If you are a bear, he is your best friend.

So something may get cobbled together, but I think the opportunity for a less onerous plan is long gone. We will now see something with conditions that the market doesn’t believe will be met, coupled with regular check-ups that would terminate the plan when those conditions aren’t met. More muddling along, which neither the market, nor the economy will react positively to.