The decisions were breathtaking—literally so, as wheelchair-bound German finance minister Schauble was rushed to hospital after almost suffocated due to an adverse reaction to new medication. Those thinking such an emergency would weaken Germany's hand were quickly proven wrong: Germany's interior minister de Maziere was an even more stubborn negotiator. As the package to support weaker eurozone countries grew, Germany dug in its heels, requesting that any country asking for support must meet International Monetary Fund (IMF) terms (read: severe austerity measures). Germany insisted that those contributing to the emergency facility must go beyond guaranteeing the debt of weaker countries and actually provide access to credit. It is our understanding that, as of Sunday night, no final agreement was reached on the mechanism. However, total fiscal commitments are approximately EUR 770 billion or US$ 1 trillion, in our assessment well above the funding requirements of all weaker eurozone countries for the coming years. Beyond existing commitments for Greece and (an older facility) for Eastern Europe, we are talking about a fresh commitment of EUR 500 billion by governments and over EUR 100 billion by the IMF.
For better or worse, those who said Europe couldn't act have been proven wrong. Europe put in place a de facto central fiscal authority over the weekend. Germany is fighting to ensure that control of the facility will remain with the member countries (i.e. Germany has to agree to how its money is spent, but this may well morph into an independent body to spend money over time).
Very relevant is that part of the package are new austerity measures announced by weaker European countries (with the exception of Ireland) ranging from 0.5% to 1.0% of the respective GDPs for this year in addition to similar cuts next year. Portugal, for example, will tighten its belt by 1% of GDP this year, amongst others by cutting public infrastructure spending; Italy announced measures to cut expenses by 0.7% of GDP both this year and next; Spain will cut expenses by 0.5% this year and 1.0% next year.
Not to be trumped, the European Central Bank (ECB) joined the fray and announced:
- A reopening of select emergency lending facilities.
- A reopening of USD swap lines with the Federal Reserve (Fed) and major central banks around the world, ensuring European banks have sufficient access to U.S. dollar credit.
- A program for the ECB to have its Governing Council decide on the purchase of government and corporate debt to ensure "depth and liquidity" in the markets. Any ECB action is to be sterilized.
What does this all mean? These facilities provide liquidity to a market that had frozen up. At the end of last week, banks in Europe were screaming for help, as no one wanted to deal with banks with exposure to any weaker European country.
This mechanism will buy Europe time, but it does not solve structural solvency issues. However, steps to address structural issues have been taken with the announcement of further fiscal consolidation. Our fear is that the relief provided by the announced programs may take the pressure away to actually follow-through with the cost cuts. It is in this context that Germany once again, with its insistence of IMF involvement, appears to be showing appropriate leadership.
Despite present measures, there is still a risk that Greece defaults. We believe Greece will implement many of the cuts the IMF demands. As a result, Greece will have a debt to GDP ratio of about 150% in a few years. At that point, Greece may still default to wipe out a good portion of its debt. Any country is free to default on its debt; the problem is that few, if any, will give you a loan the day after you default. From Greece's point of view, the country has a choice of defaulting now, imposing an overnight 15% adjustment to GDP; or considering a default in about 3 years, imposing an adjustment of about 4% of GDP overnight then. The latter may be something the political leadership may be willing to contemplate.
Because of this risk, it is paramount that a) creditors use the time to bolster the balance sheet; and b) countries use the time to engage in aggressive fiscal consolidation (cost cutting) to ensure they can stomach the shockwaves that are almost certain to flare up yet again.
What does this mean for currencies and the markets? First, it shows once again that when policy makers throw trillions of dollars at financial problems, markets act. Unfortunately, it also means that investors may be more concerned about the next trillion dollar move than fundamentals. The one positive about the sovereign debt crisis is that bond markets fulfilled their duty: by making the cost of borrowing exorbitant, governments have been forced to cut expenditures. If a central bank intervenes, the most powerful mechanism to impose fiscal discipline is in jeopardy. As a result, it is absolutely key to monitor how the ECB implements its new campaign to enhance "depth and liquidity" in the markets. Is it a question of when or a question of whether the ECB will yield to political pressure to finance government deficits?
While so much focus has been on the eurozone's problems, we may lose sight of the fact that the eurozone may actually be in a better position than the U.K., the U.S. or Japan. We continue to believe that it is more difficult to spend and print money in the eurozone than in these other regions. There's no threat of IMF involvement in California; there may be little reluctance in the U.K. to have the Bank of England finance government spending with a weak new government incapable of addressing reform; Japan's debt situation—in the long term—may be hopeless. Note that the U.K., a European Union member, but not eurozone member, refuses to participate in any aid plan for weaker European countries; it is quite understandable that the U.K. does not want to load up on euro denominated commitments, but it also means that help from the European Union may be more difficult to obtain if and when the U.K. is in need of help.
This crisis is a reminder that monetary policy may be more accommodating than is priced into the markets right now—not just in the eurozone. As we have said for some time, there may no longer be such a thing as a safe asset and investors may want to take a diversified approach to something as mundane as cash. Central banks globally have been diversifying their foreign currency reserves into baskets of currencies. Investors may also want to consider diversifying to baskets of currencies.
We were one of the few calling the depressed levels of the euro a potential buying opportunity. History will be our judge; for now, we invite you to register for our webinar this Thursday May 13, 2010, to get an update on the euro and how we believe the global dynamics may play out; make sure you have signed up for our newsletter to receive Merk Insights.
We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. This analysis is a preview of our annual letter to investors; to learn more about the Funds, please visit www.merkfunds.com.
Axel Merk and Kieran Osborne
Merk Investments, manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com.
Axel Merk, president and CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies and author of Sustainable Wealth.
Kieran Osborne is co-portfolio Manager of the Merk Absolute Return Currency Fund, part of the Merk Mutual Funds that also include the Merk Hard and Asian Currency Funds.
The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.
The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.
The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.