Europe's Red Tape Blues

Source:

"The high level of danger in the eurobond markets doesn't allow for democratic niceties right now, but the underlying issue is not going to go away. Austerity required to fix the problem will be long-lasting and in many cases severe."

David Coffin and Eric Coffin, HRA Advisories

Plus ça change. . .

Another month, another euro-area country in the hot seat. . .Italy already had issues thanks to the buffoonery of its former prime minister and it's now the target of bond vigilantes. No real surprises and no mystery about the steps the euro-area countries have to take. What steps get taken and how forcefully is the issue as it has been for months. It's still all politics.

Unless the European Union (EU) fixes everything in the space of the next two weeks plenty of tax-loss selling should be expected. Notwithstanding that, we're finding the buying in the bulk material space and strengthening oil price encouraging. There are clearly those that expect a resolution in Europe.

Economic numbers closer to home continue to improve, if slowly. Manufacturing has been a pleasant surprise and China is promising to be a bigger importer. Outside of the bulk materials and oil though, it’s still gold stocks getting the most traction. Volumes overall do continue to be light. As we move into December and tax-loss selling intensifies we may start seeing the volumes required to clean up share overhangs. If that happens, in addition to some debt resolution, we could still see a decent year-end/early 2012 rally. Stay tuned.


So, who wants to play poker with Angela Merkel? Not us. OK, it's not just about Merkel, but the country she is chancellor of is more than ever calling the shots in Europe. Many, not just Germans, think that is the way it should be. Germany has low risk bonds and high(er) growth, so its ways are considered the solution for all, particularly by Germans.

There is some truth to this but Europe's problems will not be that easy to solve. Every country in Europe can't suddenly become an export powerhouse unless there is a country somewhere (other than the U.S.) conveniently running massive trade deficits. Other structural changes in EU countries' internal markets need to come first.

In the past two weeks the debt crises have claimed two national political leaders. Before the next election cycle in Europe is over it's all but certain to claim at least a couple more.

The two latest victims were, of course, the leaders of the current basket cases du jour, Greece and Italy. Of the two, we definitely have more sympathy for Papandreou, the former premier of Greece. He's been vilified far and wide, but he wasn’t the architect of Greece’s many problems. He got elected after the mess was made. If anything he was the whistleblower.

Papandreou's surprise announcement about a referendum on the austerity package sped his demise. It may have been one of the worst-timed political maneuvers of recent memory but we can understand the motivation.

The amount of unrest in Greece shows most of its citizens are not invested in the austerity program. Greeks are sick of being asked to make sacrifices. Whether that is a realistic complaint or pure cynicism on their part is beside the point. The country is a democracy. If the populace isn’t willing to support the program it won’t work.

Papandreou obviously knew this and there was a lot of sense in the idea of forcing Greeks to make a choice they would have to stick to. He made it clear the question would have been framed as a vote on the EU. The idea was sensible; it was the timing that was crazy.

The high level of danger in the eurobond markets doesn't allow for democratic niceties right now, but the underlying issue is not going to go away. Austerity required to fix the problem will be long-lasting and in many cases severe. The fact that it's required and fair, as most would argue for Greece, doesn’t mean it’s going to be popular.

Papandreou's referendum call was a tactical disaster but it showed more political courage than he got credit for. Even at this stage of the crises it's not clear most Greeks understand how stark the choices facing them really are.

Backing down on its austerity program would mean expulsion from the euro and a complete loss of borrowing power. Debt default and the currency adjustment back to the drachma would bankrupt the entire Greek financial sector and many industrial companies as well.

Many Greeks act like they are seeing some middle-ground solution no one else is. Greece’s new prime minister Papademos is looking for a three-month mandate to push through austerity measures. His predecessor had his bluff called by chancellor Merkel, and the position of most northern European countries has hardened considerably in the past two weeks. There is open talk in the north about amending the EU treaty to make it easier for countries to exit. Everyone knows which country would be the test case.

The market's hatred of uncertainty will dog Greece until it passes measures that will satisfy the rest of the EU. This looks more possible now than it did a couple of weeks ago.

Europe is playing a dangerous game but it was right to call Greece's bluff. There is still a confidence vote in the Greek parliament to get past but indications are that most parties will back Papademos.

Markets turned on Italy almost as soon as the Greek government fell. In this case no sympathy is required. Unlike Papandreou, Italy's former prime minister Berlusconi held his position longer than anyone. He had no one to point fingers at about the lack of progress on reform, though it didn't stop him from trying.

Berlusconi had his bluff called too, and had to be dragged off the podium by his own coalition members. New prime minister Mario Monti is working to craft an interim government that will have the main task of introducing austerity measures Berlusconi dithered on.

Italy has one of the world's largest and most liquid government bond markets. That gives Italians minute-by-minute readings on the market's opinion and it's anything but positive. Yields reached all-time euro-era highs as Berlusconi departed, and Monti's arrival hasn’t helped much yet. He and his new technocrat cabinet have to be very convincing.

Italy's situation is scary because it's in the "too big to fail" camp. It's not Greece however. At 120%, its debt to GDP ratio is far too high but that ratio has been relatively stable. The country was running structural surpluses until the credit crunch struck. The combination of revenue increases and spending cuts required in Italy should be far less severe than the other PIIGS (Portugal, Ireland, Greece and Spain).

Italy needs austerity measures convincing enough to bring bond yields down. Even working back to a structural surplus won't solve things if bond yields get out of control. The European Central Bank (ECB) has been buying Italian bonds, but this is a stopgap and perhaps intentionally so. Like Greece, northern Europeans are not willing to commit too much to Italy until it proves it's serious about solving its problems.

At the end of the day, Europe is still capable of dealing with these issues if politicians are willing to be bold. Like the U.S., the EU can issue debt in its own currency and the ECB can buy unlimited amounts of it. If it's pushed to the wall, Europe can start up the printing presses. Northern Europeans insist this will never be allowed to happen but the ability to do it is there nonetheless. If even northern European bond yields started to explode, we suspect the reticence about printing euros would dissipate.

Unlike the U.S., however, doing this will only solve half the problem. Most European economies have structural issues that need to be fixed so that their growth rates can increase. Ultimately, real growth combined with spending restraint is the only way to permanently bring down debt/GDP ratios across the continent.

This is as much a generational issue as anything. Europe has extremely restrictive labor laws designed to protect long-term workers. That is coupled with monopolistic practices that cover virtually every occupation. These are designed to protect existing workers and make it all but impossible for new entrants. In Italy's case, making changes to these practices has been more contentious than deficit cutting.

Politicians have spent decades buying off interest groups to cement coalitions and stay in power. The web of protections and regulations this created is a huge drag on growth. Solutions will have to wait for the passing of the more immediate debt crisis but Europe's job is not done until they deal with this.

The European debt crisis has reached a new level. Greece has a new government that must prove it deserves EU money and Italy has one that must prove it doesn't really need it. At best, that will take a couple of months. The markets have moved to a higher level than August-September but are going sideways again. This should continue until it looks like some euro resolution is at hand. Italy's bond yields, currently 7%, should be a good proxy to track.

Gold will continue to be supported by uncertainty. Base metals appear to have stopped falling. China is promising more imports but its strikes that are the big support for copper. Strikes or not, copper inventories are dropping, which bodes well if the world can avoid a recession.

Of equal interest is strength in bulk material stocks and oil. These markets are trading like they expect stronger growth. Pundits have predicted weaker economic stats for months but they have yet to appear. That doesn’t mean it won't happen, but it hasn't yet.

Economic stats continue to be better than expected. If Greece and Italy can get their act together there is room for a year-end rally after tax-loss selling is done.

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