The sovereign debt crisis in Europe seems like the movie Groundhog Day, where Bill Murray wakes up to the same thing day after day after day. We have been discussing the problems in Europe for almost 2 years now, and it appears we are still a long way from a solution to the problems. What has happened since our last discussion on this a little over a month ago?

On November 30, many of the world’s central banks, led by Ben Bernanke and the U.S. embarked on a coordinated move to inject much needed liquidity into the world’s credit markets. Reports were that a major European bank was on the verge of failure, and this action to inject liquidity into the system would stave off the impending train wreck that was about to occur had nothing been done. The stock market enjoyed a furious rally, but this action by no means solved the debt crisis in Europe, it was just another finger in the dike.

So what exactly did the coordinated move by the world’s central banks entail?

First of all, the swap lines merely provide banks with access to dollar funding. This is nothing new so the fact that the program was touted as something new is very odd. The program has been in place since 2007 so the announcement is just an alternative form of something that was already in place. What they announced here was a reduction in the cost of the loans. The swaps were also extended to several other currencies though the USD is the primary focus. The goal is to keep short-term lending markets from seizing up like they did in 2008 after Lehman Bros went bankrupt. There had been signs in recent weeks of money market troubles and short-term loan troubles so this program should help to some degree. The Fed elaborates on the purpose of the swaps –Cullen Roche, Pragmatic Capitalism blog

“These swap lines are being implemented as a contingency measure, so that central banks can offer liquidity in foreign currencies if market conditions warrant such actions. These lines provide the Federal Reserve with the same ability to provide foreign currency, should the need arise, as foreign central banks currently have through the existing dollar swap lines with the Federal Reserve to provide dollar liquidity in their jurisdictions.”

So the move has increased liquidity which was a problem in the 2008 crisis, but it is only treating the symptoms of the problem, and not the disease itself. It buys more time and gives a bit of confidence to the markets that the central banks are willing to take a proactive role in this ordeal.

Next, the big European Union (EU) summit came and went last week and the European’s have come up with a plan to solve the crisis in Europe once and for all, right? Certainly, now we can get back to just concentrating on the economy and issues here in the U.S. Ok, let’s not kid ourselves. In the grand scheme of things, not a whole lot was accomplished last week in Europe, even though the stock market temporarily thought so. What really came out of the EU summit last week?

All in all, it appears to be a lot more of the same things they have been doing, but with an increased emphasis on more austerity. Unfortunately, austerity when the region is teetering on a recession will likely make things that much worse as curtailing spending going into a recession is a recipe for a depression. It is akin to starving yourself to lose weight. True, your calorie intake decreases, but, because of the way your body is designed, it actually increases its fat storage and instead of burning it will devour muscle tissue before using stored fat. It still appears that they are hesitant to force anyone to take write-downs, and instead want to solve the situation by increased austerity measures, which have already demonstrated their ineffectiveness.

Germany is driving the hard line on austerity measures for the weaker members of the Eurozone. They, as a fiscally stronger nation than many of their southern neighbors, will be able to tolerate spending cuts, because their economy is relatively vibrant. But how are the people in the weaker nations that have already been rioting against austerity programs that their own governments have proposed going to react when these measures are imposed from Germany?

Yes, it is true that many of the countries in Europe (and the U.S. for that matter) need to live within their means. But it does not seem that austerity alone is going to be enough to stem the crisis in Europe. Many were hoping that Euro bonds backed by the full faith and credit of the EU would be issued, or that there would be a step towards greater fiscal unity. These steps would qualify as the “bazooka” that most think Europe needs to bring to the battle rather than the “peashooter” solutions that keep getting brought to the table.

What actually came out of the summit that concluded December 9th were several things that have been discussed for weeks:

1. The creation of a fiscal compact that will include the European Commission (EC) as an oversight of EU budgets and a Court to enforce the provisions. The EC is the executive body of the European Union and is responsible for proposing legislation and upholding the EU’s treaties. This could be argued as a first step towards fiscal union in Europe, but much remains to be seen as to when it will require balanced budgets among the EU members and what kind of penalties will be slapped on countries that do not comply. The EU has a history of not following through on threats for noncompliance.
2. The European Stability Mechanism (ESM) fully in place by July 2012 that will stand alongside the European Financial Stability Facility (EFSF) instead of replacing it. First a couple of definitions. The ESM is a permanent rescue fund for the EU designed to replace the temporary bailout fund (EFSF) which is set to expire in 2013 and was only designed as a short term solution. The ESM would be launched once Member states representing 90% of the capital commitments of the fund have ratified it. The ESM is funded by the member countries of the EU with the largest contributions coming from Germany & France. The fund, together with assistance from the International Monetary Fund (IMF) would be utilized to bailout countries in the Eurozone that are facing a financial crisis and hopefully prevent the crisis from spreading to other countries. There are problems with this. First, will the markets wait until next July for the ESM to be fully functional? Second, there is a fair amount of dissension from people in Germany and France who are footing a large part of this fund. Will the populace want to go along with this new deal?
3. Eurozone states’ budgets need to be balanced or in a surplus.
4. Member states must report national debt issuance plans in advance.
5. If members violate deficit ceilings there will be automatic consequences which could include sanctions, unless a qualified majority of Eurozone member states oppose.
6. EU leaders agreed to lend up to 200 billion Euros to the IMF to help aid countries that are struggling in the Eurozone.

In regards to #3, 4 and 5, it remains to be seen what kind of “enforcement” and “penalties” will actually be carried out by the EC for noncompliance. The history of the EU has shown that it can be somewhat lax on following through on their threats.

There is also still a lot of uncertainty with the results of the summit because many of the above decisions still need to be approved in the capitals of the member countries. This has proven to be tough in the past and will likely be a challenge again when leaders bring these proposals home for ratification.

Another cloud that hangs on the horizon is the possibility that the ratings agencies may downgrade the credit ratings of several states in the Eurozone because of the additional funding needed to support the EFSF and ESM, which could affect the credit worthiness of these bailout mechanisms.

Oddly enough, the U.K. chose not to be part of the new treaty, as getting that referendum passed by its populace would likely prove daunting. This does not mean that they are leaving the EU, but rather, they are choosing not to play by the new rules proposed by the latest treaty. This looks to have created some resentment from other countries in the EU, primarily France and Germany. As a result, many people in the UK are worried that Britain is travelling down a path of isolationism.

So, as we seem to always end these missives, they have appeared to “kick the can” down the road a little more for the time being. It just appears that unless a closer fiscal union is forged, and nations are willing to give up some of their sovereignty, the situation is going to continue to fester. Will the markets allow this to continue, or will they force the issue? It is likely that we will continue to operate in an environment of heightened volatility and the proverbial roller coaster ride until there are some more concrete solutions or things unravel for good. The markets still appear on edge and the yields on Italian bonds are still very high which is a sign of continued stress. And since Italy has a large amount of bonds that are up for refinancing in the first quarter of 2012, there will likely be continued pressure on Italian yields that will prompt further action by the EU.

It is too bad that we have to constantly address the news out of Europe, because the data here in the U.S. has shown some modest improvement over the last several weeks. Retail sales have been decent, auto sales have been strong, the job market seems to be slowly recovering and corporate earnings remain robust. Can this continue with all the stress in Europe will remain to be seen? For now, as investors, it still seems prudent to play things close to the vest, until there is a little more clarity out of Europe. Other than that, Happy Holidays to all!

The ongoing saga of will Greece default or will they get bailed out continues. (For a summary of how we got to where we are today, see here) News and rumors continue to pour out of Europe and the markets continue to twitch on every morsel of information. Over the weekend (September 24-25), there were rumors of a European style TARP via the European Financial Stability Facility (EFSF) similar to what we had here in the U.S. in 2008. The new plan would increase the size of the bailout fund that would provide banks additional capital to stay solvent. But the Bank of France head said there is no secret plan to provide capital to the banks.

Lately, it also appears that Germany has been arranging things to prepare for a Greek default. And even though EMU and Greek authorities continue to say that Greece will not default, the markets are saying something different, as the yield on one year Greek government bonds is now over 135%. So, it is increasingly likely that there will be some kind of write down of Greek debt, and bondholders (primarily European banks) will have to take a loss on their Greek debt, but then probably get an injection of capital from the European TARP plan to stay solvent. So, European taxpayers would likely be on the hook for much of the bill. The exact size of any plan is still not known (some rumors put it as high as 1 trillion euros or about $1.37 in US dollars), but it would have to be quite large, as French banks alone have about $57 billion of Greek debt. Again, this would just seem to push the problem off to a later date. While all this continues to go on, the European economy continues to suffer, and it appears the effects may be starting to affect China as well so the prospects of an economic slowdown on a worldwide level begin to increase.

The bottom line, though, is the leaders of the countries in the European Monetary Union (EMU), are having trouble coming to a proposal that everyone can agree on. Although, they have announced a plan is being put together and will be announced in 6 weeks on November 4th, the hopes are that something could be announced sooner than that because the markets are likely to continue to be very volatile until a workable plan is announced. Once it is announced, will it be more “kicking the can” down the road, or will it be something that will be more fundamentally sound and better for the long term? We do not know but a lot of the indications are that it will be closer to the former unfortunately. The worry is that if they do not come up with something soon, the situation could deteriorate further. This has the potential to drive the world markets and economy towards a scenario like 2008 all over again and possibly worse. We are monitoring this situation very carefully, and are making appropriate changes in our strategies as needed for our clients.

UPDATE :

Late Monday information coming out of Europe suggests they will likely be rolling out a European version of the TARP program that was used here in the U.S. in 2008. Keep in mind, though, that as of this writing, we have not heard a definitive plan out of Europe. This may or may not be the plan, and all the participants (17 parliaments from all the countries of the EMU) will need to agree on it. However, the good news is that there is a plan, and that has allowed market participants to, at least for now, take the worst case scenario off the table. The worst case scenario would be a messy default, with many banks failing, bank runs and a possible unraveling of the EMU. Equity markets are responding favorably to the news. However, we have seen this before, and will have to wait and see if the latest news has staying power.

The plan that is being discussed involves leveraging up the EFSF and increasing its influence. This will allow it to provide more funding for the weaker countries (i.e. Greece), and will offer some form of bank recapitalization by allowing banks to sell Greek and other sovereign debt for EFSF debt. Basically swapping toxic debt for AAA debt, just like the U.S. 2008 TARP plan did here in the U.S. It provides some short term help, but it is still kicking a rather large can down the road. They would create a Special Purpose Vehicle (SPV) which is a separate entity to buy the troubled debt and issue a bond from the EFSF. Remember, SPV’s were one of the things that Enron was famous for, so let’s hope the outcome turns out better for Europe.

Who are the winners and losers? Well the large European banks get bailed out at the expense of European middle class taxpayers. (Haven’t we seen this movie before?) It also forces the weaker nations in Europe (Greece, Portugal, Spain) to endure more austerity and most likely a weak economy for some time to come. It doesn’t fix everything that is broken in the EMU, but it does buy them some time to come up with a permanent fix. This would have to involve more fiscal unity among the members of the EMU. This has been a sticking point for some time, and will likely continue to be.

Other things to consider are, will the people of accept more pain to bail out the banks? There still is no solution for the weak economy in the region, and some of the stronger countries such as Germany and France could see their credit ratings downgraded. Plus, this still does not appear to be a permanent fix and if everyone does not go along with the plan, where do things go? The situation will likely be at the forefront for some time to come.

WHAT IS THE TROIKA?

You may have heard or read about the “troika” in regards to the situation in Greece, and have wondered just what that is. The term “troika” refers to the 3 organizations that will have a large part in determining Greece’s financial future. They are the European Central Bank (ECB), European Commission (EC), and the International Monetary Fund (IMF). It is actually a Russian word and not Greek, and as you can probably tell, it refers to the number “3” or three of a kind. It actually refers to a Russian sleigh pulled by 3 horses. In the summer this would be a carriage with wheels. So the next time you hear the word “troika” used you will know what they are referring to and it is not a Greek mythological figure.

Troika

We all know what a turbulent ride it has been in the stock market over the last month or so. We hear everywhere that a lot of this is due to the slowdown in the U.S. economy partly due to the debt ceiling fiasco in Washington, but also due to the fear that another recession may be imminent. We also hear about the European Banking Crisis, but how much do we really know about what is going on over in Europe and why does this have so much impact on markets here in the U.S?

First, let’s look at how we got to where we are now and start with a brief history of The European Monetary Union (EMU). Before the EMU, each country borrowed money, based on their credit quality and controlled their own currency. This meant they could devalue their currency to make their products more competitive when their economy was suffering. The EMU changed the rules in ways we are still trying to interpret.

The EMU actually had its origins date back to the 1950’s, when the first rough plans for a unified Europe surfaced. But it was not until 1979, when the European Monetary System (EMS) was adopted to employ an exchange rate mechanism (ERM) for participating countries to keep their currency exchange rate fluctuations within a certain range, that the wheels were really set into motion. In 1988 plans were adopted for a three-stage plan for Europe to become a full economic union. These plans were formalized in 1992 with the completion of the Maastricht Treaty, which was the founding of the European Union (EU).

The Maastricht Treaty outlined the conditions or “convergence criteria” that a member state of the EU would need to meet before it could join the EMU (sorry for all the acronyms). These conditions were essential because the Europeans realized that economic crises in one member country would affect all the other member countries. The 5 conditions of the Maastricht Treaty that would have to be met for admission consisted of targets and allowable limits on the following:

• Inflation rates
• Ratio of annual government debt to gross domestic product (GDP)
• Ratio of gross government debt to GDP
• Exchange rates
• Long-term interest rates

These criteria were considered necessary to maintain price stability in the Eurozone even with the inclusion of new member countries.

The EMU was then officially formed in 1998 to promote economic and social solidarity and adopt a single currency and monetary system among the countries of the European Union. Its currency, the Euro, began trading on January 1st, 1999. Actual Euro physical notes and coins were introduced in 2002. 11 countries were members when the EMU formed, and 17 are currently full-fledged members. Some countries such as Denmark, Sweden and the U.K. are part of the European Union (EU), but opted out of joining the EMU and thus continue to use their own currencies. Monetary policy for the EMU member countries is managed by the European Central Bank (ECB), although there is no common representation, fiscal policy or governance.

Some countries such as Italy and Belgium were only able to meet the criteria through “flexible” definitions, and it now appears that Greece was only able to make the grade through some “creative” accounting as well. At the time, this did not seem like a big issue to many.

As of today the EMU represents the largest economy in the world.

So how did things start going sour? In the early part of the 2000’s, after the Sept. 11 attacks, the ECB, much like its U.S. counterpart, the Federal Reserve, kept interest rates very low for an extended period of time. Now that there was a unified EMU, countries such as Greece, Portugal, etc. were able to borrow money at the lower rates paid by economic powerhouses such as Germany. This cheap credit meant that these fringe countries experienced a consumer spending & a real estate boom (sound familiar?). The large banks of France, Italy, Germany & Greece among others quickly saw the dollar (or should we say Euro) signs in the mid 2000’s and aggressively pushed into these markets providing easy financing for not only the business entities in these countries, but for the governments as well.

With the 2008 economic and financial crisis, the boom in consumer spending and housing became a bust in these countries which were economically noncompetitive because of the strong Euro-they could not compete with German efficiency. In addition these countries governments were running huge deficits because of prolific spending and overly generous entitlement programs for its citizens.

The banks and the government of Germany showed a little more restraint during this period (but still had to bail out a few problem banks), and for that reason are in a stronger position today. Now, because of the large exposure to these troubled countries debts, the solvency of these large banks is being called into question causing severe pressure on the large European bank stocks and the entire stock market itself.

Why does this affect stocks here in the U.S? Well, these European banks trade billions daily with their counterparties in the U.S. and U.S. Banks have insured European debt through complex derivative transactions-no one knows the extent, but it is $Trillions. Another factor is there are billions of dollars from U.S. money market funds invested in these large European banks, so problems in Europe become problems for bank stocks here in the U.S. as well and call into question the stability of American banks, and worries about a relapse of the 2008 crisis which is affecting all areas of the stock market.

So why can’t the EMU just bail out all the banks like we did here in 2008? Well, when the EMU was formed, the countries agreed to a common currency, but refused to surrender control over their individual banking and financial sectors. This has greatly limited the possibilities of coordinated action like we had here in the U.S. Thus, any assistance packages must be developed, funded, and managed by each country and not the EMU itself. So countries with large and growing budget deficits and national debts, such as France, Spain and Greece would like an EMU wide bailout similar to what the U.S. did in 2008, Germany, (the strongest, most fiscally responsible country) does not since it would have to pay for the majority of the program. As you can see, this can lead to some friction and disagreement between the members of the EU and why it has taken so long for a permanent solution.

So where do things stand now? Greece stands on the brink of defaulting on its debt obligations and Ireland and Portugal are not far away as well. The worry is that the debt crisis will also engulf larger countries such as Italy & Spain and more countries will continue to fall like dominos. On July 21st, Eurozone leaders agreed to a second bailout of Greece and some changes to the €109 billion bail-out fund also known as the European Financial Stability Facility (EFSF). The new bailout plan includes programs to reduce Greek debt and exchanging existing Greek bonds for new bonds with lower interest rates and longer maturities. It will also call for continued austerity measures throughout countries in the Eurozone. However, the proposal needs to be ratified by the member countries and there are some other issues that need to be resolved as well. During the negotiations in July Finland insisted on collateral from Greece in return for its participation in the bailout, and negotiated a bilateral agreement with Greece. Because of political pressures, other countries are also now considering collateral from Greece as well in return for bailout participation. Others are wondering why Finland has received preferential treatment. Germany & the Netherlands have insisted that private bondholders share the pain of a second bailout as well and take some losses. This uncertainty has thrown into question whether the bailout will unravel and throw more chaos into the region and continue to dampen the region’s economy.

Some other ideas to stem the crisis have included the idea of Eurobonds, which would be bonds backed by all Eurozone members. These bonds would replace bonds issued by the individual countries, and could possibly solve Europe’s long-term debt problems, because they would be perceived as high quality debt. However, EMU officials say that Eurobonds raise important questions for fiscal sovereignty and require more debate on the topic. Still, many argue, that the new bailout package is still not enough to permanently fix the problem in Europe, and that this is another temporary patch and that more will inevitably have to be done down the road to solve the problems. Will Germany, who has been prudent, be willing to pay more for their partners’ spendthrift ways? Will Greek citizens be willing to reduce their living standards more to pay off German Banks? Will this become a peaceful takeover of Europe by Germany? Will the EMU break up; abandon the Euro and the member countries revert back to their own currencies? If anyone knows, please tell us.

No, it’s not the luxury liner Queen Elizabeth II (shown below), but rather the monetary policy being used by the United States Federal Reserve to stimulate the economy. We are hearing so much lately as to whether Ben Bernanke will embark on Quantitative Easing Part II, we felt a brief discussion of what exactly Quantitative Easing is was in order.

Wikipedia defines Quantitative Easing as:

The term quantitative easing (QE) describes a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

A central bank implements QE by first crediting its own account with money it has created ex nihilo (“out of nothing”).^[1] It then purchases financial assets, including government bonds, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus a hopeful stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.

Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.^[1]

So actually when people refer to it as money printing or dropping money out of a helicopter it is misleading. The Fed is simply electronically swapping assets with the private sector, mostly swapping deposits with an interest bearing asset. The result drives interest rates down and forces investors into riskier assets such as stocks because interest rates are so low on savings deposits and money markets.

So, lately the hot topic affecting the markets is will the Federal Reserve implement QEII? Remember, the first round of quantitative easing was during the peak of the financial crisis in 2008 and 2009. The results of this can be debated, but the mere idea that they are looking at performing another round of easing so soon leads many people to believe that QE is not effective and just leads to devaluation of the dollar and higher inflation down the road. Also, the fact that Japan has been doing this for the better part of two decades and still has not managed to jump-start its economy, but has rather just increased it’s debt load is another reason many people are against it.

Quantitative easing is also designed to make it easier for banks to lend money to borrowers, but the problem seems to be that you need to have demand from borrowers to make this work. But with so much de-leveraging going on in the private sector the demand for loans just does not seem to be there and there is not much that can be done to make people and businesses borrow money especially if rates cannot get much lower. So, you can increase bank reserves as much as you want, but if there is no demand from borrowers, what good will it do?

If you would like a little more detail on this, the excellent blog the Pragmatic Capitalist has a great post here.

Barry Ritholz’s excellent blog The Big Picture had a great article on the long term cycles the stock market has gone through over the last 100 years. The chart below details the price level of the stock market on top, with the P/E ratio (Price/Earnings) ratio on the bottom. The P/E ratio is one of the most well known ratios used to calculate the value of stocks. History has shown that when P/E ratios are high (think 2000), stocks are poised to underperform for the next 15 years or so, or until P/E ratios become very depressed (think 1982). Once the P/E ratios become very depressed, say around a market P/E of 7 or 8, stocks will generally perform very well for the next 15 years or until P/E ratios become inflated again.

Currently, one could argue that we are about 10 years into the current secular bear market and we may have another 5 – 8 years remaining, or until the P/E ratio again gets to a depressed level such as it was in the early 80’s, around 1940, and around 1920. You can see that the current market P/E ratio is still quite a bit higher than it was in those dates just mentioned, which were the start of fabulous bull market runs.

In the interim, there will be nice stock market rallies, but if history is any indication, stocks will still need to either go lower, or tread water for a couple of years, until the P/E ratios get to a more depressed level and the fundamentals for a healthy bull market are in place. With the P/E ratio at its current level, it is tough to make an argument that we are at the beginning stages of a new bull market run in stocks.