Please, click here to read this article in pdf format:may-17-2010

The main paradigm that has been affecting markets in the last weeks has not changed one bit. Therefore, today we want to note our surprise at reading so many optimistic research notes in light of the current events. Indeed, most of the research we’ve come across last week deems the European Union crisis as something of a temporary nature, which means that if one manages to correctly address risk via relevant capital reallocations, in terms of timing, industry or asset space, one can get by and even earn reasonable returns in this crisis.
Perhaps we are so convinced about the negative outcome of the latest fiscal and monetary policy decisions by the European Union authorities that we are blind and cannot see any reasonableness behind the optimistic argument. Therefore, we have no choice but to address what we think are the main points of our disagreement:

-The ECB will create asset inflation
This idea comes from misleadingly comparing the ECB plan, if any, with the Fed’s quantitative easing policies. We mentioned the differences between both policies in our previous letter already. Basically, the Fed was buying benchmark debt, lowering benchmark rates, to fund the purchases of assets, which are finite in quantity and identifiable. These assets were isolated from balance sheets and were a one-time event. There are no more sub-prime mortgages, no more houses built for sub-prime borrower.
The ECB is not buying benchmark debt, but junk debt. And these purchases fund fiscal deficits, flows, which are unknown in quantity or time. The only way to prevent this from spiraling is seeing fiscal surpluses from those sovereigns that issue junk debt. And that takes time and fortune. Therefore, there cannot be asset inflation.

-Devaluing the Euro will make the EU competitive
This is an issue were millions of pages have been written by thousands of economists. We are among those who believe there is enough evidence out there to confirm that devaluing a currency does nothing for a country’s productivity. In fact, devaluation only destroys the formation of capital, the ultimate driver of productivity. Does it buy time? It does, and we have been a saying too many times that the survival of the Euro required its flexibility. But not this way, not by buying junk debt. The ECB could have devalued the Euro as well by buying Bunds from a trust that would use the Euros to buy a determined and public amount of junk debt, for a determined period, where specific PIGS cash flows are ring-fenced to repay the trust. We said that indiscriminate secondary market purchases were a sure way to hyperinflation or its synonym: A run against the currency (refer end of : www.sibileau.com/martin/2010/05/10 ) .
The idea that devaluation is a potential savior implies that a) there is an optimal exchange rate and b) one can get there in a linear, smooth way. None of these exist.

Lastly, we are also very concerned about some latest news of politicians, particularly in Germany, considering the break up of the European Monetary Union. These comments are very damaging because they can and will easily become self-fulfilling. The expectation (true or false) that the end of the Euro is near would trigger a jurisdictional arbitrage within the EU banking system, that would be very difficult to defuse. Simply put, if you have a savings account at Santander in Madrid and you believe the monetary union will collapse, you will want to shift your deposits to a German financial institution, possibly in Germany. You will want your Euro deposits to be converted into Deutsche Marks, not Pesetas. In the process, the biggest winners will be Gold and the Swiss Franc, and what once was a Union will end in the most bitter resentment between nations.

On this note, not only are we bearish of the Euro and bullish of Gold, but also very bearish of stocks and credit.

Martin Sibileau