Please, click here to read this article in pdf format: july-01-2010
Today is Canada Day and we wish a happy one to all those reading us in Canada! Let’s begin by stating that we share the general and current state of confusion in the market. When one is confronted with a difficult analysis, it is possible to use what we call the “gap method”. It consists in describing what the ideal should be and how reality differs from that ideal. The gaps between the ideal and reality are therefore exposed and one can make a more informed decision. The results are of course still not guaranteed to be correct, but at least, one has a method to follow and think with rigor.

In the case of the current macroeconomic situation, we are fascinated with the late strength in the Euro, which we fear may not be “ill advised”, but in relative terms, against other factors. So here’s our gap analysis: What do we think the Euro zone needs to a) Recover from the sovereign risk, and b) defend its currency? (a & b are ideal situations)

The Euro zone is currently a highly regulated economy, which intends to cut fiscal spending and raise taxes to reduce fiscal deficits. In our view, raising taxes discourages consumption and investments. Therefore, assuming that the spending cuts are serious (which we doubt), activity and growth would also be seriously affected by this policy. The demand for welfare spending would increase and fiscal revenues would decrease. This policy choice reminds us of the De La Rua presidency in 2000 (J.L. Machinea was the Finance Minister making the infamous announcement), in Argentina, which ended in tears. Our ideal solution for the Euro zone would be a wave of deregulation, privatization of government-owned businesses, a bit of spending cuts and the announcement of a schedule to reduce taxes, slowly but steadily. However, for that to translate into a solid defense of the currency, the ideal policy would have to impact a unified point of reference. Today, that point is not unified but isolated, in Germany’s sovereign risk and unless this changes, even under an ideal widespread political move to the right in the zone, the Euro would not necessarily be any stronger, as the “reserve-currency bid” leaves. We did a gap analysis on this issue, back on May 13th, upon the bailout announcement, when we wrote:

“…What could the ECB have done differently?
A similar solution to that of the Fed in 2009 would have consisted in having the ECB buy German Bunds without sterilization, from a trust, administered by the Germans, to fund the trust’s purchase of PIGS debt. In exchange, the PIGS sovereign would have had to ring-fence a cash flow stream to repay the trust. This is similar to what takes place in federal unions, where the federal government collects through federal taxes or alternatively, through specific royalties established with provinces or states. With this structure, the ECB would have been able to carry out an accommodative policy, with specific amounts and repayment sources…” (ref: www.sibileau.com/martin/2010/05/13 )

In hindsight, it is very telling that today the spread between Spain’s sovereign risk and that of Germany continues to widen, and we are no longer speaking of Greece here, but Spain, which should get us all the more serious.

When privatizations are undertaken, resources are freed and more effectively reassigned, foreign investment is brought in, government debt is repaid with the corresponding sale proceeds, “real” interest rates are lowered as the sovereigns’ risk profiles improve, additional capital expenditures are made to increase the competitiveness of the privatized assets and the local currency is appreciated, because foreign currency is sold to buy the local assets. This is always a virtuous circle that unfortunately is never popular, as public employee unions threaten with strikes, etc.

We are seas away from the ideal just described. Therefore, we can only think that the worst is yet to come. How does one interpret the late strength in the Euro? A week ago, we would have only thought about short covering. A few days back, we would have suggested it was the underplayed interventions of the Swiss National Bank, but since Tuesday, we fear the market is making a relative comparison with the shape of the US economy. Tuesday’s sell off was indeed global in nature. However, we intuit that there is a slow awakening to the financial conditions of US municipalities and states. What could be driving this? We think it is the open difference in views between the US and Europe during the last G-20 meeting in Toronto. The US openly showed they are still not ready to withdraw stimulus. On that statement, the propensity of the market would be to reduce US risk. Hence, a relatively strong Euro, a definitely strong gold, weakness in oil and in the currency of the nation’s direct trading partner:  Canada.

Martin Sibileau