Please, click here to read this article in pdf format: march-04-2011

There are times when we wish we had listened to ourselves more rigorously. Yesterday was certainly one of those times. Exactly a week ago, we had walked to the sidelines entirely, and written that:

“…As we write, the Euro is trading above 1.38 USD, in spite of all the noise coming out of Ireland (elections today!) and Spain (recent 1.5% increase in minimum wage). The strength is explained by the hawkish messages that have been coming out of the European Central Bank lately and, if we may add, the total absence of clarity on where the European Financial Stability Facility will end. The higher Euro, via higher rates, is simply recessive and it will push Greece and others to restructure or default sooner than later. This, in addition to the folly of the new regulations on bank capital, is the sort of things that may end up in a run against a country’s financial system on a gray Monday morning…This is the sort of thing that could explain bearishness in gold, oil and stocks simultaneously, for the sake of bearishness, in spite of a $600bn quantitative easing program, strong earnings, lower jobless claims, etc. etc.

We are not saying that the strong Euro caused the yesterday’s action. We cannot prove causality here (at least not us). What we are saying is that this explanation is more consistent than any other we’ve come across, and we like it because it means that someone out there knows something we don’t know, which is proof enough, if we follow Occam’s razor principle. On this note, we take this weekend off, preferring to remain on the sidelines until the ECB meeting, scheduled for March 3rd…”
(“Why gold and oil sold off yesterday”, February 25th, 2011)

Indeed, the then strong and now stronger Euro brought gold and energy stocks to their knees. We were bruised, but not beaten, fully understanding that we need to survive to fight tomorrow’s war. Yesterday, Mr. Trichet surprised everyone by announcing the ECB will increase interest rates, perhaps as soon as April. The debate that now follows is on the possibility that that increase be a one-time action or the beginning of a more comprehensive monetary initiative.

In any case, the only market that seemed to react wisely, in our view, was the credit market: Greece’s and Portugal’s sovereign risk, which had been increasing in the last days, together with the Euro, widened even more (+15bps and +10bps intraday). In the chart below (source: Bloomberg) we can clearly visualize the point we have been making, namely, that the strong Euro is is pushing Greece towards restructuring/default (Euro in orange, 5-yr Greece’s credit default swap in white):

This leads us to take a contrarian view with the rally in Euro stocks we saw yesterday, which is no fun for us. However, in our opinion the ECB took the wrong path, which eventually, if not amended by the EFSF (whose future is decided on Mar 23-24 by the EU Council), will end in tears, with a run against banks in the periphery of Europe.

Does it make sense to see US stocks rallying? Only if it represented a global reallocation, which we doubt. The short-term myopic perspective seems to be that since a major central bank is raising rates to stop inflation, growth is around the corner and therefore, higher valuations are justified. This is however a view that totally dismisses the solvency problems of the sovereigns of every country on Earth.

When does will this end? When we see the first relevant default, be it corporate or sovereign. If corporate, a default led by margin compression driven by inflation (i.e. company has higher costs which cannot pass on to customers) will be catch everyone’s attention…

Martin Sibileau