May 21, 2012

Rebellion Against Austerity From Greece To Washington

Posted in Economy, Europe, government, greece, investment banking, investments, QE3, recession, Uncategorized tagged , , , , , , , , , , , , , at 10:38 PM by Robert Barone

Since the initial euro crisis erupted in Greece two years ago, I have speculated that the necessary move toward austerity would be sidetracked by a political response from the impacted populations, which would elect leaders who promised a move away from such austerity. I didn’t realize how rapid and rabid the response would be.
 
The table below shows a list of headline anti-austerity movements, and, yes, I’ve included such movements in the U.S.
 
Country
Anti-Austerity Development
France The May 6th election of Hollande, a leader who promised more government spending, higher taxes and a reduction in the retirement age, at a time when budget deficits and austerity are key issues.
Greece Greek voters flocked to anti-austerity parties during the May 6th elections, stoking concern in Europe that austerity may be derailed.
Ireland Sentiment has turned sour on austerity with elections scheduled this spring.
Argentina Nationalization of Spanish owner Repsol’s (REP) 51% stake in YPF (YPF), a major oil producer.
Bolivia Seizure of Spanish power grid operator Red Electrica’s (REE.MC) 57% ownership of a Bolivian power line company which controlled 85% of the power lines in the country.
Spain Inability (or lack of determination) to meet promised austerity targets.
U.S. Political attack on the so-called wealthy and on cash rich corporations for not paying their “fair share” of taxes, in order to keep from having to cut spending.
 
Much of the backlash is occurring because governments can no longer fulfill the promises made, whether they be in transfer payments, services, or salaries and benefits, etc., due to shortfall of revenue and a remarkable growth in public debt burdens. As is clear now, it is one thing for politicians to talk about austerity, and another to live with the immediate consequences, often resulting in higher unemployment and recession.
 
Europe
 
Naturally, the hotbed of anti-austerity is Europe where they have long lived the entitlement life. Europe is clearly in recession, and it appears that it will be a long and deep one. The latest data from Europe shows that the Purchasing Managers’ Index (PMI) for March was 43.8 (where 50 is the line of demarcation between contraction and expansion). In Spain, now officially in recession, the PMI was 43.5, and in depression wracked Greece, it is 40.7. The manufacturing indexes in Europe are also contracting. The manufacturing PMI in France in March was 46.9, and even in mighty Germany, the manufacturing index was 46.2.
 
Spain’s unemployment rate is over 24%; Greece’s more than 21%. In Europe, the number of unemployed stands at 17.4 million, an increase of more than 1.7 million in the past year. The official unemployment rate in the European Union will soon surpass 11%. So, it isn’t any wonder that those politicians that have adopted the Robin Hood approach have gained populist support. After all, politics are politics – and populations used to entitlements naturally vote for candidates that promise to give them something, usually by taking it away from someone else.
 
When the European Central Bank (ECB) embarked upon its Long Term Refunding Operations (LTRO1 and LTRO2), which gave all European banks access to 1% money for 3 years in order to stave off a rapidly approaching financial crisis in those banks, there was an unwritten quid pro quo. The bargain was the liquidity to stave off the financial crisis, and, in return, the member countries would have to embark upon a path of fiscal reform–austerity–that is now being unwound.
 
The question is, will the ECB continue along this money printing path to stave off the next phase of the financial crisis if the member countries have shunned their part of the bargain? Or, will the new and emerging concept of a European “growth pact” give the ECB the political cover it needs to continue printing. I suspect the latter.
 
The concept of a “growth pact” is nothing new to Europe. Austerity in the ’90s morphed into the “Stability and Growth Pact” (SGP), and it appears to be doing so again. The idea is to have the economy “grow” so that tax collections rise and deficits are reduced. Who can oppose that idea? Unfortunately, there is little that the European governments can do pro-actively to spur such growth.
 
The best thing would be to get out of the way of the private sector, but such ideas are anathema. Nevertheless, the Keynesian hope is that more deficit stimulus and more money printing with less austerity will prove to be the cure. I doubt this approach will be anything more than further can kicking. Furthermore, it is a dangerous game, especially in the hands of politicians, because even the “growth pact” still demands discipline in the budget and spending process.
 
In Greece, no government has been formed from the May 6th election results which pits polar opposite political views among the highest vote getters. The leader of the party with the second most votes ran on a platform to renege on the austerity agreements already in place with the external financing partners, to raise public pension payments and salaries, etc. And that leader seems to have gained even more popularity for the upcoming June elections. At current spending rates, Greece will run out of funds to pay its obligations by the end of June. And, it will be up to the Troika (European Commission, European Central Bank, and International Monetary Fund) to determine if Greece will get its next tranche of external financing (i.e., loans).
 
It appears that Europe is moving perilously closer to financial chaos. A Greek default on its external debt could easily result in a disorderly withdrawal from the EMU (European Monetary Union), which could trigger worldwide financial instability. Imagine if you were a Greek citizen and you woke up one morning to find that the euros in your local bank had been converted to new drachmas on a 1:1 basis. Later that day you discover that your new drachmas are worth substantially less than the euros you had yesterday. People aren’t dumb. Over the past few months, we have observed, through the borrowings at the ECB, a growing silent run on European banks in the at-risk countries (Spain, Italy). Italy even limited the amount of cash a bank can give its clients. And now, there is an outright run on Greek Banks.A Greek dismissal or withdrawal from the EMU along with its default on external debt is likely to trigger massive outright runs on Spanish, Italian and other weak European banks. The domino effects of this are unknown – all the way from other weak EMU partners electing the Greek path to a complete implosion of the EMU. The impacts will be worldwide. Expect volatility in markets and significant U.S. dollar strength.

 
The Americas
 
The U.S. isn’t too far behind Europe in the entitlement game as it has caught up rapidly over the past decade. But, in the U.S., the anti-austerity movement has taken a slightly different track. The ploy here is to avoid the basic issue of federal government overspending, over indebtedness and over promises. So, the greedy and evil corporations, which “evade” just and fair taxes, are blamed for the deficit because they refuse to pay their “fair share.” And those same corporations that “hoard” cash are responsible for lack of job growth because they won’t spend and invest those cash hoards.
 
The simple truth is that Apple (AAPL), Microsoft (MSFT), Wal-Mart (WMT), and all of the others are simply playing the tax game that was written and is orchestrated by none other than the politicians themselves. In what remains of our capitalist system, corporate managers are supposed to maximize profits, and one doesn’t do that without uncovering every dollar-saving loophole written into the tax code.
 
As for the cash, much of it remains offshore because it would be taxed if brought back. But it remains unused because of the ongoing uncertainties today’s politicians have imposed. No tax law is now permanent or at least has a long enough life for corporate managers to make prudent investment decisions. Most have a one or two year life (Bush tax cut extensions, payroll tax reduction, depreciation laws, etc.). Without some certainty about the tax code, about deficits, or about the cost of energy, those cash hoards simply won’t be invested – at least not in the U.S or other slow growth industrial countries.
 
This rhetoric is really a diversion from the real issue of too much debt, unsustainable deficits, and living beyond our means. The size of government is being addressed at most state and local levels (even by Jerry Brown in California, but definitely not at the federal level.
 
Unfortunately, the movement away from austerity either prolongs the crisis, or makes it ultimately worse. In Bolivia, the series of nationalizations that began in ’06 (natural gas fields) are now causing capital formation issues. The gas wells are producing less, as is the normal course for such wells, but there is no internal capital for new exploration (all the capital that could, fled long ago), and foreign capital simply won’t go there based upon the last six years of political behavior and private sector confiscation (besides Bolivia, the other Latin American countries with extreme left wing governments are Venezuela, Argentina, Ecuador, and Nicaragua).
 
As is evident in places like Bolivia and Venezuela, the move away from austerity via class warfare, confiscation, and nationalizations only prolongs the economic problems, usually making them far worse than the original austerity would have imposed.
 
Conclusion
 
The point is, “taxing the rich,” attacking successful corporations, nationalizing industries, or simply allowing government to pick the winners and the losers does nothing to create economic growth or jobs. It does just the opposite. Austerity, in some form, is necessary to pay back the over borrowing and over consuming of the past. There is no way around it.
 
Printing more money, running high deficits and taxing the productive members of society will not fix the growth and jobs issues. Rejecting the necessary austerity will just exacerbate the problem(s) or shift the burdens to other unsuspecting citizens, like seniors, retirees, or onto future generations through high or hyper inflation.
 
Erskine Bowles, a Democrat, co-chair of President Obama’s Commission on Fiscal Responsibility and Reform, and co-author of the Simpson-Bowles fiscal plan said this to the Council on Foreign Relations on April 24th:
 
Without serious debt reduction, it won’t take much of an increase in interest rates to create a fiscal crisis for the country the likes of which only those who lived through the Great Depression can recall. Once interest rates reach a level that reflects the genuine risk inherent in our ongoing fiscal mismanagement, and debt service eats up more and more of a shrinking pie, the financial crisis we just lived through (and are still living through) will seem like a sideshow… Deficits are truly like a cancer and over time they are going to destroy our country from within.
 
Most industrial countries with large fiscal deficits have a choice between something bad (austerity now) and something awful (high inflation, hyperinflation, social upheaval, or worse). While no one likes austerity, the consequences of choosing to kick the can further down the road are much worse. Yet, that is clearly what is happening with likely dire financial consequences, perhaps as soon as Greece formally defaults. Nonetheless, at this particular moment, “austerity” has become just another dirty word.
 
Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.  Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
 
Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

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March 15, 2012

Markets Hooked On Liquidity Drug From Central Bank Pushers

Posted in Banking, Ben Bernanke, CDS, Economy, Europe, Federal Reserve, Finance, Foreign, government, investment banking, investments, ISDA, QE3, recession, sovereign debt, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , at 10:04 PM by Robert Barone

From early last October to the end of last month, the S&P 500 rose 25%; amazing for an economy that is struggling to stay out of recession.  Then again, the equity markets are hooked on the liquidity drug.

When Federal Reserve Chairman Ben Bernanke, in his recent semi-annual testimony before Congress, did not hint that QE3 was just around the corner, the market sold off.  When the European Central Bank broke its traditional role as lender of last resort and morphed into a gift giver to its member banks (to the tune of more than a trillion dollars), much like our Fed, the equity markets soared.

Money printing can’t go on forever, can it?

In every historical context, whenever the equity markets have a run up not based on economic fundamentals, eventually, they return to what those fundamentals dictate.  And here are some of the underlying economics:

  • There is no doubt that American manufacturing is undergoing a renaissance.  Labor costs in Asia are on a steep rise while wages here have been stagnant for several years.  Shipping costs, quality control and culture are other factors.  But, manufacturing represents less than 12% of GDP.  It, alone, cannot drive significant economic growth.
  • Gasoline prices are up more than $.60/gallon year to date with talk of $4.50 gas by summer. That cost/gallon is already here in some markets. Every penny increase drains $1.5 billion annually from other consumer discretionary spending.  That’s about $90 billion so far for 2012.  And what happens to gas prices if the Middle East flares up again?
  • While the first quarter is far from over, early data suggest a much softer than expected GDP.  Retail sales have been soft except for automobiles (pent-up demand or just a rush to buy fuel efficient vehicles ?).  Consumers (70% of GDP) have shown no real income growth for many quarters, and incomes are tumbling in Europe.  Inventories appear to be on the high side given the level of demand.  So additional production won’t be forthcoming.
  • Despite a reinstitution of 100% depreciation for capital equipment, much of that demand was pulled into 2011, as the business community was uncertain as to whether or not the tax break was going to be reinstated in 2012.    The state and local government sector is still in contraction, and, given the slowdown evident in the rest of the world, exports aren’t likely to add to GDP.  Of course, the market may like the softer side of GDP, as it likely ensures another dose of the liquidity drug from the money czar, Bernanke, the king of money printing.
  • Europe is sicker than the markets have priced in.  The hoopla around the Greek bailout is just another can kicking.  Because the Greek populace hasn’t accepted the idea that they have lived beyond their means for the past decade, austerity won’t be successful.  Politicians who promise to end the austerity are likely to be elected.  Eventually, Greece will need to have their own currency which can fluctuate in value vis a vis other currencies with commensurate interest rate levels.
  • It is rare that all of Europe is in recession at the same time.  The current market expectation is that Europe’s recession will be mild.  But, don’t forget, Germany’s biggest export clients are other European countries.  In fact, as a general rule, all of Europe’s economies export heavily to each other.  Being in recession together is going to have a large impact on those exports.  In addition, if the Euro remains at its current lofty level (above $1.30), it will be more difficult to export to non-EU countries.
  • The determination by the ISDA (International Swaps and Derivatives Association) that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns (Portugal, Spain, Italy, Ireland) because it assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with Credit Default Swaps (CDS) and a Greek style default occurs, they will be paid at or near par value.  If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries.  In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
  • This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain (debt > $1 trillion) and/or Italy (debt> $2 trillion) default.  In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie.  While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.  After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries.  And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.
  • But even ignoring Greece for the short term, the ECB’s LTRO 1 and 2 appear to make Europe’s banks even more vulnerable.  Unlike the Fed, which purchased questionable assets from bank balance sheets and put them on its own, the ECB has not followed suit.  In fact, it stepped in and, by force majeure, inserted itself as senior to other bondholders holding the exact same Greek bonds, thus avoiding any losses in its own portfolio.  That makes losses for the private sector even greater.  Worse, it sours potential investors in European sovereign debt, seeing that they cannot easily quantify their risks as they can’t know how much of the same sovereign debt they own may be owned by the ECB.  This partially reverses the positive impact that the triggering of the CDS default will have on the European sovereign debt market.
  • Finally, the LTROs may make European banks even more insolvent than they are now, as they have been encouraged to take the cheap ECB funding and purchase European sovereigns for the interest spread (by Basle II and III rules, the debt of the European sovereigns is “riskless” and requires no capital backing on a bank’s balance sheet)!  Further sovereign debt crises, e.g., Portugal, Spain, or Italy, will eat away at already scarce European bank capital.  Contagion could very well result.

Looking at the GDP of Europe relative to China, if one includes all of the European Union countries and those closely related, Europe’s economy is about twice the size of China.  If China’s GDP growth went from 9% to 3%, the equity markets would certainly have a huge sell off.  But, it is likely that Europe’s GDP will fall from about 1.5% in 2011 to -1.5% in 2012, maybe even more than that.  Do the math!  This is equivalent to a Chinese hard landing.  As the European recession unfolds, the equity markets are likely to wake up.

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Speaking of China, a slowdown is clearly developing.  They actually ran a trade deficit for the first two months of 2012 signaling a real slowdown in exports.  Retail sales have been softer than expected and the real estate bubble there appears to be in the process of popping as property sales and prices are plunging.  No wonder the government recently lowered its official growth forecast from 8% to 7.5%.  This is not to say that China, itself, is entering a recession, but a slower growth rate there (2nd largest economy) in combination with growth issues in the US (largest economy), Japan (3rd largest), and a significant recession in Europe bodes ill for worldwide growth and will eventually play out in the equity markets.

The profit implications for multinational corporations of the severe recession in Europe, and a slowdown in China and elsewhere are significant.  Analysts have continued to forecast rapid earnings growth and high profit margins even in the face of rising energy and food costs and stagnant U.S. and falling European incomes.  Using such rosy profit forecasts makes the market look undervalued.  However, a 15% – 20% profit decline is normal for a recessionary world.  If you plug that in, the equity markets look overvalued today.

Wasn’t it somewhere around this time last year that the equity markets were also priced for perfection?  Didn’t we hear that the economy had achieved “escape” velocity and that the recovery was about to accelerate?  And, didn’t the market sink when the economy fizzled and needed the QE2 liquidity drug injection?  In fact, the S&P 500 ended 2011 at exactly the point where it began, with a lot of volatility in between.  So far, 2012 appears to be following 2011′s path.

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.

Statistics and other information have been compiled from various sources. Universal Value  Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United   States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

Robert Barone (Ph.D., Economics, GeorgetownUniversity) is a Principal of Universal Value Advisors (UVA),Reno,NV, an SEC Registered Investment Advisor.  Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. 

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy.  A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at:9222 Prototype Dr.,Reno,NV 89521.  Ph: (775) 284-7778.