Market Overview 27/10/11 - 'The Plan'

On Thursday 27th October, markets worldwide rallied strongly on news that a 'comprehensive package' was established, designed to protect the Euro zone from the vast systemic threats currently knocking on the door of the global economy.  I for one am delighted with this progress and thrilled to be writing on more positive terms for the first time in a while.  Before we get to the charts, let's take a look at the headlines:

• Banks to take a 'voluntary' (forced) write down of 50% their exposure to Greek debt.
• EFSF to be leveraged to the value of €1tn (NB - Not the €1.8tn needed to support Italy in the event of a default.)

The Economist Newspaper offers further detail (albeit rather critical) on the leverage of the EFSF:

"Unfortunately the euro zone’s firewall is the weakest part of the deal (see article). Europe’s main rescue fund, the European Financial Stability Facility (EFSF), does not have enough money to withstand a run on Italy and Spain. Germany and the European Central Bank (ECB) have ruled out the only source of unlimited support: the central bank itself. The euro zone’s northern creditor governments have refused to put more of their own money into the pot. 


 Instead they have come up with two schemes to stretch the EFSF. One is to use it to insure the first losses if any new bonds are written down. In theory, this means that the rescue fund’s power could be magnified several times. But in practice, such “credit enhancement” may not yield much. Bond markets may be suspicious of guarantees made by countries that would themselves be vulnerable if their over-indebted neighbours suffered turmoil.

Under the second scheme, the EFSF would create a set of special-purpose vehicles financed by other investors, including sovereign-wealth funds. Again, there are reasons to doubt whether this will work. Each vehicle seems to be dedicated to a single country, so risk is not spread. And why should China or Brazil invest a lot in them when Germany is holding back from putting in more money?


Together, these schemes are supposed to extend the value of the EFSF to €1 trillion ($1.4 trillion) or more. Sadly, that looks more like an aspiration than a prediction. And because the EFSF bears the first losses, its capital is at greater risk of being wiped out than under a loan programme."  (Full article here) 


This was where the news had greatest impact:"

Above:  Equity Indices in Europe open strongly and continue to gain momentum over the next 24 hours. 

The Euro breaks through 1.4 against the dollar and support forms just under 1.42.

Banks with exposure to Greek debt encounter huge gains.  Soc Gen up c20% yesterday.

Risk on currencies such as the CAD and AUD strengthened as investors exited 'safe havens.'

Outcome of European Summit (pt.2/?)

So, 8 days have passed and once again our European 'leaders' convene.  As I predicted last week, today's summit returned little progress towards finding a solution to the many problems now facing the Euro zone (and as a result, the global economy).  To emphasise on the all too familiar 'kicking the can down the road' demeanour governors appear to be adopting, it has been announced that final decisions will now be deferred until a second summit on Wednesday 26th (stay tuned for pt.3)

Given nothing was achieved this weekend, lets take a snapshot glance at what was discussed:

• Sarkozy backed down to German opposition to use unlimited European Central Bank funds to fight the crisis.  (As a result, the Euro zone may turn to emerging economies for bond market support.)
• It probably wouldn't hurt at this stage to examine an updated perspective of the developing relationship between Germany and France.  Last week the world observed progression as signs of collaboration emerged.  This week, we witness the French bullied out of their ideas.
• Italy comes under pressure to produce a more 'convincing' plan to implement structural reforms within its domestic economy.  Berlusconi to call a cabinet meeting on Monday morning to discuss measures to boost growth.  
• (Excuse my petulant interruption but is this to say that every option to stimulate growth in Italy hasn't already been reviewed by this stage!?)
• Merkel said only two options remained on the table for leveraging the €440 EFSF and neither involved drawing on the ECB. 
• Officials said the emerging solution would combine using the EFSF to provide partial guarantees to buyers of new Italian and Spanish bonds, while also creating a special purpose vehicle (read the at_best analysis on the Special Purpose Vehicle here) to attract funds from major emerging countries that could guarantee bonds in the secondary market (Source: Reuters.) 
• Broad framework drafted for recapitalising European banks - €100-110bn support, €46bn of which was already put aside for bank support in the EU/IMF bailout programs for Ireland, Greece and Portual - the market wanted a figure of around €200bn, instead they got c.€60bn.
• Discrepancy continues as to the value banks must accept on Greek debt write downs.  Banks are citied to have offered 40%, governments are apparently demanding 60%, market consensus is 50%.

So what next?  Monday morning's futures point modestly towards the red which tells me the market had already anticipated much of this disappointment.  It's likely to be a roller coaster ride until Wednesday which in my view will result in further procrastination.  With the Euro hovering at exorbitant highs against the USD, I see huge fundamental downside for those willing to place shorts on little being accomplished this coming week.

Who Owes What?

Continuing on with the contagion theme, this illustration offers a visual plan of the crisis and those participants who stand to lose out if action isn't taken soon.

Mapping the European debt crisis - to enlarge, Click Here (Source: zerohedge.com)

I believe this supports my view that placing short term pressure on France and Germany is undoubtedly progression, but any conjured solution will fail to address the long term problem.

Reuters Bank Stress Test Simulator

A highly recommended model which allows the user to witness the amount of support needed for domestic banking sectors under varying circumstances.

http://graphics.thomsonreuters.com/11/07/BV_STRSTST0711_VF.html

G20 Meeting & European Response

"You have 8 days" G20 Finance Ministers asserted to their European counterparts this weekend, as a lack of agreement on key issues continued and will likely be the talking point of the market on Monday morning.  Below is a summery of key outcomes and targets:

• Pressure mounted on Europe to derive a solution to its snowballing debt crisis to be presented at a continental summit in just 8 days. 
• IMF offer the prospect of wider international support if European lenders deliver on the promises and commit more of their own financial backing. 
• Details to be finalised on a comprehensive plan to recapitalise European banks.
• Europe is to come up with a feasible solution to the Greek debt crisis (haha)
• Details of whether the current EFSF safety net is to be leveraged/increased and to what amount.
• Decision on exact haircut banks will incur on Greek debt (current contribution is 21% as agreed in July).

At a glance, it is immediately obvious Europe have a lot of work to do.  I for one highly doubt the outcome to the European Summit to be held next weekend will satisfy the requests of anybody, let alone the market or G20.  While it's encouraging to witness global pressure finally impose a deadline (or would ultimatum be more appropriate?) there is too much ground to cover in too short of a period of time.  The underlying problem with this current situation is each Euro zone governments responds to bodies of people with different requirements, so reaching an agreement in such a short period of time is unrealistic.  In my view, we will witness a very similar situation to the squabbling which dominated congress around the end of July when the US debt ceiling was under review.  Plans to develop higher levels of fiscal integration within Europe could be what the market is looking for here, but for the same reasons as I mentioned earlier, I believe the chances of this happening are next to none. 

QE2 - The Vessel Designed to Stimulate our Economy

Last Thursday, the Bank of England announced its intention to launch a second round of a highly anticipated project known as quantitative easing (coined QE2 for short).  The market reacted positively to the headline statement; an additional £75bn will be printed, marking a 50% increase on the £50bn consensus.  Before exploring the implications of this news, let us first examine what QE is and why the BoE deem it necessary at this point in time.

Put simply, QE is an unconventional form of monetary policy, where a central bank prints its own currency and buys assets.  In this case, the capital will be used to purchase UK Government Gilts (evenly weighted across all maturities).  The policy has two core objectives:

• Lower the yield on UK Government debt (making borrowing on the money market more affordable.)
• Creating a trickle down effect starting with banks and other financial institutions who vend the assets providing them with more liquidity (and therefore credit) to offer to businesses looking to borrow. 

Essentially, the plan is designed to 'loosen' the pockets of UK businesses, encouraging them to spend their way back to growth.  

The extent to which printing will occur is certainly an issue to be scrupulous of.  In my view, the additional £25bn on market consensus is an elusive reflection of the systemic threat to our economy from Europe (and indeed the rest of the globe).  As discussed in a previous article, Greece has already put tremendous pressure on credit lines and this reaction confirms liquidity in the future could be a serious issue.  Others have also questioned the extent to which inflation (CPI currently at 4.5%) could be a direct outcome of this policy.  Simple supply/demand economics state that if supply increases (in this case, supply of currency), demand will fall (the value of the pound.)  While BoE policy maker Martin Weale insists "evidence shows that QE does support the economy and there is no reason to believe that it feeds directly into inflation without supporting growth," I remain sceptical of his latter point.  The BoE currently anticipate inflation rising above 5% in the short term but dropping heavily below the 2% target in the medium term (primarily next year.) 

So what will be the benefits of this announcement?  First, lets take a glance at the immediate impact.  Directly comparing the FTSE against the Dow Jones (the latter re-based on the morning additional QE was announced) we witness the FTSE making progress:

Although progress on this relatively simplistic chart could be attributable to any factor within the UK, it is fair to say the majority may be attributed to the QE programme.  Looking out to the medium term, not surprisingly, the lasting impact is much harder to predict.  QE1 supported the domestic economy through one of the most potent rises in recent history, the benefits ultimately lasting a year and a half.  The subject of diminishing returns comes into play however and I believe this wave of QE will only be enough for the next 6 months, after which the effect will ease off and essentially we'll be back to reality.  

Except many believe we won't.  Michael Saunders of Citi shares a view fairly indicative of the general consensus on this matter:

"I think it's the right thing to do, I think they will do lots more QE. What is important is they are moving ahead of consensus and that is likely to have a fairly powerful downward effect on yields, which is what they want to achieve. And they will go on doing QE until prospects for the economy improve significantly, or until they own the whole gilt market."

"He said his 'best guess' was the Bank of England would do 300 billion pounds of QE on top of the 200 billion done so far, bringing the cumulative amount to 500 billion. "Today's 75 is part of that 300. But that's only a rough guess and the key point is it is going to come in large scale."

"It's both that the economy is weak but also that the MPC's view is that QE is not a very powerful tool, or rather it takes a large amount of QE to have much effect on the economy. I think that in the markets people don't appreciate that what comes from that is that the MPC will use QE in a very large scale because it is only in very large scale that QE has a notable effect." (uk.reuters.com)

 While I agree this is certainly the right action to be taking at this point in time, my view remains bearish on short term market support at this level.  I believe it is only a matter of time before the systemic threat of Europe starts to dominate market sentiment once again and the market needs more than just a 'promise of a promise' from MerKozy before the FTSE solidifies itself above the 5,400 level.