FYI | Jul 13 2011
GaveKal offered the following observations this week: For the past few months, we have argued that the international liquidity environment is deteriorating and that markets have started to behave as if a liquidity crisis was unfolding: from the growing spate of corporate scandals, to the sudden devaluation of small currencies (Belarus, Maldives, Kenya…) to the recent outperformance of the most visible US$ cash-generating assets (US Treasuries, US utilities, US healthcare and staples…). These are all signs pointing to a growing scarcity of cash, at least outside of the US. This reality led us to whip out our old analogy that liquidity crises are like dynamite fishing: throw a stick of dynamite in the sea and at first only the "little fish" come up (whether Sino-Forest, or the Belarus Ruble…). Months later (typically in the period between August and October when the demands for cash are seasonally more acute), the "whales" float to the surface.
Given recent developments (brutal plunges in Italian bank shares, new highs on Italian spreads, etc.), we are forced to return to the question of whether the "whale" might be Italy. As our more faithful readers might remember, this was an issue we touched on in our early 2008 book entitled A Roadmap for Troubling Times. Specifically, with its EUR1.6trn of debt, Italy is, unlike Greece, Ireland or Portugal, way "too big to bail." Even more troubling, Italy is in trouble despite the fact that, as Francois argued in The Italian Job, the country has, to some extent, already done a lot of the hard reforms (e.g., pension reform, industry deregulation…) that the EU/IMF/ECB troika is now imposing on Greece and Portugal. Of course, more could still be done, and Italy, in a bid to placate the markets, will likely announce new measures in the coming weeks. But given the nasty turn that events are taking, and the deterioration in the international liquidity environment, will this be enough? Instead, the market now seems more likely to focus on the fact that, despite implementing some reforms, Italy is struggling ever more to compete on the global stage.
If recent market trends gather momentum, then the euro's moment of truth will rapidly be upon us and European policymakers will have to chose between a major expansion of federalism and the launch of pan-European bonds jointly guaranteed by the various sovereigns (Anatole's scenario), or debt restructuring for the growing number of countries that find themselves shut out of international bond markets (Charles' scenario). Needless to say, one very serious complicating factor is that voters have very little interest in the first solution; and if it is adopted "by force," the reaction of voters may turn out to be violent. For example, as the French presidential electoral season gets closers, a nightmare scenario with a second round pitting Marianne Le Pen (nationalist, protectionist and anti-Euro) against Jean-Luc Melenchon (hard-left, protectionist and anti-Euro) may no longer be complete science-fiction…
The coming three months are thus likely to be very important to the euro's survival. Simply put, the market is increasingly indicating that it is losing patience with policymakers' attempts at fudging answers. Of course, as Charles has argued incessantly, Europe's policymakers may have little choice but to "fudge" because the solutions to the euro dilemma are no more feasible than the solutions to fix the Soviet Union in 1990; when technocrats have built a system that cannot work, we perhaps should not be surprised when it implodes. As this becomes ever clearer, we continue to believe that unlevered assets generating stable cash flows in US$ should be overweighted, and that there are few reasons to expand risk aggressively.
The above expressed views are GaveKal's, not FNArena's (see our disclaimer). All copyright GaveKal.
GaveKal is a financial services firm that offers institutional investors and high net worth individuals fund management, independent research on global macro-economic trends and events, and independent advisory work on China and its impact on the global economy.
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