INTERNATIONAL. One of our central premises during this EU debt crisis has been that it will only end when we have a ‘Meeting of the Cardinals’, a meeting of key EU players once the crisis reaches a critical phase that results in a dramatic restructuring of Europe.
This is a theme we introduced in our Outrageous Predictions for 2012. The meeting could happen sooner rather than later as Europe is painfully divided into the economic camps of North versus South and the political camps of Club Med versus Merkel.
We are now nearing the point of no return for Europe. Time is running out as higher capital costs for Club Med combined with no lending and capital flight increases the odds of a need for a true crisis summit meeting sooner rather than later. Europe’s internal differences have never been more irreconcilable.
The gang of five (Draghi, Barroso, Monti, Rajoy and Hollande) is trying to force Germany to accept a pooling of debt, but the Hollande plan is always based on others paying.
Meanwhile, in France he is merely extending-and-pretending that he can deliver on his socialist agenda without any need for structural reforms.
To illustrate how out of touch the concept of “Germany paying is” let’s look at some round numbers:
• Germany’s GDP: EUR 3.2 trillion
• Deleveraging of European banks over next five years (IMF): EUR 5.0 trillion
• Balance sheet of banks in Europe: EUR 33.0 trillion, or about 300% of Euro Zone’s GDP
• ECB Balance sheet: EUR 4.0 trillion
The magnitude of this debt crisis is far larger than the market realizes, and in fact is so big that there is no real solution as imagined by either side of the north/south divide. The idea that it’s merely a question of Germany paying is not only naïve, but also impossible. They cannot and they should not.
And we can all forget the silly notion that the ECB is the only solution to this debt crisis.
There is only one solution: the system must fail and the Euro and the EU needs to be redefined. Let’s be clear that the German plan is nowhere perfect, but it is conceptually the right way. We can’t solve this by taking short-cuts to a banking union when there is no political or fiscal union.
The reason Europe is going up in flames economically is the lack of accountability on behalf of policy makers and politicians. Giving them more rope to hang themselves via extend-and-pretend measures is not the path forward.
Over the next few days we will have the inevitable song-and-dance from the EU, and yesterday Van Rompuy leaked his “game changing plan for Europe” to the Financial Times. I think the headline speaks for itself: Van Rompuy scales back Eurozone plan – as per usual it was all talk and no substance. Extend-and-pretend squared.
I note that since my piece: Is Merkel misinterpreted, the German government and its officials, including the Bundesbank, have made it absolutely clear to the Club Med that she is in no position to give up on the fiscal compact and strict adherence to the EU Treaty and ECB’s mandate.
Overall the problem is more with Hollande and France than with Germany. Hollande has again and again stated: “There can be no transfer of sovereignty if there is no improvement in solidarity”.
Consider that Hollande is running a country with no growth, massive fiscal deficit and the lowest pension age in Europe – the pinnacle of Entitlement Europe.
Hollande has managed to change J.F Kennedy’s famous inauguration speech 180 degrees: For France and Club Med the speech now reads: “Ask not what you can do for Europe: ask what Germany can do for you”.
As Simon Nixon writes in his WSJ piece: France is the main obstacle to a Euro Solution: “France has always been reluctant to cede sovereignty to the European Union. To create a fiscal and banking union without a political union would multiply the original mistakes in the creation of the monetary union. And there is one country that has historically said “non” to the transfers of sovereignty that put the Euro Zone on a long-term stable footing: France
How is France going to “back down” from here if Germany stands firm? France’s self-image is one of power and influence, but the more France is relying on help from the German friends or ECB the more likely it is they will lose power. You can’t be borrower or beneficiary of help and name the conditions. Take your pick, Hollande.
Hence even for France the ultimate and best solution is to go the German way. Yes, they will lose face, but they will do so anyway as the Hollande plan is a non-starter and as such bound to fail and only lead to lower growth and higher unemployment. Maybe someone should point out to Hollande that The Third Way introduced by Bill Clinton and finessed by Tony Blair never really worked?
There are two ways this summit can go down: Either Germany gives up and takes all of Europe with it in a tail-spin of ever lower credit ratings and higher funding costs as the systemic risk for the entire EU climbs higher and higher on the lack of common sense from Germany and the final abandoment of what should have been a cornerstone of the EU - the stability and growth pact. Or: France gives up and Hollande will be the President who forced France to transform its own self-image.
I do not see either France or Germany giving up but remember in the context of Europe we have been here before: After the Delors Committee report in 1989 there was long and extensive negotiation between mainly Kohl and Mitterand on when the Euro should start.
Germany wanted everyone to be inside the convergence criteria first, but in the end France won a concession in 1991 that the European Monetary Union would start January 1999 regardless of the degree of convergence. This was a mistake by Germany (and France) as it is the very reason the Club Med is in trouble – they never really qualified. I think Germany remembers this and has learned from it.
We now have a Mexican stand-off. How do we move on from here? I see three possibilities:
• Meeting of the Cardinals – 40 per cent probability
• Extend-and-pretend Squared – 40 per cent probability
• Doom-and-Gloom - 20 per cent
The Meeting of the Cardinals will be the only orderly solution dictated by rational and practical solutions. Some countries need to leave the EUR, whether permanently or temporarily.
Here, the guinea pig will most likely be Greece. This will force Club Med to the table and make them accept further loss of sovereignty on fiscal- and monetary policy, most likely in a German model where the European Court of Justice becomes the highest ranking authority.
The lead-in to the Meeting of the Cardinals (MoC) will be a negative market reaction but it will trigger the final phase of our three phase crisis model (Denial, Protest and Mandate for Change). Inside the mandate for change there is a V-shaped recovery when reforms are initiated from the low point, so for investors, the MoC is the best solution and could lead to several years of prosperity and lead us to the better returns for equities, which right now have been declared dead by most media.
Extend-and-pretend squared. The reason for “squared” is that we have done this for so long that the impact will be more negative and the upside when doing more QE and LTRO will be shorter and less potent, probably even counterproductive. No one in their right mind believes lower interest rates will solve anything.
The market clearly knows that to deal with solvency someone needs to take a loss – not get more debt. As governments and the ECB get more desperate in Q3 and Q4 they will initiate more of their unconventional measures, but the impact will fizzle away as quickly as the English dreams of winning the European football championship.
Doom-and-gloom. This is the concept that there are no good solutions to this crisis. We are trained/educated to think there is always a solution to a problem, but we have been doing this for so long and we are out of time. If there is a complete impasse, the only immediate path left will be a “Destruction of Capital” in the good old Joseph Schumpeter sense. The forest fire of deleveraging that cleans the slate.
In this scenario, markets will retest their 2009 lows and there will be a deep rooted discontentment with politics and the banking system, which could even lead to social unrest and worse.
I do not see an initially positive outcome for any of the above scenarios. We are primed for a summer of discontent in Europe and even if I am wrong, and Germany caves in, the reaction will be a maximum of 10 per cent on the upside before the market realizes that this is again merely extending-and-pretending, not the first step towards a better stronger Europe. The investors I talk to whose opinion and insights I value the most feel that:
• Credit getting expensive, although it’s still the most tempting asset.
• EMG pricing is a story of overvaluation and over-projection of a positive bias
• Stocks – fairly priced, but still with no outlook for improvement in earnings or momentum
• No end in sight for the EU debt crisis
• A US fiscal cliff that is growing ever larger
• China real growth is closer to 5-6% than 7-8%
Basically, there is no value for stocks, bonds or commodities in this environment as there is no appetite. The appetite has been dulled by the inability of policy makers to come up with simple credible solutions rather than non-plans and empty promises.
The summer of discontent will be the result and the market could be under pressure all the way into August, at which time Greece may be on the brink together with Spain and Italy as inaction is not an option.
The markets are finally calling the policy makers’ bluff – time is ripe for reforms, not more talk.
About Steen Jakobsen
Steen Jakobsen was appointed to the position of Saxo Bank’s Chief Economist in March 2011.Mr. Jakobsen returned to the Bank after two years’ absence. During that time he has been Chief Investment Officer for Limus Capital Partners. Prior to his departure in early 2009, Mr. Jakobsen was with Saxo Bank for almost nine years as Chief Investment Officer.
Mr. Jakobsen has more than 20+ years of experience within the fields of proprietary trading and alternative investment. In 1989, after finishing his studies in Economics at Copenhagen University, he started his career at Citibank N.A. Copenhagen from where he moved to Hafnia Merchant Bank as Director, Head of Sales and Options.
In 1992, he joined Chase Manhattan in London as VP, Head of Scandinavian Sales, and then the Chase Manhattan Proprietary Trading Group. 1995-1997 he worked as a Proprietary Trader and Head of Flow Desk at Swiss Bank Corp., London. In 1997, he became Global Head of Trading, FX and Options at Christiania (now Nordea) in New York until he joined UBS in New York in 1999 as the Executive Director in the Global Proprietary Trading Group.