Felix Zulauf on the inevitability of further crisis in Europe
Felix Zulauf spoke to Barron’s Alan Abelson about his thoughts on the European sovereign debt crisis now that Greece has received its second 100 billion euro bailout. Here’s what Abelson says about the conversation:
We’ll turn our focus on the latest Greek bailout project. And here we’re lucky because we managed to enlist our old friend and Roundtable regular Felix Zulauf to guide us from his perch in Switzerland…
The rescue blueprint is supposed to provide Greece with financing through 2014…
In other words, as Felix puts it, the banks will take a hit of €50 billion over three years (around 21% of their original investment), while the EFSF and the IMF supply the rest. The bailout blueprint avoids for the time being default and escalating contagion, but in Felix’s view it does zilch to ameliorate the causes of Greece’s (or anybody else’s) fiscal woes. "The politicians," he explains, with only the vaguest of smirks, "obviously believe that the world will get back to good growth and great tax revenues" and the problems will vanish. Which, not surprisingly, he sees as pure, unadulterated hogwash…
The banks of the peripheral members are suffering from what he calls "a slow-motion bank run." To make matters worse, the governments of the peripherals have imposed fiscal austerity, which he expects, will plunge their economies back into recession by the time the fourth quarter rolls around.
In the short run, Felix says, the plan, as we’ve seen, allows investors to exhale and markets to rally. But once the touch of euphoria plays itself out, the omens are anything but bright.
Thanks to the decision to once more bail out Greece, equity markets, he concludes, may rally and U.S. shares might even reach new highs in the next two to four weeks. But, avers Felix, stocks are moving in a different direction than the sluggish underlining economies. He compares the situation to a fully loaded plane flying too low and at slowing speed. "Under such circumstances," he warns, "all sorts of unpleasant surprises usually arrive."
I think that’s exactly right. As Zulauf points out in a part of the interview not quoted above, not only is fiscal policy restrictive, so too is monetary policy in the euro zone. Two weeks ago I said the Eurozone sovereign debt crisis was at a critical point and outlined how I saw this going moving forward.
“eventually, after living in a constant state of stress, we will get hard restructuring and full monetisation i.e. rate easing. It’s either this or a full-blown collapse of the single currency, something that will require a lot more stress than we have seen to date.”
But, let me add in a few words here now that the second Greek bailout has been announced. Like Zulauf, I believe what the European Greek debt deal means is some temporary relief in European debt and equity markets. “This step is positive. It will calm markets – for how long is anybody’s guess.” It could be a day or it could be two months.
But, clearly we are already living in a constant state of stress. This is a rolling crisis wave through the eurozone infecting more countries, closer and closer to the core. As Marshall wrote recently, this is a structural problem. All of the euro zone countries face liquidity constraints and all of them will eventually succumb to the rolling wave of yield spikes one by one until we get a systemic solution: full monetisation and union or break up.
Think back to the origins of this crisis with Dubai World in November 2009. The month before, Greece and Portugal were downgraded. And because of low nominal yields in Europe, permanent zero in the US and unbelievably low yields elsewhere, the risk on trade made these bonds look attractive to some in the liquidity seeking return crowd. Investors piled in to take advantage of the 12-year high 146bps spread to Bunds offered by Portuguese debt.
But, prudent investors were avoiding these bonds because they knew that stocks and bonds were being artificially buoyed by an increased risk appetite driven by low interest rates. Then came Dubai World and it was immediately apparent that Greece was going to be affected. The Europeans had a good half-year to get things sorted on Greece before things spiralled wildly out of control. As far back as April 2010 readers here were saying that Greece would eventually default. That tells you something.
My conclusion, therefore, is that while the pressure is off temporarily, Greece will eventually default and restructure their existing debt. Their gross debt and interest levels are too high. And the deficit level cannot be closed without a civil revolt or a collapse of the economy. Moreover, given that the new facilities are senior to the existing debt, the loss of principal, which S&P previously gauged to be 30-50%, will be much higher, say 50-70%. So, huge losses are eventually coming on Greek sovereign debt. The question is when.
But what about contagion? Greece is small, but so was Thailand when it precipitated the Asian Crisis – which eventually brought much of Emerging Market (EM) Asia as well as Russia and Argentina. Once the sovereign default genie is out of the bottle, markets will be stressed until countries can demonstrate clearly that they will not default. So beyond, Greece, the questions go to the rest of the Eurozone and to EM sovereign debt as well.
And that is how it has proceeded. Greek yields blew up and went parabolic and never came down again. Meanwhile the crisis rolled into Portugal and Ireland. Their yields were already in stress. But they then went parabolic soon after the Greek bailout was final. Eventually Portugal and Ireland succumbed and were forced into bailouts. Meanwhile crisis rolled into Spain and Italy and those countries have been in a permanent state of stress since. Felix Zulauf even warned that Italy was next two months ago. And we all know the bailout provisions are not large enough to handle either Spain or Italy individually.
Rebecca WIlder of News N Economics sent me this chart of Italy’s spread to Germany. Notice the gaps up in yield, the basing when bailouts are announced , followed by renewed gapping up. That speaks to the permanent state of stress and the rolling wave I am describing.
My expectation is that Spain and Italy will be perceived as the new Ireland and Portugal, meaning they will now be stressed permanently – the spread to bunds will be permanently elevated at levels that are almost unsustainable for economic growth. The right way to deal with this is for the ECB (not the under-powered EFSF) to provide liquidity. Earlier, I suggested the ECB targeting the Italian-Bund spread at 200bps would be an effective way to go about this. But given the politics of the matter, that will never happen.
So we are going to get another crisis flare. What you need is a trigger for a gap up move in yields that would signal the next flaring of the crisis. The trigger and its timing are unknown, but the crisis they will precipitate is inevitable until the euro zone’s structural deficits are dealt with. As this is a rolling crisis, any gap up will also infect Belgium and France and potentially Austria.
My hope is that Europe moves to address the medium- and long-term issues before the crisis flares. However, I don’t anticipate they will.
Source: Back From the Brink – Alan Abelson, Barron’s