The most important debate of our lifetimes is now ongoing. For many, the answer will be existential. First, the question: Should the ECB “write the check’ for the euro area national governments? In thinking about the answer to this all-important question, I prefer to shift the focus by changing the verb “should” to “will”.
Answering this slightly different question is much more important than answering the first question for you as an investor, a business person and as a worker. If the ECB writes the check, the economic and market outcomes are vastly different than if they do not. Your personal outlook as an investor, business person or worker will change dramatically for decades to come based upon this one policy choice and how well-prepared for it you are. The right question to ask then is: Will the ECB “write the check’ for the euro area national governments?
To date, my answer to this question has been yes. See, for example, my thoughts on why questioning Italy’s solvency leads inevitably to monetisation and why Investors will buy Italian bonds after ECB monetisation. But what if the ECB doesn’t write the check? What if the ECB let’s Italy default, what then?
Here’s my thinking on that score.
Italian death spiral
Let me start off with what I have previously written from two posts from November 7th.
The euro zone periphery was a sideshow. This stuff with Italy is the real deal. With yields at 6.7% and rising, it’s game over for the euro zone. The extend and pretend stuff ain’t gonna work.
And if you are an investor, this is the moment of truth. Everything – every asset class – depends on how the euro zone performs in the Italian Job. There are only two outcomes, here. If Italy blows up, a Depression is upon us; banks would be insolvent, CDS triggers would implode the system, bank runs would begin, stock markets would crash, and you will would see sovereign debt yields go to unbelievable lows for nations with a lender of last resort. If Italy survives, I would expect a monster rally in periphery debt, stock markets, and bank shares and a selloff in CDS at the minimum. However, the euro zone is already in recession so that rally will not be sustained.
Forget about Berlusconi and austerity in Italy. That’s a sideshow too. Austerity is not going to bring Italian yields back down. These days are over, folks.
Here’s the real problem: Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. That’s never going to happen. So the yields for Italian bonds must come down or Italy is insolvent. More than that, a stressed Italy means a stressed euro zone and a deepening recession with all of the attendant ills that means: Ireland would suddenly start missing deficit targets for example. Bank shares would be under stress, triggering more Dexia’s. So even if Italy limps along at 7 percent yields, we will see a nasty double dip recession and bank failures. And we know that yields will rise. Last November, we were discussing Ireland in the same way with its yields at these levels. Soon, the yield went to 9% and Ireland was forced into a bailout – one that Italy is to big to give.
So we are definitely facing a real financial Armageddon scenario here.
Here’s what I am saying.
- Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. It won’t ever be able to do so.
- Therefore, yields for Italian bonds must come down or Italy is insolvent as it must roll over 300 billion euros of debt in the next year alone.
- Austerity is not going to bring Italian yields back down. First, Italian solvency is now in question and weak hands will sell. Moreover, investors in all sovereign debt now fear that they are unhedged due to the Greek non-default plan worked out in Brussels last month. As Marshall Auerback told me, any money manager with fiduciary responsibility cannot buy Italian debt or any other euro member sovereign debt after this plan.
Conclusion: Italy will face a liquidity-induced insolvency without central bank intervention. Investors will sell Italian bonds and yields will rise as the liquidity crisis becomes a self-fulfilling spiral: higher yields begetting worsening macro fundamentals leading to higher default risk and therefore even higher yields.
Soft depression
I believe the global economy is in a cyclical upturn within a larger depression. Two years ago, I wrote:
… all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
–Credit Writedowns, Oct 2009
Last week I wrote that this is “a soft depression scenario where the countries with a true lender of last resort can backstop without problems.” The problem, however is that the ECB is not a true lender of last resort as we are now seeing.
Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.
–Italy’s debt woes and Germany’s intransigence lead to Depression
Outlining the Armageddon scenario
This is the crucial piece in understanding how to protect yourself in the event the ECB decides to not act as a lender of last resort for the euro area national governments. This is a true Armageddon and Depression scenario.
The reason no real alternative to the ECB’s acting as a lender of last resort is offered by hawkish types is because the alternative is economic collapse – and recognising this is not politically palatable. We know that Italy will default without the central bank based on the analysis above. Italy’s default would trigger a cascade of interconnected bank runs default and Depression as did the insolvency of Creditanstalt in 1931. Could Italy unilaterally exit the euro zone and redominate euro debts at par into a new Lira currency to forestall the default? Perhaps. That is something to consider at a later date. For now, here’s what will happen if Italy defaults.
- Credit event: An Italian default would be a credit event, meaning it could not occur under the voluntary arrangement which the EU is trying to force through for Greece because Italy is simply too large for banks to willingly take the writedowns needed to deal with its insolvency. Doing so would render many financial institutions insolvent. Even in the Greek case, I doubt whether they will get enough participation from the private sector to meaningfully reduce the Greek sovereign debt load. So, an Italian default would be uncontrolled and immediately crystallise losses that must run through the balance sheets of everyone holding their bonds.
- Italian bank run: Once Italy defaults, Italian banks would be insolvent as a result of these losses since they are the largest holders of Italian sovereign debt. Given the 10 billion euro writedown at Unicredit just yesterday, we can see these banks are already weak. Therefore, we should anticipate wholesale bank runs in Italy beyond just the weakest banks.
- Spain and Slovenia insolvency: Other weaker sovereign creditors within the euro area without IMF funds would come under heavy selling pressure. This includes Spain and Slovenia first but would also include Belgium later and perhaps Austria due to its bank exposure to Eastern Europe. Spain’s yields have already crossed 6% and Slovenia’s have already crossed 7%. These governments would default as well then, cascading the losses onto their banking systems. Defaults here would lead to domestic bank insolvency and bank runs as in Italy. Countries like Ireland, Portugal and Greece would want to default in order to escape the suffocating strictures of austerity given the now untenable solvency path that a deep Depression would cause. Likely, these countries would default as well. Analysts like Sean Egan estimate eventual losses in Greece will be 90%. In the Italian default scenario, these losses would crystallise overnight.
- Contagion into Eastern Europe: Unicredit’s losses included significant writedowns in Eastern Europe and Central Asia (Ukraine and Kazakhstan). One area of contagion could be to other banks with exposure to weak economies elsewhere in Eastern Europe like Hungary and Slovenia. Greek, German and Austrian banks would be most vulnerable because of exposure to central Europe and the Balkans. Hungary, already under threat of a sovereign downgrade to junk, amidst a record decrease in the Forint/Euro exchange rate, would suffer contagion. the currency would come under heavy selling pressure. Other weaker sovereign debtors would be affected as well.
- Euro bank insolvency: Other debtors with significant exposure to Italy would suffer huge writedowns. Core bank exposure to Italian debt an order of magnitude larger than periphery combined. Financial institutions with exposure could be recapitalised by the state, however. The questions here for the likes of Germany, France and the Netherlands are a) how explicit a backstop will these banks get? would bond holders take losses; b) how would this affect the sovereign debt level and credit rating? c) how would this lack of capital affect credit availability and economic growth?
- Credit default swaps: As an Italian default would be a credit event, it would trigger credit default swaps, many of which were sold by American financial institutions. Would these institutions pay out? Could they? How would Italian losses affect their capital base? The same questions for euro countries become applicable here as well as American banks could be recapitalised by the state. (Will Americans allow another bailout?): a) how explicit a backstop will these banks get? would bond holders take losses; b) how would this affect American sovereign debt level and credit rating? c) how would this lack of capital affect credit availability and economic growth in the US?
There are a lot of other potential areas where this could go like capital controls, civil unrest, eurozone breakup, government coups, etc, etc. All of that is speculation. But above are the six parts I see as a sure thing: credit event, Italian bank run, Spain and Slovenia insolvency, contagion into Eastern Europe, some euro bank insolvencies and credit default swap triggers. Clearly, this would mean an economic downturn of at least the magnitude of the Great Depression.
I also tend to think contagion will spread throughout the eurozone until it breaks apart – and we do see yields rising right across the euro zone, today in France, Austria and even the Netherlands:
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.
–Felix Zulauf on the inevitability of further crisis in Europe, July 2011
Protecting your wealth
Hedging against this outcome means preparing for black swan scenarios in stocks, government bonds, currencies, commodities and precious metals. This is a world of unpredictable policy paths that will certainly involve civil unrest, government repression and economic nationalism, but may also involve competitive currency devaluations, currency controls, and trade wars.
My view is that such a scenario will mean significant dead weight economic loss due to debt deflation dynamics. Economic output would decline significantly, as would stocks and high-yield debt. Commodity prices would also decline. But depending on the policy response of governments, bonds and precious metals are wildcards.
Governments like Norway’s are protected because of low debt and rich natural resources. On the other hand, governments like Australia’s and Canada’s are exposed because of significant household sector indebtedness and high property valuation. In essence, there is nowhere to hide in the sovereign bond area. As a foreign investor in sovereign debt, you want to know where the currency and the interest rate are going and neither is foreseeable in this train of events.
If governments try to inflate their way out, precious metals might be a good safe haven, although paper gold presents a problem of reliability and physical gold is subject to confiscation. On the farmland front, as Jim Grant testifies, yields are already very low, so you have to wonder how much upside there is to that trade. Obviously, in a world of financial repression and competitive currency depreciation, those investments won’t necessarily lose value.
Highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens.
Those are my thoughts on what an Italian default would mean. The overall thrust of the arguments here is that a default would be economically catastrophic and put into play a lot of outlier scenarios. The potential for large losses would be significant, and, therefore it pays to think about how to protect your wealth in such an environment, given that serious policy makers believe letting Italy default is a justifiable policy choice.