Contributing editor Gavin Graham is also with us for this issue with his thoughts on the latest twists and turns in the European debt saga and advice on what to do about it. Gavin is the president of Toronto-based Graham Investment Strategy and has worked in the financial industry for more than 30 years including stints in London, Hong Kong, and San Francisco. Over to him.
Gavin Graham writes:
The continuing saga of the European debt crisis has dominated headlines for the last couple of weeks. First there was the last-minute deal agreed by European leaders on Oct. 26. That had banks agreeing to a "voluntary" 50% haircut in the value of their holdings of Greek debt in exchange for a further austerity program by Greece and the leveraging of the €440 billion European Financial Stability Facility (EFSF) bailout fund to €1 trillion.
This was unexpectedly followed on Nov. 1 by the proposal by then Greek Prime Minister George Papandreou to hold a referendum on whether to accept the bailout. That shocker led to him being summoned to the G20 meeting at Cannes by French President Nicholas Sarkozy and German Chancellor Angela Merkel who demanded that he drop the referendum. Duly chastised, he returned to Athens to announce that, yes indeed, the referendum idea had been abandoned. Mr. Papandreou then agreed to step down as PM after barely winning a vote of confidence to allow a government of national unity to be formed led by technocrat Lucas Papademos, former deputy head of the European Central Bank.
But whatever sighs of relief the markets exhaled after the abandonment of the referendum speedily vanished as Italy finally succumbed to the crisis of confidence caused by the prolonged European dithering over Greece's debt problems. With €1.85 trillion outstanding, Italy has the third largest government debt market in the world after the U.S. and Japan. Greece, Ireland, and Portugal had been forced to apply to the European Union for bailouts in the last 18 months when the yield on their 10-year debt rose above 7%, a level which makes it impossible for governments to afford to keep paying their interest bills without making enormous cuts in public spending.
With pressure mounting on scandal-plagued Prime Minister Silvio Berlusconi to step down, Italy's 10-year bond yields rose through 6.5% on Nov. 3. That created a record spread with German 10-year Bunds since the euro was established in 1999.
On Nov. 8, after barely winning a vote of confidence, Mr. Berlusconi finally agreed to resign, but only after the austerity package demanded at the G20 meeting the previous week was passed. But even the downfall of Italy's longest serving premier since Mussolini failed to appease the markets, as one of the bond clearing houses doubled the margin required to trade Italian government bonds and yields shot up through 7%. What some commentators have called "The Endgame" is now definitely on the horizon.
As I have commented on several previous occasions in the IWB, there are really only two possible outcomes to the present eurozone crisis. The first is that European countries agree to accept a unified fiscal policy dictated by the region's paymaster, Germany, and surrender the majority of their autonomy. Alternatively, the weaker economies, effectively the PIIGS (Portugal, Ireland, Italy, Greece, and Spain), leave the eurozone and reintroduce their own national currencies or a devalued version of the euro.
This, by the way, was what the U.K. and Italy did in September 1992, when both countries were forced out of the eurozone's predecessor currency union, the ERM. Both economies devalued by 30%-35%, reduced their cost bases, and became competitive. Both economies subsequently enjoyed major booms in the mid-1990s.
I noted in my review of Argentina last year how the default and devaluation that it went through in 2001 led to a decade of very strong growth as its cost base was sharply reduced and its cheaper exports became very attractive. Of course, this route involves foreign investors and lenders accepting big losses and it has been the attempt by France and Germany to avoid having to bail out their banking systems again that has been responsible for much of the delay in facing facts.
There was a third option, which was for the European Central Bank (ECB) to introduce its own version of Quantitative Easing 2 (QE2). But it seems the ECB and its new Italian President, Mario Draghi, are unwilling to start printing money to offset the deflation caused by the austerity programs in the PIIGS, even if the Germans were willing to allow them to do so. In any case, Italy's bond meltdown means it's probably too late.
Once the problem is resolved, European governments will be forced to print lots more money, as happened in 2008-09, in an attempt to pull Europe out of the recession everyone (the IMF, the Bank of Canada, the Federal Reserve) now expects for 2012. In the U.K., Bank of England Governor Mervyn King announced his own QE2 last month, with £75 billion of new money printed as growth weakened. In the U.S., Fed chairman Ben Bernanke made it plain at the last meeting that he stood ready to begin QE3 if freezing interest rates at zero for two years and bringing in Operation Twist didn't reduce unemployment and stimulate growth.
Given that central banks will soon be printing a lot more money, investors should be looking at how best to benefit from this process. Metals and minerals stocks, both precious and industrial, should be beneficiaries of the coming increase in global liquidity. Since demand from China has been a major concern in relation to future growth, the fall in China's inflation rate in October from 6.1% to 5.5% is a very encouraging sign. It indicates that the 18-month period of tightening, including increased reserve requirements and higher interest rates, can now begin to be relaxed. On Nov. 9, Goldman Sachs sold US$1.1 billion worth of shares in Industrial and Commercial Bank of China (ICBC), whose share price had risen 48% in the last month, after the government announced it would be supporting the banks in writing off some of their bad loans.
Gavin Graham writes:
The continuing saga of the European debt crisis has dominated headlines for the last couple of weeks. First there was the last-minute deal agreed by European leaders on Oct. 26. That had banks agreeing to a "voluntary" 50% haircut in the value of their holdings of Greek debt in exchange for a further austerity program by Greece and the leveraging of the €440 billion European Financial Stability Facility (EFSF) bailout fund to €1 trillion.
This was unexpectedly followed on Nov. 1 by the proposal by then Greek Prime Minister George Papandreou to hold a referendum on whether to accept the bailout. That shocker led to him being summoned to the G20 meeting at Cannes by French President Nicholas Sarkozy and German Chancellor Angela Merkel who demanded that he drop the referendum. Duly chastised, he returned to Athens to announce that, yes indeed, the referendum idea had been abandoned. Mr. Papandreou then agreed to step down as PM after barely winning a vote of confidence to allow a government of national unity to be formed led by technocrat Lucas Papademos, former deputy head of the European Central Bank.
But whatever sighs of relief the markets exhaled after the abandonment of the referendum speedily vanished as Italy finally succumbed to the crisis of confidence caused by the prolonged European dithering over Greece's debt problems. With €1.85 trillion outstanding, Italy has the third largest government debt market in the world after the U.S. and Japan. Greece, Ireland, and Portugal had been forced to apply to the European Union for bailouts in the last 18 months when the yield on their 10-year debt rose above 7%, a level which makes it impossible for governments to afford to keep paying their interest bills without making enormous cuts in public spending.
With pressure mounting on scandal-plagued Prime Minister Silvio Berlusconi to step down, Italy's 10-year bond yields rose through 6.5% on Nov. 3. That created a record spread with German 10-year Bunds since the euro was established in 1999.
On Nov. 8, after barely winning a vote of confidence, Mr. Berlusconi finally agreed to resign, but only after the austerity package demanded at the G20 meeting the previous week was passed. But even the downfall of Italy's longest serving premier since Mussolini failed to appease the markets, as one of the bond clearing houses doubled the margin required to trade Italian government bonds and yields shot up through 7%. What some commentators have called "The Endgame" is now definitely on the horizon.
As I have commented on several previous occasions in the IWB, there are really only two possible outcomes to the present eurozone crisis. The first is that European countries agree to accept a unified fiscal policy dictated by the region's paymaster, Germany, and surrender the majority of their autonomy. Alternatively, the weaker economies, effectively the PIIGS (Portugal, Ireland, Italy, Greece, and Spain), leave the eurozone and reintroduce their own national currencies or a devalued version of the euro.
This, by the way, was what the U.K. and Italy did in September 1992, when both countries were forced out of the eurozone's predecessor currency union, the ERM. Both economies devalued by 30%-35%, reduced their cost bases, and became competitive. Both economies subsequently enjoyed major booms in the mid-1990s.
I noted in my review of Argentina last year how the default and devaluation that it went through in 2001 led to a decade of very strong growth as its cost base was sharply reduced and its cheaper exports became very attractive. Of course, this route involves foreign investors and lenders accepting big losses and it has been the attempt by France and Germany to avoid having to bail out their banking systems again that has been responsible for much of the delay in facing facts.
There was a third option, which was for the European Central Bank (ECB) to introduce its own version of Quantitative Easing 2 (QE2). But it seems the ECB and its new Italian President, Mario Draghi, are unwilling to start printing money to offset the deflation caused by the austerity programs in the PIIGS, even if the Germans were willing to allow them to do so. In any case, Italy's bond meltdown means it's probably too late.
Once the problem is resolved, European governments will be forced to print lots more money, as happened in 2008-09, in an attempt to pull Europe out of the recession everyone (the IMF, the Bank of Canada, the Federal Reserve) now expects for 2012. In the U.K., Bank of England Governor Mervyn King announced his own QE2 last month, with £75 billion of new money printed as growth weakened. In the U.S., Fed chairman Ben Bernanke made it plain at the last meeting that he stood ready to begin QE3 if freezing interest rates at zero for two years and bringing in Operation Twist didn't reduce unemployment and stimulate growth.
Given that central banks will soon be printing a lot more money, investors should be looking at how best to benefit from this process. Metals and minerals stocks, both precious and industrial, should be beneficiaries of the coming increase in global liquidity. Since demand from China has been a major concern in relation to future growth, the fall in China's inflation rate in October from 6.1% to 5.5% is a very encouraging sign. It indicates that the 18-month period of tightening, including increased reserve requirements and higher interest rates, can now begin to be relaxed. On Nov. 9, Goldman Sachs sold US$1.1 billion worth of shares in Industrial and Commercial Bank of China (ICBC), whose share price had risen 48% in the last month, after the government announced it would be supporting the banks in writing off some of their bad loans.
