The Unsolved Euro Crisis
The Euro crisis is not “solved.” Not by a long shot. Yet Bloomberg reports this morning (i,e, March 2nd) that European leaders “declared a turning point in the Greece-fueled debt crisis.” The next project for the busybodies: a commitment to a “pro-growth agenda.” This agenda, we can be sure, will involve the few remaining creditworthy EU governments borrowing even more money for stimulus plans.
But aren’t the problems in Europe rooted in spending more than incomes and tax revenues and having to borrow the difference? Yes. Europe has already run out of money — that is, money defined as having a certain amount of purchasing power today. But what about paper money that will buy less goods and services in the future? Isn’t there plenty of that? Sure, there is! In fact, [in order to finance its Long-Term Financing Operation (LTRO)] the European Central Bank printed about 1 trillion euros in just the last few months.
But this much-heralded LTRO isn’t fueling purchases of risky assets — at least not yet. If investors follow the money, they’ll discover that banks are depositing the three-year euro loans they borrowed from the ECB right back at the ECB! These banks are, obviously, not in a hurry to speculate with the cash proceeds from their three-year LTRO loans.
Here’s the part about EU bank behavior that should terrify anyone basing an investment strategy on the fact that the PIIGS governments will continue to enjoy lower and lower yields at sovereign bond auctions: The banks that borrowed three-year money from the ECB at a cost of 1% per year are willing to redeposit the cash at the ECB for a 0.25% per year return. In other words, banks are willing to suffer a “negative carry” of 75 basis points just to have cash available to satisfy depositors at a moment’s notice.
The most plausible explanation for this behavior: Banks will use this cash to satisfy their own lenders and depositors, many of whom will decide not to roll over their loans to these banks. EU banks are, in short, replacing private-sector funding with ECB funding.
Here is the consequence: the slow-motion nationalization of many European banks. When the LTRO loans mature in three years, many of them will not be able to go back to the private-sector funding model. This will ultimately force the ECB to indefinitely roll over the LTRO loans to insolvent banks. A better name for the “long-term refinancing operation” would have been “infinite refinancing operation” (for as long as the euro exists) — or, for the acronym fans, IRO until RIP EUR.
As European investors realize this LTRO cash will be used simply to satisfy maturing liabilities, we’ll probably go right back to the market environment we saw in July-September 2011. The situation in Europe is as fragile as ever. Political change in Greece has the potential to bring about a messy default, and the April election in France has the potential to spark the end of the euro by ending the Merkel/Sarkozy “bailouts at any cost” status quo.
The euro crisis is about as “solved” as the US financial crisis was solved after the March 2008 Bear Stearns rescue. I remember spring 2008 well, having spent hours identifying the next banking victims of the US mortgage crisis, while the consensus breathed a sigh of relief (as it is today), that the Fed rescue of Bear Stearns “solved” the mortgage crisis.
The only thing these central bank rescues accomplish is to impose the cost of bank bailouts onto the holders of paper currencies. That’s why the S&P 500 Index remains 50% below its 2008 peak in real (gold) terms, even though the index is only 12% below its all-time high in nominal terms.
All the cash the central banks are printing is dry tinder for a great explosion in consumer prices that should, unfortunately, more than offset any meager gains in the S&P 500 that have the talking heads in the financial press so excited.
Here’s the good news: By the end of this bear market, the S&P will be an even tinier fraction of gold prices. If you save heavily in the form of gold, your buying power when the next great stock buying opportunity arrives will be that much greater.
As central banks prop up bankrupt governments with newly created money, an ocean of paper money will be desperate to own gold, bidding it up in the process.
Over the next few years, I expect that as consumer prices rise, investors will greatly hike the rate at which they discount future corporate cash flows, which will result in much lower price-earnings ratios for most stocks.
The list of negative market catalysts is long and scary. The list of positive market catalysts is nothing to get excited about. The most-important positive catalyst to drive the market up from here is an old standby: “Stocks offer a better total return, including dividends, than 2% Treasury bonds and 0% bank CDs.” This meme is ready to celebrate its second or third birthday, by my calculations. It’s front-page news. It’s a talking point for financial advisers and Wall Street strategists. So it’s hard to argue that this well-worn debating point of the bulls is not already reflected in stock prices.