Economic & Market Update, December 2011

The European Drama Continues
by Richard Morey

After re-reading last month's report I was tempted to just send the same report out again! Some of the details have changed, but the broad picture remains exactly the same. In November, markets dropped precipitously in the middle of the month as the economic picture in Europe continued to deteriorate. Then European leaders, along with several other central bankers including Fed Chairman Bernanke, came out with a new program to address the European crisis. Stock markets were ecstatic and erased the most recent losses. Unfortunately, along with the dozen or so other measures that have been announced to stem the eurozone crisis, these newest announcements did not address the core problem. As a result, you should expect the recent gains from markets to once again disappear relatively soon.

I am also tempted to simply summarize the entire European affair with two sentences from legendary investor Jeremy Grantham of GMO who recently wrote: "I have no particular insight into the problems plaguing the eurozone, but I can recognize a terrifying situation when I see one. The appropriate response is surely to be more cautious than usual." I have either studied the eurozone problems more than Mr. Grantham (somewhat unlikely) or am less humble (more likely), for I do believe I have some insight into what is going on there. That being said, the more one studies this topic, the more uncertainty remains regarding how it is ever going to be successfully resolved.

This has certainly been an odd year for anyone who spends much of their time studying economics. Every time the European leaders come out with a new plan I spend a few hours analyzing the details (or lack thereof). Each and every time, by the end of the day I simply cannot see how their newest solution can possibly solve anything. But the top people in the eurozone assure us it will, and stocks and other risky assets soar in price. Then I spend the following week reading the views of the best economists from around the world. They have almost uniformly agreed with my initial analysis – due no doubt to the fact that all the proposed solutions have had truly glaring holes in them. A few more days or weeks pass, the markets realize the newest solution solved nothing, then investors around the world get scared again and the markets tumble back down.

The newest panacea for Europe's ills involves making it easier for the European Central Bank (ECB) to borrow money a little more cheaply from the U.S. Federal Reserve Board so the ECB can lend it to countries in the eurozone who can then lend it to their banks. These are short-term loans that are needed to keep credit flowing in the European banking system. The banks need to borrow their money from central banks, i.e. governments, because they are scared to lend money to each other. They won't lend money to each other even for one night because they're not sure the other banks will be in business tomorrow. Since a huge amount of trade done in Europe involves U.S. dollars, the banks needed somebody willing to lend dollars to settle all their trades and keep business flowing. So the U.S. Federal Reserve Board said it would lend the dollars needed to keep business alive in Europe, thus helping to solve a serious liquidity problem.

Lest you think I am critical of everything the Europeans are doing, I will be the first to say this was a very good idea (assuming we can trust the European Central Bank to pay us back all the dollars we lend them each night). If European trade came to a standstill we would have a catastrophe on our hands immediately.

The day before this new program was announced, Wolfgang Münchau, who is one of the editors of the Financial Times of London, wrote an article entitled "The eurozone really only has days to avoid collapse." I mention this to highlight the extreme danger the world is facing right now. Think back to the fall of 2008 when the headlines in our papers said Lehman Brothers might only have days before it would collapse. It did, and we know the result. But while Mr. Munchau mentions liquidity as one of the problems, it is as a footnote. Liquidity is something, however, that central banks can solve, so that's what they did. Good.

If liquidity, or keeping money flowing through the banking system, isn't the real problem, then what is? The answer is the same one it has been for the last 20+ months: Somebody in Europe is most likely going to end up losing at least $3 trillion euros (approximately $4 trillion dollars). That is enough money to bankrupt Europe's banking system, and the European leaders have not presented a plan thus far to prevent this from happening.

One European leader I listen to more than most is Mervyn King, the Governor of the Bank of England. Mr. King has more objectivity than the others because Great Britain never joined the eurozone. Last week Governor King said: "Many European governments are seeing the price of their bonds fall, undermining banks' balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks' balance sheets further. This spiral is characteristic of a systemic crisis.

"Tackling the symptoms of the crisis without resolving the underlying causes, by measures such as providing liquidity to banks or sovereigns offers only short-term relief. Ultimately, governments will have to confront the underlying causes…"

This is what all the best economists are now saying. Then we have German Chancellor Angela Merkel, who today (12/5) came out with French President Sarkozy saying they have agreed upon a new structure for the eurozone that will prevent future crises. Once again, markets are excited. And once again, their new structure does nothing to address the $3 trillion+ in looming euro losses. Not that their new structure is ever likely to be enacted by all 17 European countries involved.

Please note that while I have criticized much of what Chancellor Merkel has said and done for the last two years, her views are not without merit. She is in an impossible situation. Last week she said it will take years to resolve their problems. While it is true that it would indeed take years to solve them following their current course, it is very highly unlikely (read impossible) that the bond markets will give them that much time. But even if given years, they still would not get out of unsustainable debt unless the economies of their weaker nations miraculously began to grow at, say, 5% a year. This is what Chancellor Merkel is praying for, because the alternatives are to have either their banks and bank bondholders (i.e. her wealthiest donors) or the German taxpayers assume trillions of euros of losses. Most politicians would pray for a miracle before admitting either of those realities.

Although Ms. Merkel and the other eurozone leaders have managed to push their problems out into the future for nearly two years, each day it looks more and more likely they will end up having to take the decisive actions they have needed to take much sooner than they would like. These actions will probably be precipitated by an escalation of the crisis and massive financial losses throughout the world. They will most likely involve having numerous countries leave the eurozone and having most of the major banks in Europe nationalized – at least for a couple of years. (This is the scenario that lays the losses on the wealthiest strata of European society that loaned most of the money to the banks.) The alternative would be to simply print all the money owed by issuing enough "Eurobonds" to pay off all their debts. (This is the alternative that transfers all the losses to the taxpayers.) This would fix the immediate solvency problems in one fell swoop. It would also most likely lead to an inflationary spiral that Ms. Merkel and Germany have shown absolutely no willingness to tolerate.

At the end of the day, a banking crisis remains the most likely outcome for Europe and, therefore, the rest of the world financial system. Here in the United States we will survive it, as will Europe for that matter, but very large losses are likely for all but the safest investments, such as U.S. Government bonds and others that move in tandem with those bonds – i.e. what we primarily own for our clients at Secure Retirement.

In our last monthly report I said I expected stocks to go down in November, up in December and early January and then down, a lot, beginning in mid-January. So far this has been fairly accurate – although stocks did start to go up a few days sooner than anticipated. With U.S. stocks as a whole still down slightly for the year, the only stock investors who have made any money are the traders. (Of course, roughly half of them also lose money.) Having studied probably well over one hundred approaches to short-term trading, I am quite familiar with most of the major methods. In fact, should I find an opportunity to buy a stock fund (exchange-traded fund) after stocks have gone down again, I may make a modest investment in many accounts before the end of the year. However, assuming the European problems are not fully resolved, this would not be a long-term investment.

From a broader investment standpoint, most of our accounts have some small gains this year, despite the fact that bonds have cooled off in recent weeks. However, most of our funds will be putting out a significant amount of their yearly income this month, so we should have a profitable month. And, of course, our portfolios remain remarkably safe. Given the looming risk of a European financial collapse, owning funds that are getting ready to put out good income while being very safe remains the most prudent path to investing retirement money at this time.