Subject: The German Question
From: "Mason, Christopher W" <[email-masked]>
To: "Mason, Christopher W" <[email-masked]>
Date: Mon, 21 May 2012 11:21:23 -0400

Eye on the Market, May 21, 2012 (pdf easier to read this week)
Topics: The German Question, the Greek Question and the Market Question

For the better part of a century, the "German Question" related to conflicts in Europe that tended to coincide with Germany's economic might galloping ahead of its neighbors:

Over the last 3 years, the gap between Germany and the European Periphery has been widening at a similar pace.  Now, however, the German Question is quite different: will Germany spend its accumulated national wealth to save the Eurozone (at least temporarily), and how much might it cost them?  This is a complex question, so Michael Vaknin and I tried to strip it down to its underlying economics [a].  Let's assume the following: Germany has to bear the cost of backstopping the crisis in the Periphery on its own, without the ability to rely on countries like France (which are struggling themselves) or the IMF; the ECB cannot be used indefinitely as a dumping ground for questionable collateral; Germany will not accept an inflationary solution; and the Periphery needs another 5 years of help to support growth, finance the departure of foreign capital (see "running of the bulls" below), and  avoid the kind of social collapse seen in Greece.    Our estimate: around 1 trillion Euros (the attached PDF walks through our assumptions regarding growth, fiscal accounts, current accounts and capital accounts).

How much is 1 trillion Euros for a 5-year fix?  For context, we compare it below to estimates of the cost of German unification.  If our estimate is anywhere close to reality, this is a political decision rather than an economic one.  After having paid for German reunification over the last 20 years (which explains part of the steady, gradual rise in the chart on the right below), from a purely financial perspective, there's not that much room to add more debt.   Even if Germany only had to pick up half the tab we estimate, its debt to GDP ratio would still rise above 100%.   Just how much does this mean to Germany and Europe?  IMF Managing Director Lagarde gave a speech last week in which she highlighted the historical importance of Europe and how the concept of the Euro dates back to Charlemagne in the 800s.  True, perhaps; but that has not prevented other European monetary unions from failing in the interim.  You can ignore economics, but it will not ignore you.

The running of the bulls.  The first chart below shows the capital flight taking place out of the European Periphery, which drives our capital account forecast on the prior page.  The other running of the bulls shown below: in the first quarter, many Wall Street firms increased their 2012 S&P 500 forecasts, perhaps believing that the European debt crisis had been adequately addressed through the ECB's unlimited free-money auctions for EU banks.  But like 2010 and 2011, the Feb-April rally turned out to be another Prague Spring.  The ECB's auctions may only finance Italian and Spanish governments through the end of 2012, so there are still a lot of questions left unanswered.

Our job is not to figure out how long the Euro survives or what its constituents will be; I will leave that to the Council on Foreign Relations.  Our job is to navigate markets, and over the last 3 years, we've had a very skeptical and underweight view of Europe at a time when its equities underperformed the US by 36%.  Little has changed, and we are still concerned about where it goes from here.  Our sources tell us there was little agreed during the Hollande and Merkel summit; all that may come of it is a few billion of capital for the European Investment Bank.  Maybe rising pressure (e.g., new highs in Spanish spreads relative to Bunds) will lead to joint and severally guaranteed Euro T-bills; a pan-European deposit guarantee program;  a banking license for the European Stabilization Mechanism fund to invest directly in European banks; or a larger rescue package involving the IMF and current account surplus countries in Asia and the Middle East, who have a lot to lose if the Eurozone remains weak.  But maybe is not an investment strategy.  The situation calls for extreme caution regarding allocations to European assets unless they are priced very cheaply; and for not underestimating Europe's ability to disrupt global markets.

The Greek Question.  Three years ago, a lot of politicians and economists [b] said Greece shouldn't be compared to Argentina; they were wrong about that.  Now, some of the same people believe Greece would be much worse off leaving the Euro; I think they're wrong about that too.  In the charts below, the dotted line represents Argentina's default/devaluation in 2001.  You can judge for yourself what the consequences were.  Argentina underreports inflation (at least by half), which flatters some of these charts, and they also benefitted from a sharp rise in soybean prices.  Even so, the message here is that after devaluation of 70% and a brief, sharp rise in inflation and interest rates (charts 1 and 2), there is a morning after (charts 3-15). These charts look similar for the UK after 1992, Southeast Asia after 1998, and Iceland after 2009.  Post-devaluation Greece would probably not recover as fast as any of them, due to the damage that being in the Euro inflicted on Greece's economy, and the damage from the austerity program.  But if the IMF did what it is supposed to do and lend into a devaluation/ structural adjustment (instead of financing a German and French bank rescue), Greece just might have a shot.  Within the Euro, they don't.

Argentina, before and after

Back to markets and portfolios.  A lot of risk appetite indicators have now swung from high to low as the challenging macro environment reappears (China slowing, but should partially revive later this year from stimulus; US recovering at a steady pace but facing a fiscal cliff; and the problems in Europe).  Since January 2010, the S&P is up 13% during earnings season, and up another 13% following Central Bank interventions in Europe and the US.  The rest of the time, the S&P is down.  With this kind of backdrop, in underinvested accounts, it makes more sense to be adding risk now when things look dim than earlier in the year, since markets are better reflecting the reality at hand.  Furthermore, we expect some kind of announcement out of Europe over the summer, which markets are likely to be pleased with even if its beneficial half-life is as brief as prior efforts.  More broadly, we stand by our asset allocation recommendations covered on March 8, showing lower allocations to directional equities than most other firms (primarily a reflection of a large underweight to Europe), offset by investments in credit, distressed real estate and hedge funds.

Michael Cembalest
J.P. Morgan Asset Management

Prague Spring: a period of political and economic liberalization in Czechoslovakia in the Spring of 1968, subsequently crushed by the Soviet Union and other Warsaw Pact countries later that summer

Notes

[a] Michael Vaknin, who did the heavy lifting on the assumptions, is a macroeconomist with a PhD from Columbia.  Michael has taught International Finance, Advanced Macroeconomics and Monetary Economics, and has worked with Nobel Laureates Joseph Stiglitz and Edmond Phelps.   Some of our assumptions may be too conservative, others too generous.  I think our number may be too low.

[b] Sidebar to the European debt crisis: the firms that had their developed country economists try to sort out Greece and the EU over the last three years, rather than those experienced in Emerging Markets balance of payments crises, were off by the widest mark.

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