Week in Review Part I: Europe, Washington and Wall Street

I’ll switch things up this week and start with the conclusion. Europe will continue to stumble from crisis to crisis, the Continent needs growth and none is forthcoming, there is no backstop for the likes of Italy and Spain despite what the politicians said three weeks ago, and, longer term, there is zero cause for optimism.

Short-term the market remains nothing more than a casino, albeit more of a headline driven one than ever before, and who knows where stocks will go the final seven weeks of 2011? I don’t change my annual forecast and I’m stuck with 5% to 7% declines for the major averages and now we’re back up for the year, though we’ve learned these days seven weeks can be an eternity.

Just look at the last three. For the week ending Oct. 28, stocks soared around the world on optimism the European Union, European Central Bank and IMF had reached a comprehensive agreement to recapitalize the banks, slash Greece’s debt as part of Greek Bailout II, and super-charge the existing European Financial Stability Fund that was designed to backstop Greece, Ireland and Portugal while those little wieners, three of the PIIGS, I mean, got their acts together. The concern, though, was that markets move faster than ever these days and contagion would spread to Italy and Spain, which in the case of the former it did.

But first, after soaring the week ending Oct. 28, equity markets took it on the chin the week ending Nov. 4 because Greek Prime Minister Papandreou decided that the bailout agreement for his country of the week before needed to be voted on by the entire country first, a rather pissed off nation at that, witness all the rocks that have been displaced this year in Athens, plus everyone looked around and said, hey, that agreement between EU, ECB and IMF officials doesn’t really stand a chance of being implemented. Like how the heck do we finance this super-duper leveraged EFSF? Who is going to buy the bonds that would be issued? What kinds of guarantees are bondholders getting? And, in the case of Greece, just why am I, a holder of Greek crappola, getting a 50% haircut without being able to cash in my insurance (in the form of credit-default swaps)?

But by the end of this week, one ending on Veterans Day, which formally marks the end of the stupidest war in the history of the planet, World War I, the war to end all wars, peace broke out across Europe anew, or at least in financial markets, as both Italy and Greece reached agreements (or were darn close to one in the case of the former) on new governments, both to be run by technocrats, which is purposefully not as exciting as Technicolor because this is serious business, you see.

In the case of Greece, a new prime minister was sworn in, Lucas Papademos, a respected (so they tell me, I never met the man myself) former vice-president of the European Central Bank.

“The Greek economy is facing huge problems despite the enormous efforts made,” he said the day before he was officially sworn in by a gang of Greek Orthodox priests in fancy robes that are probably worth more than all of Greece’s state-owned operations the government is charged with selling off these days combined.

“Greece is at a crucial crossroads…the course will not be easy, (but) the problems will be resolved faster…if there is unity, cooperation and wisdom,” Papademos said, he having an easier name to type than Papandreou, at least for yours truly.

Papademos and his unity government, which will contain the old finance minister, Evangelos Venizelos, now must implement the Oct. 26 Euro bailout, Greek Bailout II, that entitles Greece to 130bn euro ($179 billion) on top of the first Greek Bailout of 110bn euro, plus manage the voluntary debt swap that gives bondholders a 50% haircut. Additionally, new elections are to be held around Feb. 19. For at least taking the first steps in implementing the new bailout, Greece will finally be rewarded with an 8bn euro ($11 billion) loan installment from the first bailout that allows the government to pay its bills come mid-December at the latest. Otherwise, there is no money and we’ll all be locking our doors as a precaution against Greeks bearing rocks.

Oh, and Greece’s economy is supposed to contract a further 2.8% next year, after falling 5.5% in 2011, which is why the debt to GDP ratio in Greece is slated to approach 200% in 2012 before beginning to decline.

As for Italy, with the senate here having passed a mandated package of austerity measures as called for by the EU and ECB, and with Prime Minister Sleazio Berlusconi having agreed to step down once the lower house ratifies the package on Saturday, Mario Monti, a former European commissioner, i.e., bureaucrat, will become prime minister. Markets rallied Friday on word Monti was the man.

But earlier in the week, boy was it touch and go in terms of Italy’s ability to take us all down.

You see, Italy has 1.9 trillion euro in sovereign debt, or a cool $2.6 trillion, and 300bn euro of it needs to be refinanced next year, for starters, so it would be nice if the government could do so at low interest rates. After all, the German 10-year bund is trading with a yield around 1.85% these days, that’s nice and low.

But Italy’s 10-year rocketed above 7.00% this week, almost touching 7.50% before closing Wednesday at 7.25%. Yikes, said global financial markets. Why that’s unsustainable! Or as Italian broadcaster Dick Vitale was heard to exclaim, “That’s Bailout City, baby!!!”

Thursday morning, though, the Italians sold $6.8 billion of 12-month bills at a yield of 6.08% and everyone breathed a sigh of relief. Forget the yield at auction for such an instrument last month was only 3.57%, and 1.90% a year ago, 6.08% was better than what folks expected.

Yes, friends, we’re just lurching from crisis to crisis, and there is no mechanism in place to deal with it all. The only thing that kept the Italian 10-year from shooting through the roof was first, the hoped for change in government, and second, the European Central Bank apparently buying gobs of Italian debt to drive the yield down to 6.53% by week end, though this can’t continue, as some of the below commentary spells out better than I can right now because my brain is nothing more than a disorderly pile of linguine after having to write about this mess for 18 months.

Yes, this was a week where IMF Managing Director Christine Lagarde told an audience that the world economy was headed for a “lost decade” unless nations acted together to counter the threats to growth.

“In our increasingly interconnected world, no country or region can go it alone,” she told a forum in Beijing. “There are dark clouds gathering in the global economy.”

Advanced economies, Lagarde said, have a “special responsibility” to restore confidence and lift growth, adding that her host, China, needed to boost domestic consumption, which as you’ll see shortly they’ve been doing a nice job of.

“If we do not act, and act together, we could enter a downward spiral of uncertainty, financial instability, and a collapse in global demand. Ultimately, we could face a lost decade of low growth and high unemployment,” at which point attendees ignored the shrimp cocktail and went straight to their rooms to hide under the covers.

And just to close the circle from my above opening, this was also a week where EU economic and monetary affairs commissioner Olli Rehn said “Growth has stalled in Europe and there is a risk of a new recession. There is a broad consensus on the necessary policy action. What we need now is unwavering implementation.”

Rehn’s staff at the European Commission lowered its growth forecast for the EU’s 27 economies to 0.6% in 2012 from an estimated 1.6% in 2011. The 17-nation eurozone is now expected to grow just 0.5% next year. Ergo, recession for a portion of this time is a certainty, probably starting in the current quarter.

The U.K.’s retail sales for October, for example, declined a worse than expected 0.6%, while Spain reported its third-quarter GDP was unchanged over Q2, not what that place needs given its 21.5% unemployment rate. [Spain elects a new government on Nov. 20 as well.]

And it just needs to be said that Europe is already facing a massive credit crunch, particularly when it comes to small business, while I noted a number of weeks ago that the next real flashpoint is going to be Eastern Europe, a fact everyone else seemed to pick up on this past week. Eastern Europe relies heavily on Western European banks for credit and those banks are looking at mandated recapitalization efforts through next June that will lead to a further closing of the loan window at the worst possible time.

Further opinions…
Gideon Rachman / Financial Times

“As the European ship heads for the rocks, so the officers in charge are being thrown overboard….But while politicians may come and go, European leaders insist that one thing will remain neutral – the euro. No summit is complete without the ritualistic declaration that Europe will do ‘whatever it takes’ to preserve the single currency. But the repeated vows to save the euro betray a dangerous confusion.

“The euro is not an end in itself. The single currency is just an instrument, aimed at promoting economic prosperity and political harmony across Europe. As the evidence mounts that it is doing the precise opposite, it is time to think not about how to save the euro – but about how to scrap it, or at least allow the weakest members to leave.

“For reasons of pride, fear, ideology and personal survival, it is extremely hard for European leaders to accept that the euro is a large part of the problem. Instead they search for other explanations for the economic crisis. Countries have failed to stick to the rules. They have lied. Europe needs new political structures. The bazooka is not big enough. The markets are irrational. The people are revolting….

“The euro has helped both to create and sustain the crisis in Europe. First, it caused interest rates to plunge in southern Europe, encouraging countries such as Italy and Greece to go on a borrowing binge. Now the single currency rules out the options that postwar Italy and others traditionally used to cope with high levels of debt: inflation and devaluation of the currency. Neither policy was cost free, but they provided an alternative to the ‘internal devaluation’ (otherwise known as wage cuts and mass unemployment) that is currently being urged on Italy, Greece and much of southern Europe….

“Economic chaos in Greece is now being supplemented by political chaos. In Italy, meanwhile, borrowing costs go up and up – in a way that will soon make the country’s finances unsustainable. If Italy, the world’s seventh largest economy, applies to the EU bailout fund – or even to the IMF – there simply may not be enough money to meet its needs. It would be like an elephant getting into a life raft….

“Greece and Italy are not the only problems. Ireland and Portugal have already had to accept bailouts – and may be destabilized anew by the latest crisis. Spain’s vulnerability is clear. France has not balanced its budget since the 1970s and is fretting about its triple-A rating.”
Nouriel Roubini / Financial Times
‘With interest rates on its sovereign debt surging well above 7%, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt of 1,900bn euro. That would partially address its ‘stock’ problem of large and unsustainable debt but it would not resolve its ‘flow’ problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

“To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone….

“(Once) a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario skeptical investors will push the sovereign spreads to a level where it either loses access to the markets or when the debt dynamic becomes unsustainable.

“So Italy and other illiquid, but solvent, sovereigns need a ‘big bazooka’ to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.

“One is urgently needed now. Eurobonds are out of the question as Germany is against them and they would require a change in treaties that would take years to approve. Quadrupling the eurozone bailout fund from 440bn euro to 2,000bn is a political non-starter in Germany and the ‘core’ countries. The European Central Bank could do the dirty job of backstopping Italy and Spain, but it does not want to do it as it would take a huge credit risk. It also cannot do it, as unlimited support of these countries would be obviously illegal and against the treaty no-bailout clause….

“Output now is in a vicious free fall. More austerity and reforms – that are necessary for medium-term sustainability – will make this recession worse….The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable….

“The eurozone can survive with the debt restructuring and exit of a small country such as Greece or Portugal. But if Italy and/or Spain were to restructure and exit this would effectively be a break-up of the currency union. Unfortunately this slow-motion train wreck is now increasingly likely.

“Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster.”

Editorial / Wall Street Journal

“In the European economic crisis, all roads lead through Rome….

“In Italy, as in Greece, Spain and Portugal and eventually France, the welfare-entitlement state has hit a wall. Successive governments on the Continent, right and left, have financed generous entitlements with high taxes and towering piles of debt. Their economies have failed to grow fast enough to keep up, and last year the money started to run out. The reckoning has arrived….

“This is a crisis of the welfare state, and Italy is a model basket case. Mario Monti, who is tipped to lead a new government of technocrats, once described the Italian economy as a case of ‘self-inflicted strangulation.’ Government debt is 120% of GDP, making Italy the world’s third-largest borrower after the U.S. and Japan. Its economy last grew at more than 2% a year in 2000….

“But now hard choices can no longer be postponed. And the solution to Europe’s debt crisis must begin with reforming, if not dismantling the welfare state….
“The road from Rome may now lead to Paris, Madrid and other debt-ridden European countries. But this is no cause for U.S. chortling, because that same road also leads to Sacramento, Albany and Washington. America’s federal debt was 35.7% of GDP in 2007, but it was 61.3% last year and is rising on an Italian trajectory. The lesson of Italy, and most of the rest of Europe, is never to become a high-tax, slow-growth entitlement state, because the inevitable reckoning is nasty, brutish and not short.”

Nick Squires / Irish Independent

“Decades of turning a blind eye to endemic tax evasion, corruption, and dismal economic growth have sent Italy careening into its present crisis.
“The country may be renowned for global brands such as Ferrari, Gucci and Armani but the eurozone’s third-largest economy has been hobbled by the chronic failure of successive governments to enact reforms.

“On the streets of Rome, Italians may express relief and grim satisfaction that Mr. Berlusconi has announced his intention to resign, but many realize that the country’s problems extend far beyond the failings of the scandal-prone prime minister.

“Italy’s people know they have been sleepwalking into an economic abyss for years and must now pay the reckoning….

“The country’s dismally low growth is a consequence of corruption, a bloated bureaucracy, an overpaid and cosseted political class, stifling bureaucracy, low productivity and a third-rate educational system.

“On almost all those indices, the problems in the ‘Mezzogiorno,’ the sun-baked, Mafia-plagued south of Italy, are much more acute than in the wealthy north, highlighting a regional divide that has existed since unification in 1861, threatening to split the nation.

“Of the world’s top 200 universities, only one is Italian – Bologna University in the north....

“Italy also performs poorly in global rankings of transparency and competitiveness….

“Tax evasion is almost a national sport. Italians resent paying high taxes when they feel they get little in return – streets are potholed, hospitals are overcrowded, playgrounds for children are often smashed up and covered in graffiti and public transport is frequently shabby and outdated.

“And they have been set a terrible example – among the plethora of accusations that Mr. Berlusconi has faced in his many trials are those of tax fraud and false accounting.
“ ‘How do you expect Italians to respect the rules when the law is ignored by our politicians?’ said Alessio, 42, who sells T-shirts and souvenirs to tourists from a shop overlooking the Trevi Fountain….

“Seeing no prospects at home, young Italians are leaving in droves to seek better opportunities in Britain, the U.S., Australia and the Gulf, in an accelerating brain drain that will deprive the country of much-needed entrepreneurial talent….

“Italy’s fat cat politicians are also a drain on the public purse. The 945 members of the Senate and the Chamber of Deputies earn an average annual salary of 140,000 euro ($193,000) – almost twice as much as British MPs….

“They are chauffeured around in expensive Alfa Romeos, Maseratis and Audis with tinted windows.

“There are a staggering 30,000 of these executive cars and they cost the Italian taxpayer an estimated 2bn euro a year….

“So even with Berlusconi on his way out after 17 years at the heart of Italian politics, the prospects for meaningful change look distant.”

[Ed. Don’t change the system yet, my Italian friends. I’m thinking I might want to be a chauffeur there.]
Washington

It was a very light week in terms of economic data, as in the only releases of note were Thursday’s jobless claims report that came in at 390,000, better than expected and below the psychologically important 400K mark, and a better than expected reading on consumer sentiment that helped the equity markets out on Friday.

Otherwise, all eyes are on the supercommittee in Washington, that 12-member bipartisan congressional panel charged with coming up with at least $1.2 trillion in budget savings by November 23rd, after which Congress has until Dec. 23rd to act on it or allow automatic cuts of like amount, half from defense, to be put in place.

But as of this writing it seems clear the supercommittee will not act heroically and come up with the $3 or $4 trillion in savings that is really needed to put a dent in the ever-rising federal deficit. They either come up with $1.2 trillion, or let the automatic trigger mechanism take hold, before which there will be intense pressure to shelve the process because of the deep cuts to defense. It’s a joke, though a very bad one for the future of our country let alone financial markets.

Should the supercommittee fail to act…fail to come up with real cuts…I stick to my prediction of months ago that in 2012 we will have our budget moment, our Italy, in the form of a Crash, worse than this summer’s crashette. We already know that should Congress miss this opportunity (after President Obama missed his own in trashing Simpson-Bowles at the start of 2011), next year will go down as one of the ugliest, and destructive, political campaigns since 1860, and you know what followed that one.

I hope I’m proved wrong…that Congress will do the right thing at the last moment, but we’re already past the time when the Congressional Budget Office was supposed to be able to ‘score’ whatever the supercommittee comes up with before presenting it to the full Congress for debate.

Lastly, some news on China’s economy. Consumer prices for October rose at a 5.5% clip, far better than the 6.5% rate in July that spooked markets. Producer prices also came in at a less than expected increase of 5.0%, the smallest increase in a year. Critically, food costs rose 11.9%, which is still way too high but better than September’s 13.4% pace. The non-food inflation rate was only 2.7% for the month. None of this means the government is about to lower interest rates, but it is taking other steps to ease monetary policy and will likely do more before year end, such as reducing bank reserve requirements to encourage more lending, especially to small business. [A report on Friday revealed that lending had already picked up more than forecast in October.]

Additionally, retail sales rose a strong 17.2% in October, on the heels of September’s 17.7% rise. Imports for the month soared 28.7%, much higher than forecast, so domestic demand is rising, just as the West, and the Chinese government, wants it to. [Imports from the U.S. rose 20.5% in October.]
Conversely, exports rose only 15.9% in October, owing in no small part to Europe’s weakness. China’s exports to Europe increased just 7.5%.

Lastly, industrial production in October rose 13.2% vs. a 13.8% gain in September, while car sales were at the slowest pace in five months and housing starts fell 1.3% from a year earlier. There are real signs the housing bubble has popped, as the government wanted, but now we have to watch the speed of the decline in prices and the first anecdotal evidence is a bit worrisome.

My large holding in Fujian reports earnings this week and I suspect I will be commenting extensively on this next time.