A scant 24 months ago, we were desperately worried that a Euro Zone financial/fiscal crisis would precipitate a global financial meltdown analogous to that following the bankruptcy of the once-powerful Lehman Brothers. Today, we see the likelihood of some sort of breakup of the Euro Zone as being greater than it was then, but this no longer worries us nearly as much. Paradox? Not really.
En La Hora Mala
The situation that created the Euro Zone crisis has only deteriorated. European banks are starting to recognize losses on bad assets, further depleting their capital – and finding a shortage of private investors willing to replenish it. The Long-Term Repurchase Operation (LTRO) of the European Central Bank (ECB) has enabled the banks to remain liquid as a silent deposit run takes place. But it has not replaced equity capital. Moreover, by encouraging banks to earn a positive carry by buying the bonds of distressed sovereigns, the ECB has increased the amount of bad assets that the banks must ultimately write off (but tomorrow, not today).
Because these governments are running large deficits, few private investors are willing to buy their bonds. The German government’s policy of enforced austerity imposed on the feckless has made their deficits worse as austerity causes recession, mounting unemployment and falling government revenues. Greece, the poster child
for the impact of austerity policies, has more debt, more unemployment and a faster-shrinking economy than before the policies (the price for the bailout loans) were imposed. As a result, Greece is now on its third bailout and more will be needed. All the countries on which austerity is being imposed face rising political discontent and social unrest. It is highly likely that governments will fall and the austerity policies will be reversed, triggering a termination of bail-out assistance. The exploding debt problem is not like a fall off a cliff, it is more like quicksand: The more you struggle, the deeper you sink.
And of course the fundamental problem of the zone, the increasingly diverging competitiveness between Germany and the “north” on the one hand, and the “south” on the other, has not been addressed at all. Unit labor costs have diverged by perhaps 40% over the 12-year life of the euro. German workers may be paid more but they are increasingly productive relative to those in the “south.” The zone will not survive unless this problem is fixed. And fixing it requires two and a half actions:
The euro must depreciate significantly against the US dollar, perhaps by 30%; and There must be higher inflation, lower saving and greater fecklessness in Germany; and The half-action, much more must be invested to educate the labor force and increase productivity in the “south.”
These actions will lower German competitiveness within the zone while improving the external competitiveness of the southern countries as those nations slowly make fundamental economic adjustments.
If you give the notion that the Germans will embrace fecklessness, inflation and depreciation the same probability that we do, you can see where this argument is going. Moreover, and this is crucial, Greece has now defaulted without precipitating an immediate domino-collapse. Clearly Portugal is next, but the markets are not panicking. The actions of the ECB (supported by a generous half-trillion-dollar swap line from the Federal Reserve!) have convinced market participants that we can have a controlled process of default that will not destroy the European banking system and will maintain intact the zone’s central economic powerhouse.
We No Longer Care
Well, we still care, just not as much. The Europeans are going to be left to sort themselves out. Appropriately, there is an English children’s rhyme that encapsulates the lesson that Euro Zoners will have to learn:
Piggy on the railway, picking up stones
Along came an engine and broke poor Piggy’s bones
Oh, said Piggy, that’s not fair
Oh, said the engine driver, I don’t care.
It is true that the zone is our largest export market and China’s largest export market. But it won’t go away; it will just buy less during the crisis. In the US, we are growing slowly stronger despite the deteriorating situation in Europe and the slowdowns in China, India and other emerging markets. China, in any case, needs to restructure its economy more toward domestic consumption and somewhat less to exports. The breakup of the Euro Zone would certainly affect the world economy, but probably not enough to create a renewed global recession. Late this year, we could see renewed growth initiatives in various emerging markets that would pull up resource suppliers like Australia and Canada as well as our global corporations.
In terms of the financial system, our biggest banks are linked to Euro Zone banks by layers of derivative trades and counterparty obligations. But they have had 24 months to try to insulate themselves. The regional and community banking system is likely to be little affected by Euro Zone developments. And the ECB and the Fed have again shown that they will put out trillions of the currency of your choice to shore up the banks.
But What’s In It For Me?
We are maintaining our investment stance, focusing on blue chip equities, short duration and higher-quality fixed income while positioning in various real asset categories in anticipation of later growth. We believe that the odds of something really bad happening have materially decreased (although we anticipate the merely bad with confidence). Keep your cool.
The opinions expressed above are solely those of Contango Capital Advisors and do not necessarily reflect the views of Zions Bancorporation, its affiliates or its management.
IMPORTANT NOTE: Wealth management services are offered through Contango Capital Advisors, Inc. (Contango), a registered investment adviser and a nonbank subsidiary of Zions Bancorporation. Investments are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value of the amount invested. Some representatives of Contango are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a nonbank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company (WNTC), a subsidiary of Zions Bank andan affiliate of Contango. CCA0312-0055