Some Thoughts on Europe

Currency in Crisis

The last few days have been very significant and will likely shape investors views in the weeks ahead.  While Greece remains at the epicenter of the European debt crisis, the issue is much bigger.  It has begun bleeding over not just into Ireland and Portugal, but Spain and Italy as well.

After a re-shuffle of the Greek cabinet to solidify the fracturing Socialist Party, the government survived a vote of confidence.  There were no Socialist Party defections.  However, the market's reaction was transitory.  Now it needs to pass the IMF/EU approved austerity measures.  The government has about a three seat majority, but the general strike planned for early next week may be able to winnow away a couple members of parliament.  

The IMF/EU wanted support for austerity across party lines.  Not happening.  Moreover, the latest polls show that the Socialists now, for the first time since the election in late 2009, are trailing the opposition.  In my writings, even before the crisis, I emphasized the weakness of political leadership throughout the major industrialized countries.  The austerity that is being demanded is producing a political backlash.  Even if Greece parliament approves the austerity measures, a vote along party lines warns of 1) implementation risk and 2) an even larger political storm should the Socialist government collapse.    Would a "petite oui" like the French gave to EMU really be sufficiently credible?

Greece may be serving as a lightening rod, but Ireland, Portugal, Spain and Italy have their own problems and this in effect compounds the contagion from Greece.  I have argued before, and submit again, that Ireland will most likely not be able to return to the capital markets next year, though its aid package is predicated on it doing so.  When the European elite deign to recognize this, Ireland is going to have to get more assistance too.  

One of the metrics which monitor the firewall that has protected Spain from the periphery I have employed is the correlation between Spanish and Portuguese bonds.  The 30-day rolling correlation is near 0.80.  There was an inverse correlation as recently as late May.  Meanwhile the premium Italy pays over Germany on 10-year government bonds widened to it highest level since the advent of EMU.  

Adding insult to injury the flash PMI readings, especially for France, were particularly weak and increasingly it looks as if the euro zone is past its cyclical peak.  The ECB is still going to hike rates in a couple of weeks.  Given market expectations, spurred on by none lesser than ECB President Trichet himself, not hiking rates would be even more destabilizing than hiking rates during the crisis and with a slowing economy.

The ECB's independence appears to be being threatened on another front.  Bini Smaghi sits on the ECB board.  If Draghi becomes the next ECB President, that would put two Italians on the board and no French.  Even though Sarkozy endorsed Draghi before Germany, reports suggest that France will no vote for Draghi unless it has assurances that Bini Smaghi will step down.  At first Bini Smaghi seemed to resist pressure. The pressure for him to step down to appease some governmental machination is seen by some as yet another sign of ECB's lack of independence.  

Given the situation and conflicting priorities,  the best course may be to appoint Bini Smaghi as Draghi's replacement at the head of the Italian central bank.  Perhaps, seeing how a French person has been president of the IMF for some time and its program in Greece appears a failure, Draghi maybe should have been offered that position as Merkel suggested earlier this year.  

I expect the euro to be undermined by these developments.  The toothpaste has been squeezed out of the tube and it is very difficult to put it back in.  At the same time, I expect some better US economic data.  On the back of falling oil and gasoline prices, easing of Japanese supply line issues, and the lower interest rates, it seems reasonable Q3 growth is better than H1.