Economic data in Europe brought us back to our typical reality. The economic conditions are getting worse, unemployment is breaking records, and the stocks and banks of the periphery are in trouble again. The main support for the market is complete faith that Draghi and ECB will unveil some new plan that will make everything better.
LTRO was done on February 29th. Just 2 months after the ECB flooded European banks with money and encouraged them to buy sovereign debt we are back in the midst of a crisis. How could LTRO fail so quickly? The better question is how could LTRO not fail? The premise that banks, already heavily exposed to their own sovereign’s debt would buy more, book the carry, and live happily ever after was flawed from the start. Carry takes a long time to work. Carry is a slow, dull, process, but mark to market and fear of default is fast and painful. Now banks are massively overexposed to the risk of their country’s debt, fund themselves through a variety of “non-traditional” methods, and face real risk of big losses as restructuring becomes the obvious conclusion.
There has been so much talk about growth versus austerity lately, that the true goal was lost in the shuffle – sustainable debt levels. The debt burden is too high both in terms of repayment, but just as importantly the cost of servicing it. Any legitimate plan to resurrect the economies of Spain and Italy will need targeted long term cuts, focused short term growth/productivity oriented projects, debt restructuring, and possibly a new currency. When every path leads to the same logical conclusion, it is time to accept the conclusion, and implement it now. As Greece clearly demonstrated, clinging to some false notion that default is “doomsday” and delaying true restructuring to appease foreign creditors (including the Troika) leads to a much worse collapse. Greece needs another round of restructuring already because it didn’t truly embrace default the first time. Default /Restructuring is a process. It needs to be planned for and carefully implemented, but it is now inevitable that it will be a part of the European “solution” and banks will bear the brunt of the cost.
In the meantime, the question for investors is how likely Draghi unleashes some new money and gives the market another brief relief rally? I’m not sure he is able to do anything meaningful and right now I believe the market will fade over the course of the day as realization sets in that not much can be done. I’m not quite ready to put this trade on, but am looking closely at going long Spanish stocks versus short German stocks. The belief that Germany will be fine while Spain is a disaster seems too common and priced in. I’m not quite there on that trade, but it is only that am looking at very closely.
While European PMI was a “clear” indicator of how deep the recession is in Europe, the Chinese PMI data seems to tell a different story? Chinese Manufacturing PMI was below 50 for the 6th straight month. China is largely a manufacturing based economy, yet GDP growth is still in excess of 8%. Somehow this reminds me of high school physics when you are supposed to understand that sometimes light is a wave, and sometimes it is a particle, but never both at the same time. That was basically as far as I got in physics, as I just had a lot of difficulty comprehending that phenomenon. Similarly, I can see how PMI can continue to show slowdown, but GDP can be really high, but it is getting harder.