BACK FROM THE BRINK / BARRON´S ( A MUST READ )

Up and Down Wall Street


SATURDAY, JULY 23, 2011

Back From the Brink

By ALAN ABELSON

What a double play! It was as if that celebrated trio of Tinker to Evers to Chance had been summoned back from the field of dreams where they led the Chicago Cubs to dominate the National League in the early years of the last century, and had invoked their nonpareil baseball wizardry to enable the world to avoid financial calamity.


It was an extraordinary week, indeed, as both the euro zone and the U.S. hovered on the cusp of the precipice, with Greece headed for disaster and the real possibility of touching off a chain reaction that could wreak havoc on the European Union and beyond, while the standoff here on whether or not to lift the debt ceiling threatened our proud nation, once the globe's leading creditor, with the ignominy of defaulting on its borrowings.


Little wonder, then, when the Europeans frantically threw together a plan for still another bailout of Greece, and word came from Washington with admirable simultaneity of a likely breakthrough in our debt-ceiling impasse, the global response was one enormous sigh of relief. In truth, the stock market in the U.S. had begun rallying earlier in the week on the blithe conviction that the warring parties in the capital would somehow contrive to arrive at any uneasy armistice that provides the pols with cover no matter which side of the struggle they were on.


The trouble with sighs of relief is that they're occasioned by the grateful release of great tension—a terrifying close call, an event that wasn't as bad as expected or fears that didn't prove out. They're a response, in other words, to something in the past and not necessarily an anticipation of good things to come. And as Friday's becalmed market action demonstrated, the buoyancy inspired by the seeming resolution of looming financial woes tends to wear down rather quickly in the absence of some fresh catalyst. Especially, we grant, when it's the last trading session of the week, at least as hot as Hades and the beach and cool mountains beckon.


Obviously, however jerry-built the device designed to shore up Greece, it's inarguably preferable to throwing that financially imprudent country to the wolves. In the same vein, however contorted the compromise that staves off default by the U.S., it's likely to be far and away less damaging to our reputation and pocketbook than becoming the world's No. 1 deadbeat.


At this writing, said compromise is not yet a done deal. But given Mr. Obama's aversion to down-and-dirty combat and the reluctance of the Republican leadership, whatever the cries from the rank and file, to risk the political fallout from the public's perception that their party's intransigence shut down the government, we're still of a mind that a deal will be done.


Once the exultation dies down—and that may take a few weeks—investors are apt to realize that a listless economy is not the stuff bull markets feed on. For as Northern Trust's Paul Kasriel and Asha Bangalore point out in a recent commentary, in the 38 weeks ended July 6, quantitative easing, love it or hate it, accounted for all of the 6.7% annualized growth in combined Fed and commercial bank credit, with bank credit actually contracting at an annualized rate of 0.8%.


As it happens, QE is now a dead bird. And its absence, so reckon Paul and Asha, will be "a persistent head wind to growth" for both domestic aggregate demand and real GDP. Nor is it going to help, they posit, that China's economy is slowing, which may well exert a negative effect on U.S. exports.


Come to think of it, dubbing this economy listless, as we just did, may turn out to be a gross understatement. Just trying to be kind, we guess.


WHEN THE SPARRING IS OVER and terms of the proposed agreement to lift the debt ceiling and take a swipe out of expenditures become clear, we'll undoubtedly have a go at the results and their implications for life, liberty and the markets. Gosh knows what kind of devil's brew our blessed representatives are concocting, but we aim to parse the thing close-up no matter how repugnant. Meanwhile, we'll turn our focus on the latest Greek bailout project. And here we're lucky because we managed to enlist our old friend and Roundtable regular Felix Zulauf to guide us from his perch in Switzerland.


Felix runs the eponymous investment firm Zulauf Asset Management, is a bright and sensible fellow and has a truly global purview of markets and economies. We should say he has long been a euro skeptic in keeping with his precept that a monetary union can only survive if the different economies of the member countries are very similar or it's composed of a full fiscal and political entity, comparable to the good ole' U.S. That obviously isn't the case with the euro. And, fair warning, he's not very much taken with the latest effort to keep Greece afloat.


The rescue blueprint is supposed to provide Greece with financing through 2014. (We've forgotten how long the first bailout was projected to be good for, but, if nothing else, the Greeks emerged as pretty adept at spending large sums in a short time.) The European Financial Stability Facility (EFSF, for short) and the IMF will cough up 109 billion euros ($157 billion), the private sector (read: banks) will chip in, one way or another, 50 billion, while the Greek government will use some of its new-found largess to buy back old debt currently changing hands in the open market at a discount of 50%.


In other words, as Felix puts it, the banks will take a hit of €50 billion over three years (around 21% of their original investment), while the EFSF and the IMF supply the rest. The bailout blueprint avoids for the time being default and escalating contagion, but in Felix's view it does zilch to ameliorate the causes of Greece's (or anybody else's) fiscal woes. "The politicians," he explains, with only the vaguest of smirks, "obviously believe that the world will get back to good growth and great tax revenues" and the problems will vanish. Which, not surprisingly, he sees as pure, unadulterated hogwash.


He points out that Luxembourg, the Netherlands and Finland seem to have a thing about spendthrifts, and can't be counted on to support the loan guarantees. Belgium is groaning under the burden of its own heavy indebtedness and la belle France is much weaker than it seems on superficial analysis. That leaves Germany to pay the mounting bill, which he estimates already tops a cool €500 billion, and he owns up to the distinct feeling that Chancellor Merkel doesn't like that one little bit.


As the primary cause of the euro crisis, Felix fingers the huge competitive differences between Germany, which has frozen labor costs over the past 10 years and the weak sisters of the euro union, not a few of whom merrily partied and went deeply in debt often via real-estate booms even gaudier that the one that ultimately laid us low. The banks of the peripheral members are suffering from what he calls "a slow-motion bank run." To make matters worse, the governments of the peripherals have imposed fiscal austerity, which he expects, will plunge their economies back into recession by the time the fourth quarter rolls around.


In the short run, Felix says, the plan, as we've seen, allows investors to exhale and markets to rally. But once the touch of euphoria plays itself out, the omens are anything but bright. For one thing, the EFSF has only €440 billion in its vaults. That's more than enough for humble folks like us, but scarcely enough if, as he deems likely, global growth slows and other troubled mendicant governments come cup in hand begging for a bailout.


The European Central Bank, moreover, seems bent and determined to continue to steer a tight policy course out of fear of misusing monetary policy to manage short-term economic problems. The result is sparse liquidity in Europe in contrast to abundant liquidity in the U.S., compelling the shakier members of the union to fund themselves via dollars and turning those bucks into euros. That makes the euro stronger but further weakens the competitive position of the peripherals.


Mario Draghi, the Italian successor to Jean-Claude Trichet as head of the ECB (the change is slated for September) apparently wants to show, Felix suspects, he's more German than the Germans, which means the bank will be in no hurry to ease up. But come the next crisis and the bank will have to cave and switch to a more accommodative monetary policy. Once that happens, Felix predicts, the euro will take a mean spill.


Thanks to the decision to once more bail out Greece, equity markets, he concludes, may rally and U.S. shares might even reach new highs in the next two to four weeks. But, avers Felix, stocks are moving in a different direction than the sluggish underlining economies. He compares the situation to a fully loaded plane flying too low and at slowing speed. "Under such circumstances," he warns, "all sorts of unpleasant surprises usually arrive."
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