Equities were heading for their worst week since October 2008 in the penultimate week of September before rallying. Banks globally were showing that they are, despite much management protestation, still at the heart of the problems troubling the global economy since 2008. EU banks, especially the French, have fallen 50 per cent in a month as sovereign stress and super leverage plus funding concerns grow and grow.
At the IMF in Washington, the message coming from the Rest of the World to the EU was to get their act together and this time they seemed to have listened. So has anything changed so far other than market sentiment?
Possibly and at the margin, conclusions are now being drawn.
Firstly there is now a common acceptance that Greece must default.
We supported this option back in May 2010, and we continue to believe that Greece can default within the Euro. The questions are thus by how much, and who will recapitalise its banks? Recent IMF estimates suggest that Greek debt to GDP is around 180 per cent and not yet under control with the economy currently contracting at around 7 per cent a year. Markets are pricing in a default of 50 per cent which may not be enough to place Greek finance on a sustainable footing. So perhaps a default of 50 to 60 per cent of GDP is mooted with a clear plan for austerity going forward and a model for other financial perpetrators.
The EU banks with greatest exposure to this default are Greek and French, so a recapitalisation plan is required.
The world is suffering from excess and excessive debt, such that default and inflation inevitably beckon
There is a clear plan emerging for either the EU or the IMF to supersize the European Financial Stability Facility (EFSF) or an EU special purpose vehicle (SPV) which can forcibly recapitalise all banks as required, as the US did with TARP in 2008/9. How this is done is unclear at this time.
Politically, this will be very difficult to achieve within the EU and Germany as they are already in the process of approving the second Greek package and thus unlikely to want to be bounced into a new mega-EU peripherals plus banks rescue plan before receiving the clear undertaking that all EU Governments will be managed properly in the future.
As ever politics is such a hard issue to call and sentiment from investors in all markets will be swung by changes to the assessments of them ’doing the right thing’. Arguably, to date the EU has done just enough only when faced with a financial black event on the horizon.
But there remains building evidence of deteriorating economies.
Back in the real world there is growing evidence of difficulties from the USA to the UK, EU and increasingly in China where recent comments from Rio Tinto caused a sell-off in commodities. Emerging markets have the financial firepower to address any weakness, but are keen to keep a control over financial property speculation and domestic food inflation for now.
When QE3 and EU solutions are put to work, through the use of printing money and excess Government borrowing, investors should remember to protect the real value of their investment, not the monetary value, especially if holding depreciating assets like the US Dollar.
Equity markets, excluding the USA, have moved to adjust to the lower economic growth scenarios, and in the EU banks are now at 2008 Lehman-lows, though they still need massive amounts of dilutive rights issues. So equities have fallen a lot already, are under-owned in the EU, and offer twoor three-times the yield of most sovereign bond markets. The world is suffering from excess and excessive debt, such that default and inflation inevitably beckon. Equities are the answer, not the problem, but remain whipsawed by events which are not of most corporates’ making.
