2012 Second Half Outlook: European Debt Crisis Catalyst
2012 Second Half Outlook: Introduction: Psychology & Sentiment
2012 Second Half Outlook: Policy Response & How To Invest
The global
financial system is now more interconnected than ever.
What happens in a trading room in London now impacts the workers in a factory
in China. This is known as the butterfly effect - a concept I discussed in detail
in 2012 Outlook: Global Butterfly Effect.
Entering the
year, the yields for government bonds in European economies were falling due to the impact of the
European Central Bank’s LTRO program. (For a detailed explanation of the LTRO program see Behind The Curtain: The European Bank Bailout & LTRO Part 2: Central Banks Are Making Their Last Stand)
Fast forward to today and Spanish
government bonds are once again approaching the 7% mark, considered by many the “point of no return”, where they will have massive difficulty funding both
their current and future payments. Italy has
tracked higher along with Spain, quietly moving into the danger territory.
Greece
continues to be an ongoing disaster. Before Greece’s bailout in March
(discussed in detail here) the country had 368 billion in government debt
outstanding. The bailout forgave 100 billion of this debt and simultaneously
provided a 130 billion euro rescue package (additional debt). This gives Greece
a current debt total of close to 400 billion as their GDP continues to shrink
in size month after month.
They lurch forward as a zombie country today based solely on life support with no access to the debt markets outside
the current bailout system. Based on the information in the paragraph above, a
5th grader can understand that their current situation is now worse
than before the bailout and they will need continuous help moving forward.
As part of
the bailout package, the Greeks were forced to agree to “austerity programs”
which means spending cuts. These cuts come at a time when the economy is already
in deep recession/depression based on the unemployment numbers and negative GDP
growth.
The people
of the country are obviously upset. Polls show that Greeks do not want
austerity cuts, but they do want to stay in the euro. Both of these cannot
happen simultaneously and which direction they choose to move in the months
ahead will have an enormous impact on their political polls and the global
economy.
In the
meantime, while their general public decides on whether they would like to remove
themselves from the euro currency or not, depositors have decided not to wait.
Money has been fleeing the Greek banking system over the past six months at a
relentless pace, moving into the safety of German and Swiss banks.
The following chart shows this silent bank run taking place:
While the
Spanish bond market has not quite reached the dire levels of Greece, the Spanish citizens, corporations, pensions, and financial institutions have connected the
dots and have already begun moving their money as well. The month of April saw a 31 billion euro outflow from the
Spanish banks.
The deposit
outflow only compounds the problems the battered Spanish banks face with their
mountain of toxic real estate loans resting on the balance sheets. Bankia, one of the largest banks in Spain
(after already merging with other toxic balance sheets), announced over the past few
weeks that they will need a bailout of 19 billion euros ($24 billion) in order
to survive. The current bank bailout fund in Spain has only 5.3 billion euros
available. Where will the government find the remaining 14 billion euros when
they are having trouble financing their current deficits? This is an excellent
question.
Estimates
have already begun to emerge on what type of bailout package/firewall would be
needed to keep both Spain and their banking system alive. An EU/IMF bailout
package to cover their funding needs through the end of 2014 (enough time to
temporarily calm the markets) would need to be 350 billion euros in size, 75
billion of which would be used to recapitalize the banks.
The European
banking system as a whole is $46 trillion in size. In comparison, the US
banking system is now only $12 trillion in size. This is due mainly to the
excessive leverage the European banking system has in place (26 to 1) vs. the
United States which has deleveraged significantly following the financial
crisis (12 to 1).
Standing
behind their banking system is the balance sheet of the European Central Bank
(ECB), which is currently leveraged at 36 to 1 and has mushroomed to over $4
trillion in size.
Up to this
point the ECB has not begun to monetize assets directly as the Federal Reserve
has over the past few years through various QE programs. The ECB has created programs that exchange assets in return for cash. The problem is that European banks are
running out of assets. Europe will soon reach the point where either the ECB must
monetize debt directly or their entire massively leveraged banking system with
both real estate and government toxic debt will collapse on itself. The following chart shows the continuous decline in European banking stocks, now down 50% from July 2011.
What lies
next for Europe? Forecasts for unemployment continue to rise across the board.
Deposit
outflows appear to be picking up speed and the bond yields of Portugal, Spain,
and Italy continue to move slowly toward the abyss. Political battle lines have
been drawn between “Austerity vs. Growth” on how to deal with the future.
My belief is
that in the short term, the people of Europe will continue to vote for anyone
who tells them they are against austerity and for both increasing government
spending and “stimulating” the economy through this rough period.
As recently
as a few months ago, both France and Germany were vocal supporters over the need
for austerity across Europe. As the French economy begins to slow down and their
banking system (which holds a massive amount of Italian government bonds)
continues to deteriorate, they have slowly changed their tone and moved toward
“growth through spending.”
In the
meantime, while the politicians argue back and forth, the rest of the global economy is
feeling the pain of the European slowdown. The butterfly effect is now once
again front and center.
Up Next: The Butterfly Effect Returns
h/t Wall Street Journal, Eric Sprott, Phoenix Capital Research, Zero Hedge
h/t Wall Street Journal, Eric Sprott, Phoenix Capital Research, Zero Hedge
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