``The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.” Thomas Sowell
As we have repeatedly argued, politics today more than the economy shapes market activities. That’s because boom-bust cycles are essentially politically oriented where inflationism is about the politics of redistribution.
Whether the source of this week’s troubles has been from China, Greece or the US, they have a common denominator, politics rule the day.
Bizarrely, there has been an apparent disorientation from media on who to blame or which among these nations have spawned major global markets to swoon!
Perhaps we can get some clues from the recent activities depicted in the charts (see figure 1)
Figure 1: stockcharts.com: What Caused The Meltdown?
The Dow Jones Stoxx 50 (main window-STOX50) or a benchmark of major European heavyweights collapsed only during the last three successive sessions of the week which also had been reflected on the US S & P 500 ($SPX).
Whereas China’s Shanghai Index ($SSEC), has peaked last August of 2009 and has repeatedly been underpressure since the start of the year.
Meanwhile the US dollar index bottomed during the start of December, and has, from then substantially ascended.
So gleaned from the first mover advantage perhaps it could have been China. But correlations appear rather unconvincing. Possibly a time lag effect? Maybe.
Greek Mythology And Market Divergences
This brings us first to the Greece.
The Greek episode as we earlier discussed in Poker Bluffing Booby Traps: PIMCO And The PIIGS seems more like a political poker bluff. That’s because European authorities won’t likely afford to put at risk the Union’s credibility that could easily escalate and eventually result to its disintegration.
Moreover, it wouldn’t also seem in the interest of Greece to take radical actions that would result to its leaving the Union. Since most of her debts have been denominated in the Euro, any devaluation would only expand her outstanding liabilities and result to more painstaking adjustments.
The team from the Danske Bank, Frank Øland Hansen and Gustav Smidth, puts it nicely, ``Greece could also choose to leave the euro and devalue. This is seen as a 'quick-fix' by some market participants. The Greek Central Bank Governor, George Provopoulus, has however emphasised today in the Financial Times, that this is not an option. Referring to Greek mythology, he said that "The future of its economy is unwaveringly tied to the mast provided by the euro". If Greece were to leave the euro and devalue, the new currency would lack credibility and there would be expectations of further devaluations. The outcome would be higher inflation and higher rates. In addition, existing eurodenominated debt would become foreign-currency debt. Any devaluation of the new domestic currency against the euro would thus increase the debt burden. We think that this 'quick-fix' is a highly unlikely scenario too.”
In other words, Greece will have to embrace austerity with or without the Union. But to disengage with the Union will likely result to greater hardship (larger debt, lesser access to financing, lose the privilege of integrated markets) and could present as “lose-lose” scenario for both parties. Hence assuming reform under the EU’s auspices would likely result to enhanced collaborative efforts to resolve her problems.
So unless there would be other unidentified incentives that implicitly serve the political parties involved, the most likely option would possibly be either for a broad European based rescue or with an IMF assisted bailout for Greece.
Figure 2: Danske Bank: Credit Markets Amidst The Market Turmoil
True, while the recent market volatility has triggered considerable anxieties in the credit sphere, as premiums on Credit Default Swaps-or cost to insure bonds- have spiked, it’s been largely a Greek problem (see figure 2 left window-lime green trend line).
Although Italy (gray) and Spain (blue) have likewise accounted for substantial upside movements, it hasn’t been as steep as Greece.
On the other hand, Ireland’s CDS (red) has improved in spite of the recent trembler.
In addition, the index of high yield spreads of the European (right window-blue trend) and US corporations (red trend) appears somewhat little shaken by the turmoil.
Let me add that Greece’s equity bellwether, the Greece [Athens] General Share index, has fallen by 31% since mid October. This brings her back her down 61% off its 2007 highs which has been reflective of the market’s apprehensions over her default risks. The Greece index lost over 70% during the market meltdown of 2007-2008 on a peak-to-trough basis.
Now if the ECB’s forthcoming actions will, as we expect, likely focus on market calming measures then we should see some semblance of rebound for Europe’s market.
To give us a clue, former crisis affected economies of emerging Eastern Europe such as Estonia, Latvia, Lithuania, Ukraine appears to have even shrugged off the recent antsy to stage massive rallies. Estonia is up 30% (!!!) on a year to date or 3 weeks basis after falling by about 75% from the 2007 peak. The current rally has only recovered 50% of the losses [see Scorecard From This Week's Global Equity Bloodbath].
So unlike in the 2008 episode where there had been a generalized fear, which resulted to a flight to safety, the apparent market based dissonance gives some credence to the decoupling theory.
And this has two important implications:
One. If markets deteriorate further, then the current inter-market divergences (Euro credit spreads, emerging markets versus G-7 equities and bond performances) would appear as belated responses to the lead actions of the core group, particularly the G-7 and BRICs which recently suffered from heavy losses.
In short, the losses will spread and close any gap that would lead to a convergence-partially resembling the 2007-2008 episode. I say partially because policymakers given will likely react in the same magnitude and swiftness to arrest any signs of a repeat of a 2008-esque meltdown.
Two. If major markets do find some stabilization or a base in the coming sessions from the recent mayhem, then we should expect inter-market divergences to materially widen. This implies that major emerging markets will likely recover earlier or ahead of its developed country peers and that those that has recently outperformed as emerging Eastern Europe could increase its outperformances. Emerging Eastern Europe looks likely on a catch up mode.
So the perma bears, whom have mostly anchored on a 2008 meltdown or a Japan crash scenario, will possibly be met anew by another setback-failed predictions.
I think this is the most likely outcome given the significant evidences of market divergences (credit, equity and bond markets) in the face of this week’s intense selling pressure.
Gold Tracing Euro’s Path
Another aspect that I’d like to dispel is the nonsensical view that gold is behaving like a bursting bubble or reflecting on deflationary forces.
Figure 3: stockcharts.com: Nonsensical Views About Gold
One should realize that gold’s action has NOT been exhibiting deflation or inflation but instead has moved mainly in consonance with the Euro, or inversely, but to a lesser degree, against the US dollar index where the Euro constitutes a hefty 57.6% of the index (see figure 3).
Notice that the contours of both gold (candlestick) and the Euro ($xeu-black line behind gold) have been nearly the same for the past 6 months. Thereby any variances lie within the degree of the changes.
A rising Euro does NOT translate to “inflation” nor does a falling Euro imply “deflation”. That would be another sign of clustering illusions.
As the earlier divergences discussed, this seems UNLIKE the AFTER LEHMAN Syndrome of October 2008. It hasn’t been the case where liquidity is being sucked out of the system that has resulted to a banking gridlock. The problems such as Greece, China or the US Volker fund appear to be more political than economic.
In short, the Euro and gold has had a strong correlation of late. But as caveat, the high correlation doesn’t imply any semblance of causation, that’s because gold’s relevance is as nemesis of any paper based currency and that’s why even central bankers tacitly revere it as “insurance” [see Is Gold In A Bubble?].
More signs of divergences? Just look at copper ($copper). Even as gold and oil has flailed along with major equity benchmarks over the last few sessions, copper prices remains vibrant and even rose.
In addition, if one should argue about prices being representative of less speculation and more real demand for commodities, then the Baltic Dry Index seems to be another sign of deviation. It has been in consolidation.
In short, unless markets will prove us wrong, signs have been saying that the recent meltdown is likely a bear trap.
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