The Fantasy of Forcing the Rich to Bail Out Europe

In the world of statism, everything operates in very simple terms. Just come up with the numbers (supplied by supposed experts), and expect every edict to deliver the targeted results.

Such insight can be gleaned from the blaring drumbeat of class warfare politics in the Eurozone where political authorities have been eyeing to tax the rich to solve the current crisis.

Writes the CNBC,

To many in Europe, the Continent has two big economic problems: Huge debt, and high inequality between the rich and the rest.

Now some politicians are advocating a plan to solve both.

The idea, first floated by a German economic policy group, calls for imposing a 10 percent tax on the wealth of the richest Europeans and forcing them to lend money to their governments.

The plan calls for placing a one-time 10 percent levy on the total assets for those with more than $309,000 in assets (or couples with more than $611,000). In addition, it calls for a “forced loan” program, in which the wealthy lend money to their governments that could be paid back over time.

Stefan Bach of the prestigious the German Institute for Economic Research (DIW) in Berlin, which floated the plan, said that: "In many countries the sovereign debt levels have increased considerably, and at the same time we also have very high amounts of private assets that, taken together, considerably exceed the total national debts of all [euro-zone] countries."

In other words, the wealth of the wealthy is more than enough to plug government budget holes.

The idea gaining popularity among European politicians. An Austrian member of the European Parliament, Jörg Leichtfried, favors the plan for forced loans, saying the rich could lend to the states at low interest rates. The loans, he said, would not be an “expropriation,” since they would be paid back. The head of Austria’s Social Democratic Group also backs the plan, saying states need to fix their budget troubles.

For statists: legalize the plunder of the wealthy, collect and the problem gets easily solved.

But there are two more problems to reckon with;

one, statists and politicians are dealing with human beings who will act to protect their own interests from political predations, and

second, if taxing has been that easy then what stops government from spending more? Having to confiscate everything else from the rich, these politicians would end up with no one else to tax. So we end up with a crisis again.

A good example of the first scenario is the recent incidents of “runaway luxury yachts”, as blogged by Dan Mitchell of the Cato Institute, where wealthy yacht owners flee Italian taxing authorities by sailing to and docking at foreign “friendlier ports”. These yacht owners would instead access their boats through “low-cost budget flights from Italy for a fraction of the tax bill they might otherwise face”.

In addition, the unexpected consequence from taxing yacht owners has been to penalize the industry which affects mostly the middle income people, who suffer from lost business opportunities.

So tax authorities essentially does an Aesop, kill two birds with one stone.

The moral of the tax story says Dan Mitchell is that

The politicians need to understand that taxpayers don’t meekly acquiesce, like lambs in a slaughterhouse.

• When tax rates increase, sometimes people engage in tax avoidance, lowering their tax liabilities legally.
• When tax rates change, sometimes people choose to alter their levels of work, saving, and investment.
• And when tax rates go up, sometimes people resort to illegal steps to protect themselves from the tax authority.

Heck, even the folks at the International Monetary Fund (a crowd not known for rabid free-market sympathies) have acknowledged that excessive taxation is the leading cause of the shadow economy.

Thus, the idea that forcing the rich to bailout Europe is just that…a statist fantasy.

Phisix: Why the Contagion Risk Must Not be Discounted

Here is what I wrote last week[1]

after 3 successive weeks of advances which racked up 8.53% in returns, it would be normal to see some profit taking.

So apparently correction of the Phisix materialized.

In line with the activities of the region’s bourses, the Phisix fell 2.76% this week.

For our ASEAN peers, the outcome had been mixed. Thailand and Malaysia was modestly higher while Indonesia joined the Phisix in a correction mode but had been down moderately.

The BRICs or Brazil, Russia, India and China continue to suffer from hefty losses.

Whatever bounce we have seen lately have mostly signified as deadcat’s bounce for the BRICs. So far only India (BSE) has shown a little bit of strength compared to her contemporaries; China (SSEC), Brazil (BVSP) and Russia (RTSI)

If you have noticed, events have become sooo incredibly short term oriented, exceedingly volatile, and at worst, complacency seems to have become a dominant feature, especially in the Philippine setting, where the current environment has largely been seen as hunky dory.

And part of my concern stems from idea that BAD news has been interpreted as GOOD news where many have come to believe that either local and regional markets have become immune to the external developments or that interventions has been seen as a sure thing and will always be successful.

And as I have pointed out during the past few weeks, my other concern is that perhaps the Philippine market may have been “jockeyed” to project political goals.

Bubble Cycles: This Time Will NOT be Different

“This time is different” are four words that I fret most. For the late investment legend Sir John Templeton these are the four most dangerous words in investing[2].

Such statement is symptomatic of overconfidence, a deeply ingrained euphoric sentiment or an embedded belief that a new paradigm has somewhat reconfigured how life would play out.

A classic example is when the late distinguished monetary economist Irving Fisher infamously declared that the US stock market, at the climax of the bullmarket in 1929, had reached “a permanently high plateau.”[3] What followed in the coming months were the gruesome Wall Street Crash and the Great Depression.

So when I stumble upon news which avers that “Southeast Asia is looking more a safe haven than a risky bet, with foreign investors souring on China and India and pouring money into markets proving resilient to the global gloom”[4] such assumptions gives me a creepy feeling.

That’s because such sentiment evokes of the memories of the excruciating Asian crisis which once was heralded as the “Asian Economic Miracle”[5] in 1994 and which ultimately turned out into a grand cataclysmic bubble bust in 1997.

Yet it took 3 years for the bust to occur.

But euphoria does seep through public’s consciousness even when bubble cycles have not been homemade.

Exactly during the pinnacle of the last boom phase of the Philippine stock market, a local news outfit featured the ‘basura queen’ in June of 2007[6]. Basura is a local term for garbage and a stock market colloquial or slang for high risk issues.

The ‘Basura’ Queen swaggered about her making millions out of ‘basura’ issues, or the penny stock equivalent of Wall Street.

Overconfidence and the increasingly desperate search for returns seem to be revving up the public’s appetite for gambling.

But the seeds of a homegrown bubble are also being sown.

The Fitch Rating, a US credit rating agency recently, seems to have echoed on what I have been repeatedly warning about: that the Philippines may be on the ‘brink’ of a domestic credit boom[7]. Not just on the brink, we are already having a domestic credit boom[8].

Of course, local officials will hardly do anything about this, since the credit boom will spruce up the economy over the short term and would thereby provide an image booster or political advertisement to the incumbent administration as their “major accomplishment”.

The boom will be seen as a feat, but the bust will be passed on like a hot potato. In politics, who cares about the future?

Besides, officials have limited knowledge of the unseen or undefined “equilibrium” levels from where or which point to put the policy brakes on.

In addition, since the Philippine political economy have been mostly state driven, chieftains of the industries involved in the boom, who are most likely allies of the administration, will exert their political capital to influence on the direction of policymaking thereby extending the boom to unsustainable levels.

Finally since policymakers have innate Keynesian leanings, who try to promote consumption as the main policy thrust, the policy of negative real rates will drive

1. consumer spending through acquisition of more debt via mortgages, credit cards, and other consumer loans,

2. encourage more government spending which will be financed by low interest rates from the private sector, particularly channelled through banks and other financial institutions, which again would add to systemic debt, and importantly leads to consumption at the expense of production, and lastly,

3. fuel capital intensive speculation which will likely be directed to real estate projects, manufacturing and mining, and which again leads to more systemic debt accrual. Such misdirection of allocations of resources eventually leads to the consumption of capital. A great bust.

Again all inflation is political, designed to push the interests of a few at the expense of the society

And I am talking here of a locally fuelled bubble which is aside from today’s present risk: contagion.

Europe’s Capital Flight Paradigm

In case of a full blown global recession, there has hardly been convincing evidence that ASEAN bourses will entirely decouple.

As I predicted Japanese foreign direct investments capital flows into ASEAN has currently been intensifying[9].

Since Japan’s capital flows into ASEAN have still been couched on the term ‘investments’ based on ‘growth’, this has yet to translate into a full capital flight dynamic where Japanese investors frantically stampede into ASEAN assets regardless of risk conditions.

Once Japan’s debt crisis reaches a ‘tipping point’[10], where in the face of the dearth of access to private capital and from external financing, and where the Bank of Japan (BoJ) will substitute as the buyer or financier of last resort of local sovereign papers in order to save the banking system, then this ‘growth’ dynamic will likely be substituted for ‘flight to safety’[11].

Such dynamic appears as partially being played out in the Eurozone: government debts of Germany, Finland and Netherlands[12] (as well as Denmark[13]) have become lightning rods against the concerns of the Eurozone’s dismemberment and this dynamic has also began to diffuse into Belgium and France.

Yes, it is panic time in the Eurozone as expressed by the bond markets…

…but not in the equity markets

I think that the difference is that the European Central Bank (ECB) has yet to aggressively step up as the buyer and financier of the last resort which is why most of the capital flows have been absorbed into government bonds.

Nevertheless some of these safehaven flows may have already been rechanneled to the equity markets of Germany (DAX), Denmark (KFX), Netherland (AEX) and Belgium (BEDOW).

Meanwhile the Finnish and French bellwether has yet to ventilate similar ‘capital flight’ dynamics.

Remember if the risk conditions in the Eurozone stabilize, then these capital flight dynamics will likely be reversed as money flows back to their sources, and the current boom may turn out to another bust, which ironically may again fuel more destabilization.

Some bullish background, eh?

Contagion Risk Must Not be Discounted

We shouldn’t forget that the Asian Crisis proved that contagion risk was a real risk that spread throughout the region.

As the Reserve Bank of Australia noted[14],

One can then locate the onset of crisis in Korea, Indonesia, Malaysia, and the Philippines in a process of contagion: a flip to the bad equilibrium to which the economies were vulnerable, in response to the ‘wake-up call’ (i.e. signal) from Thailand that this was a possible outcome.

This was likewise true with the 2007-2008 meltdown of the US property and mortgage bubble.

Remember that the real effects of an external transmission of contagion were hardly felt since the Philippine economy escaped a recession and that the ensuing global slowdown hardly left an imprint to local corporate earnings, yet the Phisix lost over half of its value from peak to trough[15]!

So while it may be true that those years had different conditions from today, despite some of the real relatively positive changes on ASEAN economies, we must be reminded that globalization and dependence on the US dollar through international currency reserve accumulation via the global banking system has been the umbilical cord for global asset markets.

Merchandise trade as % of GDP remains as a significant factor to ASEAN economies particularly to the Malaysia and Thailand.

But the Philippines also depends on foreign remittances (10.73% of GDP 2010[16]) as well, and to the lesser extent Indonesia (>1% of GDP 2010[17])

While the Philippines and Indonesia may be less exposed, the question will be internal dynamics.

Dependence on government spending only provides temporary relief (benefits the cronies) at the expense of the future (higher taxes, higher debt levels, and higher inflation)[18].

Has the political, legal, tax and regulatory environment eased to incentivize entrepreneurs to take on more productive ventures?

Philippine economic growth has recently been powered by exports[19], most likely due to global restocking. But with a ongoing recession in the Eurozone, as well as, a pronounced slowdown China and other major emerging market economies, and importantly the US, expectations of robust “double digit” growth signifies as wishful thinking…unless major central banks come up with more aggressive short term palliatives.

And a slowdown in global merchandise trade has been prompting for a contraction on trade surpluses (perhaps partly due to increasing domestic demand) and a reduction of foreign currency reserves, as some emerging market central banks have attempted to stabilize exchange rate values with use of these surpluses and thus results to monetary tightening conditions that may not be conducive for equities[20].

In addition, the banking crisis at the Eurozone will prompt for major balance sheet adjustments in order to raise capital mostly through shrinkage, particularly banks are slated to reduce balance sheets by €2 trillion by dumping 7% of these assets by the end of 2013. This also means that supply of credit to the economy will contract.

Of course the real problem isn’t due to credit contraction which affects mostly the government and their protégé the banking system but of the failure to undertake real reforms focused on competitiveness and productivity[21].

Yet under the worse policy scenario arrived by IMF estimates according to DBS Research[22], a dramatic slowdown in the economy compounded by bank deleveraging (bursting bubble) will affect even the US and emerging markets will not be spared (most especially in Eastern Europe).

So we can hope for the best and prepare for the worst.

So underneath the headlines, ASEAN+3 (China Japan and South Korea) have doubled their Chiang Mai Initiative Multilateralism (CMIM) currency swap buffer to USD 240 billion which was a third funded by total foreign reserves accumulated by ASEAN 5 (US 765 billion as of April)[23][24].

So while Asian central bankers have been adding insurance against the risk of the aggravation of Europe’s banking crisis, domestic investors have been in a buying binge.

Yet the ongoing Euro-Brazil, Russia, India, China slowdown compounded by deleveraging within their respective economies has already affected Singapore whose economy suffered a contraction last quarter[25]

Yes China’s economy managed to post 7.6% growth last quarter, but many questioned on the validity of the statistics used to arrive at this output which for some have been overstated for political reasons[26]

And yet US and European markets rallied fiercely last Friday, which according to news drew on the conclusion that the recent conditions of China’s economy will lead to more monetary accommodation by policymakers[27]. Bad news again seen as good news.

I think that such knee jerk response represents more of a melt-up from “crowded short positions” rather than a major inflection point.

As Prudent Bear analyst Doug Noland rightly points out[28],

But the downside of the Credit cycle radically alters rules of the game. Over time, reality sinks in that the previous prosperity was in fact an unsustainable boom-time phenomenon. The downside of the Credit cycle ensures faltering asset prices, deflating household net worth and financial sector deficiencies, along with the revelation of problematic economic imbalances and maladjustment. It’s not long into the bust before many see themselves as losers – and to have lost unjustly at the hands of an unfair system. The growing ranks of losers become an increasingly powerful political force.

Nevertheless I expect Friday’s huge jump to filter into Asian markets including the Phisix at the start of the week.

My conclusion remains: for as long as political gridlock over policies persists (in the US, China and Eurozone) and central bankers of major economies remain rudderless, markets will remain subject to extreme volatility from the collision of hope (expectations of decoupling, deeply embedded Pavlovian expectations of major central bankers coming to the rescue and of the narcotic effects of inflationism) and reality (ramifications from deflating bubbles: economic slowdown and deleveraging). Not to discount of the possibility of major policy errors from too much focus on the short term fixes.

While I remain bullish over the Phisix over the long term, the short term horizon has been filled to the brim with uncertainties coming from almost every direction. This for me magnifies the tail event risks.

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[1] see Why Current Market Conditions Warrants a Defensive Stance July 9, 2012

[2] SirJohnTempleton.org Consider these 'words of wisdom' about investing September 20, 2006

[3] Wikipedia.org Irving Fisher

[4] Reuters.com Southeast is Asia safe haven as China, India stumble, July 14, 2012

[5] Wikipedia.org 1997 Asian financial crisis

[6] See Philippine Stock Exchange: The PUBLIC’s MILKING Cow???!!!, June 17, 2012

[7] Inquirer.net Philippines on the brink of a credit boom, must be wary of dangers—Fitch Rating, July 6, 2012

[8] See Why has the Phisix Shined? July 2, 2012

[9] See Japan’s Capital Flows to ASEAN Accelerates July 4, 2012

[10] See The Coming Global Debt Default Binge: Japan’s Government Under Financial Strains July 9, 2012

[11] See Will Japan’s Investments Drive the Phisix to the 10,000 levels? March 14, 2012

[12] Bloomberg.com AAA Yields At Zero Drive Investors To Belgian Debt: Euro Credit July 13, 2012

[13] See Denmark Cuts Interest Rates to Negative July 6, 2012

[14] Corbett Jenny, Irwin Gregor and Vines David From Asian Miracle to Asian Crisis: Why Vulnerability, Why Collapse? 1999 Reserve Bank of Australia

[15] See Dealing With Financial Market Information February 27, 2011

[16] Tradingeconomics.com Workers' remittances and compensation of employees; received (% of GDP) in Philippines

[17] Tradingeconomics.com Workers' Remittances And Compensation Of Employees; Received (% Of GDP) In Indonesia

[18] See S&P’s Philippine Upgrade: There's More than Meets the Eye July 3, 2012

[19] ABS-CBNNews.com May exports growth at 17-month high, July 10, 2012

[20] See Emerging Market “Liquidity” Conditions Deteriorate July 5, 2012

[21] See What to Expect from a Greece Moment June 17, 2012

[22] DBS Vickers Economics Markets Strategy 3Q 2012 June 14, 2012

[23] Ibid

[24] Wikipedia.org Chiang Mai Initiative

[25] See Contagion Risk: Singapore Economy Contracts, July 13, 2012

[26] See China’s Economic Growth Slows Anew, Economic Data Questioned July 13, 2012

[27] Bloomberg.com S&P 500 Erases Weekly Loss On JPMorgan Rally, China, July 13, 2012

[28] Noland Doug Game Theory And Crowded Trades Credit Bubble Bulletin, Prudent Bear.com July 13, 2012

Is it Time to be Bullish BRICs and other Emerging Markets?

Goldman Sachs’ Jim O’Neill is bullish BRICs

From Bloomberg,

The biggest emerging markets are contributing more than ever to the global economy as their proportion of the world stock market shrinks, leaving investors with the widest valuation gap in seven years.

Brazil, Russia, India and China, known as the BRICs, will comprise 20 percent of the world economy this year after growing more than four-fold in the past decade, International Monetary Fund data show. At the same time, their combined stock-market value has dropped to a three-year low of 16 percent of the total invested in equities, according to data compiled by Bloomberg.

To Jim O’Neill, the chairman of Goldman Sachs Asset Management who coined the term BRIC in a 2001 research report, the 4 percentage point difference makes stocks in these markets irresistible. The last time the gap was this wide, in 2005, the MSCI BRIC Index (MXBRIC) jumped 53 percent in 12 months, more than double the gain in the MSCI All-Country World Index. (MXWD)

“Unless we are seeing a major collapse of those economies, it’s a huge opportunity for investors,” O’Neill, who helps oversee $824 billion, said in a June 28 phone interview. The BRIC stock markets may double by 2020 as their share of world gross domestic product increases to about 27 percent, he said.

Combined GDP in the BRICs will rise to more than $14 trillion this year from $2.8 trillion in 2002, according to the IMF. Their equity value, which includes locally-traded shares and companies based in the BRIC nations with primary listings abroad, has dropped to $7.6 trillion from $9.5 trillion a year ago, when they made up 18 percent of the global total, according to data compiled by Bloomberg.

History is not a reliable indicator of the future. Otherwise to paraphrase Warren Buffett, the best investors or the richest people would have been librarians.

Contra O’Neill foreigners have become defensive and have taken the home bias stance.

Again from the same article…

Fund Outflows

Petroleo Brasileiro SA (PETR4), Brazil’s state-controlled oil company, fell to the world’s 39th-largest company by value from the 10th-biggest in July 2011. China Construction Bank Corp. (939)’s rank dropped to 20 from 12 while OAO Rosneft,Russia (INDEXCF)’s largest oil producer, sank to 106 from 70.ICICI Bank Ltd. (ICICIBC), India’s second-biggest lender, has lost 17 percent during the past year, compared with an average gain of 9 percent for global peers.

The retreat has pared what was a 180 percent increase in the MSCI BRIC index since October 2008 and reflects concern that economic growth is slowing, according to John-Paul Smith, an emerging-market strategist at Deutsche Bank AG in London. Mutual funds that invest in BRIC equities, which recorded about $70 billion of inflows in the past decade, have posted 16 straight weeks of withdrawals, losing a net $5.3 billion, EPFR Global data show.

Why?

Downside Risk

While the BRIC economies expanded by 4.8 percent on average during the first quarter, more than double the pace in the U.S., their growth decelerated from 6.8 percent a year earlier.

Falling stock markets suggest the slowdown will worsen because share prices are a leading indicator of economic growth and corporate profits, said Michael Shaoul, the chairman of Marketfield Asset Management in New York. The $2 billion Marketfield Fund (MFLDX) has topped 99 percent of its peers this year in part because of bets that emerging-market shares will retreat.

“Equity markets have started to anticipate much more difficult economic times in these countries,” Shaoul said in a June 28 phone interview from New York. “The balance of risks is to the downside.”

The balance of risks has indeed been to the downside.

Here’s Zero Hedge to prove that point. (bold original)

The sea of red just got even redder as Japan, Korea, Norway, South Africa and Taiwan all dropped below 50, i.e., into contraction territory. From Bank of America: "Overnight and early this morning, a bevy of global manufacturing PMI reports were released. This provides us with an early reading on the state of manufacturing. Out of the 24 countries reporting so far, 10 saw month-over-month improvements in their manufacturing PMIs, while fourteen countries saw their PMIs worsen in June. Seventeen of the manufacturing PMIs were below the 50 breakeven level that divides expansion (+50) from contraction (+50). A majority of the below-50 PMI indices are located in the Euro area. The ongoing sovereign debt and banking crisis continues to weigh on the region’s economic activity and sentiment. The Euro area slowdown is beginning to impact the rest of the world."

I believe this is more than just about the Euro debt crisis, but also of the slowdown (or bubble bust) in China.

So far what has been kept the markets buoyant has been the repeated doping of the markets with minor bailouts and of the torrent of pledges of more bailouts.

In reality, markets remain highly fragile.

As I wrote last weekend

But the dicey cocktail mix of political deadlock, escalating economic woes and the uncertain direction of political (monetary) policies contributes to the aura of uncertainty that may induce a fat tail event.

A recovery in the BRICs and emerging markets will likely be reinforced by a recovery in commodity prices. This has not yet been established.

Until perhaps central bankers of major economies makes major moves, I don’t think the time for positioning on the BRICs is ripe.

Global Financial Markets: Will the EU Summit’s Honeymoon Last?

Intense global market volatility continues. Today’s ambiance seems conducive for adrenaline seeking high rollers.

The Philippine Phisix has been experiencing sharp volatility too. But contrary to my expectations, gyrations has swung mostly to an upside bias.

Along with Pakistan, the local benchmark has been outperforming the rest of the Asian region. The Philippine Phisix ranks as the sixth best performer based on year-to-date nominal currency benchmark returns.

Of the 71 international bourses on my radar screen, about a hefty majority or 67% posted gains on a year-to-date basis as of Friday’s close.

This hardly has been representative of a bearish mode.

In addition, the Phisix is just about a fraction or spitting distance away (1%) from the May record highs at the 5,300 level. And considering that equity markets of the US and European markets skyrocketed Friday, a new Phisix milestone record seems to be a “given”.

Repeated Doping of the Markets Triggered a RISK ON Environment

Yet global stock markets appear to be detached from real world events.

Bad news has prominently been discounted and bizarrely treated as good news. It’s a sign of abnormal conditions, as well as, the amazing complexity of the nature of markets behaving in response to massive price distortions from political actions.

Global equity markets began with their creeping ascent in June. This excludes China’s Shanghai (SSEC) index though.

Each week since, global equity markets rose on a barrage of bailout related developments. The evolving events can be categorized as actualized bailouts and events that accommodated a prospective bailout.

Spain’s bailout[1], the extension[2] of Operation Twist by the US Federal Reserve and the latest EU summit[3] could be seen as examples of the actualized bailouts. They account for as promises made good through actions.

The culmination of the Greece elections[4], the easing of collateral rules[5] and pledges for stimulus[6] signifies as both market conditioning, and of the prospective accommodation for future bailouts. People saw these events as indicators of prospective political actions

I drew and noted of the timeline of the actualized bailout events along with the chart of the major indices. Clearly we see Europe’s STOX 50, the US S&P 500 and Dow Jones Asia (P1Dow) responding to political actions.

Friday’s supposed “breakthrough” from the EU summit sent global markets into a frenzied RISK ON spiral.

The deal reportedly[7] facilitates a direct injection mechanism into stricken banks by EU’s rescue funds, particularly the temporary European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM). The rapprochement also included the option of intervening in the bond markets, the waiving of preferred creditor status on ESM’s lending to Spanish banks and the creation of a “single banking supervisor” which marks the first step towards a banking union and an allegedly a backdoor route towards a fiscal union.

Since the deal has been seen as a “shock and awe” policy, and went beyond market’s expectations and partly fulfilled the mainstream’s yearnings for a union, global financial markets went into a shindig

The soaring Phisix has given some the impression of decoupling. This hasn’t been accurate. While there have been some instances of short-term divergence, decoupling or lasting divergence may not be in the cards.

What has distinguished the Phisix is her OUTPERFORMANCE. The repeated doping of the markets which has been inciting the current “recovery” benefited the Phisix and the top performers most.

Yet both developed economy markets and ASEAN markets (Thailand’s SETI, Malaysia’s MYDOW and Indonesia’s IDDOW) have virtually and coincidentally “bottomed” during the start of June and ascended in near consonance from then. The point is that the underlying trend has been similar but the returns have been different.

And since shindig from Friday’s EU summit has yet to be priced in on ASEAN markets, perhaps Monday’s open will likely reflect on the newfound euphoria.

The elation from the EU Summit deal has not been limited to the global stock markets but was likewise ventilated on the commodity markets and on the currency markets.

Gold, Oil (WTIC), Copper and the benchmark CRB or an index accounting for a basket of 17 commodities all scored hefty one day gains.

Non-US dollar currencies like the Euro likewise posted a huge one day 1.83% gain. The Philippine Peso also firmed by .7% to 42.12 to a US dollar. The Peso is likely to break the 42 levels if this momentum continues.

Overall, this is your typical RISK ON environment.

EU Summit’s Honeymoon: Sorting Out the Cause and Effects

The ultimate question is does all these represent an inflection point that favors the bulls?

Candidly speaking this “rising tide lifting all boats” scenario are the conditions that would make me turn aggressively bullish. BUT of course, effects shouldn’t be read as the cause.

In the understanding that the markets have thrived throughout June on REPEATED infusions of bailouts and rescues, my question is what happens if markets are allowed to float on its own? What happens when the effect of the bailouts fade? Or outside real political actions of bailouts, will markets continue to rise on the grounds of mere pledges or from hopes of further rescues?

The current environment seems so challenging.

Yet there seems to be many kinks or obstacles to the supposed EU deal.

First, while the premises of the EU deal have been outlined, the details remain sketchy.

Second, a change in the lending conditions of Spain’s bailout may also trigger demand for changes of other bailed out nations to seek similar terms. This may lead to more political squabbling.

Third, the ESM has yet to be ratified[8] by members of the Eurozone

Fourth, EU’s combined capacity for the EFSF and ESM, even if complimented by the IMF, represents a little over half of the total funding requirements[9]. Thus, the proposed therapy from the EU summit will likely only buy sometime.

Fifth, the controversial deal rouse a popular backlash against Germany’s “surrender” or “blackmailed” into accepting the conditionality set by the EU. Such views have been ventilated by major media outfit[10].

Even after the German parliament immediately passed bailout pact, several German lawmakers along with opposing political groups responded swiftly by filing suites to challenge the accord at the Federal Constitutional Court[11]. Since the German President President Joachim Gauck said that he would withhold the passage of the new laws pending the resolution of lawsuits, the rescue mechanism may suffer risks of delay, or at worst, a reversal from the courts.

Sixth, the preferred path towards centralization will likely exacerbate the problems caused by regulatory obstacles and by deepening politicization of the marketplace[12]. Politicians don’t seem to get this. They have been inured to treat the symptoms and not the causes.

Yet the problems have not been confined to the EU. There remains uncertainty over China’s seemingly intensifying economic woes. The local Chinese government have reportedly resorted to selling cars to raise finances[13]. As of this writing, a new report shows that China’s manufacturing conditions have been worsening[14]. Most importantly Chinese authorities seem to be in dalliance over demand by the media for more rescues.

Developments in the US have not been upbeat either. The Supreme Court’s upholding of the Obamacare will have massive impacts to the economy and to US fiscal balances[15]. “Taxmaggedon” or massive tax increases[16] slated for 2013 out of the expiration of tax policies may also impact the economy. There is also the contentious US debt ceiling debate. All three are likely to become critical issues for the coming US elections, this November.

Importantly the rapid deceleration of money supply is likely to pose as a headwind for the US markets as well as the economy.

Bottom line:

Yes momentum may lead global markets climb the wall of worry over the interim. But the dicey cocktail mix of political deadlock, escalating economic woes and the uncertain direction of political (monetary) policies contributes to the aura of uncertainty that may induce a fat tail event.

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[1] See Expect a Continuation of the Risk ON-Risk OFF Environment June 11, 2012

[2] See US Federal Reserve Extends Operation Twist, Commodities Drop June 21, 2012

[3] See Markets in Risk ON mode on Easing of EU’s Debt Crisis Rules June 29, 2012

[4] See Shelve the Greece Moment; Greeks are Pro-Austerity After All, June 18, 2012

[5] See ECB Eases Collateral Rules as Banking System Runs out of Assets, June 23, 2012

[6] See From Risk OFF to Risk ON: To Stimulus or Not?, June 7, 2012

[7] Reuters.com EU deal for Spain, Italy buoys markets but details sketchy, June 29, 2012

[8] Wikipedia.org, Ratification European Stability Mechanism

[9] Zero Hedge Last Night's Critical Phrase "No Extra Bailout Funds", June 29, 2012

[10] Telegraph.co.uk EU Summit: How Germany reacted to Merkel's 'defeat', June 30, 2012

[11] Bloomberg.com Germany’s ESM Role, EU Fiscal Pact Challenged in Court June 30, 2012

[12] See What to Expect from a Greece Moment, June 17, 2012

[13] See Out of Cash, Local Chinese Governments Sell Cars, June 27, 2012

[14] See Deeper Slump in China’s Manufacturing, Will Bad News Become Good News? July 1, 2012

[15] See Obamacare’s 21 New or Higher Taxes for the US economy, July 1, 2012

[16] Heritage Foundation Taxmageddon: Massive Tax Increase Coming in 2013, April 4, 2012

Quote of the Day: Connecting the Dots: The System is Crumbling

Simon Black of the Sovereign Man eloquently nails it:

This week may very well go down as ‘connect the dots’ week. Things have been moving so quickly, so let’s step back briefly and review the big picture from the week’s events:

1) After weeks… months… even years of posturing and denial, Spain and Cyprus became the fourth and fifth countries to formally request aid from Europe’s bailout funds on Monday.

In doing so, these governments have officially confessed to their own insolvency and the insolvency of their respective banking systems.

Meanwhile, Slovenia’s prime minister said that his country may soon ask for a bailout. (Humorously, Slovenia’s Finance Minister denied any such plans.)

Spain’s 10-year bond yield jumped to over 7% again in response, and many Spanish banks were downgraded to junk status by Moodys.

2) Over in the US, the city of Stockton, California filed for bankruptcy this week… the largest so far, but certainly a mere drop in the proverbial bucket.

3) JP Morgan, considered to be among the few ‘good’ banks remaining in the US, conceded that the $2 billion loss they announced several weeks ago might actually be more like $9 billion.

4) The Federal Reserve reported yesterday that foreigners are reducing their holdings of US Treasuries.

5) Countries from Ukraine to Kazakstan to Turkey announced that they have purchased gold in recent months to bolster their growing reserves.

6) Chile has joined a growing list of countries that has agreed to bypass the US dollar and settle all of its trade with China in renminbi.

7) China has further announced plans to create a special zone in Shenzhen, one of its wealthiest cities, to allow full exchange and convertibility of the renminbi.

8) World banking regulators from the Bank of International Settlements to the FDIC are proposing that gold bullion be treated as a risk-free cash equivalent by commercial banks.

So… what we can see from this week’s events is:

- European governments are insolvent
- European banks are insolvent
- US governments are heading in that direction
- Even the best US banks are not as strong as believed
- Foreigners are abandoning the US dollar and seeking alternatives
- Gold is money

These events are all connected, and the trend is becoming so clear that even the most casual observers are starting to wake up.

When you connect the dots, the next steps lead to what may soon be regarded as an obvious conclusion: the system, as it exists right now, is crumbling.

No amount of self-delusion can make this go away.

Global financial markets have been ignoring these developments and seems to be desperately interpreting any political actions as having potential long term positive effects. To paraphrase novelist Anatole France if millions of people say and do a foolish thing, it is still a foolish thing.

So far it’s been about hope over reality.

Wealthy Swiss Hold Cash and Gold on Fears of the Euro’s Doom

From CNBC,

If you want proof that the world’s wealthy are worried, consider this: Swiss banking clients have nearly a third of their portfolio in cash. And one in five believe the Euro will collapse.

The findings are included in a new report from LGT Group, the Austrian banking company, conducted with Austria’s Johannes Kepler University. The study found that wealthy Swiss and Austrian private-banking clients remain highly risk-averse and fearful of inflation, sovereign debt defaults and the unstable financial system.

In Switzerland, 58 percent of private banking clients have lost confidence in the financial system. Forty-four percent worry about inflation.

Fully 22 percent expect the euro zone to collapse. The number was the same for Austrian clients. Only 15 percent of Swiss and 16 percent of Austrians say the lessons have been learned from the euro crisis.

The study also said clients are reducing their diversification strategies and retreating to gold, cash and their home markets. Only a small fraction of clients are out to get better returns than the broader market.

I sympathize with the position of these affluent Swiss banking clients. The financial system has indeed been unstable and has become too dependent on political steroids

And I think that the present concerns goes beyond the Euro crisis as current woes seem multipronged: the BRICs (especially China) and the US too.

Yet geopolitical events, which has been holding the global financial markets hostage, has been very fluid and can move very swiftly and dramatically which would likely incite even more volatility in the financial markets from what we are seeing today.

Uncertainty prevails.

Markets in Risk ON mode on Easing of EU’s Debt Crisis Rules

It seems that global financial markets are in a RISK ON mode anew as EU officials come into an accord to ease debt rules.

From Bloomberg,

Euro-area leaders agreed to ease repayment rules for emergency loans to Spanish banks and relax conditions on possible help for Italy as an outflanked German Chancellor Angela Merkel gave in on expanded steps to stem the debt crisis.

After 13 1/2 hours of talks ending at 4:30 a.m. in Brussels today, leaders of the 17 euro countries dropped the requirement that governments get preferred creditor status on crisis loans to Spain’s blighted banks and opened the door to recapitalizing banks directly with bailout funds once Europe sets up a single banking supervisor.

The leaders struggled for consensus on reducing market pressure on Italy and Spain, where surging borrowing costs stoked concern among investors and global policy makers that the currency union threatened to splinter and risk damaging the global economy. They would be allowed access to rescue loans without relinquishing control of their economies.

“We agreed on short-term measures that should apply to Spain and Italy,” said Luxembourg Prime Minister Jean-Claude Juncker, who heads the group of euro finance ministers. “We will keep all options open to do the interventions that need to be done to calm the situation. There is a whole array of possible interventions and measures.”

Make-or-Break

The gathering marked at least the fourth time in the past year that the guardians of the euro faced a make-or-break summit to restore confidence in their 17-nation bloc. They have struggled so far in vain to contain the financial crisis that began in Greece in 2009. The turmoil claimed its fifth victim this week when Cyprus sought a bailout.

Rules are made to be broken in order to accommodate the interests of the political elites, so what else is new?

We have seen this story play out again and again.

1. Realization that the crisis hasn’t been resolved sends the market into a RISK OFF mode.

2. EU officials meet and make announcements (pledges to inflate, new accord, new rules, new lending and etc…) and the markets switches to a RISK ON mode.

3. Go back to stage 1.

The problem is that the positive impact from such political actions seems to be diminishing.

The article says that EU “have struggled so far in vain to contain the financial crisis that began in Greece in 2009”.

Well that’s because EU officials have been using politics (such as the above) as the main tool to solve economic problems in order to preserve the status quo, mostly through financial repression measures.

Instead, EU officials should adjust politics to conform with economic realities through economic liberalization reforms.

Denials and measures that bank on hope or short term patches won’t have any lasting impact. This only worsens the uncertainty and sets the conditions for magnified volatility.