Ian Nar­ine

Last Thurs­day, in the midst of re­newed eco­nom­ic and in­vest­ment en­thu­si­asm, I point­ed out that much of the good news such as im­proved em­ploy­ment num­bers were, in fact, lag­ging eco­nom­ic in­di­ca­tors and there should be some mea­sure of cau­tion about the pos­i­tive eco­nom­ic da­ta. That warn­ing rang true on the very day as in­di­ca­tors were re­leased de­pict­ing a slow­down in eco­nom­ic ac­tiv­i­ty in Chi­na and Eu­rope. The mar­kets be­gan to sell off, end­ing the week down slight­ly. Re­mem­ber, though, I said stay the course as the da­ta is mixed and mar­ket tim­ing is very of­ten a fool's game. There are, of course, many grem­lins lurk­ing in the shad­ows for in­vestors to fear.

The counter is that cen­tral banks around the world are in­ter­ven­ing in a man­ner that, whether by ac­ci­dent or de­sign, is skewed to push­ing mar­kets high­er. Any neg­a­tive news must be tak­en in this con­text, so un­der­stand­ing the down­side risks but keep­ing a steady hand, seems to be the best op­tion. More than two years ago this col­umn high­light­ed the sit­u­a­tion in Eu­rope, in par­tic­u­lar, Greece. There are many who hold the view that this prob­lem came to a cli­max with the re­cent re­struc­tur­ing of Greece's debt and liq­uid­i­ty in­jec­tions from the Eu­ro­pean Cen­tral Bank which "shored" up the Eu­ro­pean bank­ing sys­tem. Let me as­sure you that this is not so. The prob­lems are still there, and quite press­ing, but they have evolved and, as an in­vestor you need to keep pace with the evo­lu­tion. Be­fore get­ting in­to the specifics, take a mo­ment to un­der­stand how the process works.

Short­ing

As we have seen from 2007 to now, there are prob­lems lurk­ing in the shad­ows and the more dili­gent an­a­lysts will high­light these is­sues ear­ly enough. The main­stream, in­clud­ing the politi­cians and the reg­u­la­tor, ei­ther be­cause of ex­u­ber­ance or com­pla­cen­cy, tend to ig­nore the warn­ing signs. When an in­vestors sees an op­por­tu­ni­ty that the mar­ket is ig­nor­ing, there is prof­it to be had from tak­ing the ini­tia­tive. In this in­stance, signs of trou­ble mean that the best po­si­tion to be in is to seek to prof­it from a mar­ket de­cline. This is of­ten re­ferred to as short­ing the mar­ket. Speak­ing specif­i­cal­ly to Eu­rope, bond in­vestors recog­nis­ing the prob­lems with Greece and oth­ers, sold off or short­ed the debt as­so­ci­at­ed with the coun­try. When a sell off oc­curs, there is more sup­ply than de­mand and so prices fall. In the bond world, low­er prices means high­er yields so as the price of a bond falls from US$100 to US$90 the yield may climb from say four per cent to six per cent. A high­er yield makes it more ex­pen­sive to bor­row.

If a coun­try runs a bud­get deficit and or needs to roll over ma­tur­ing debt and its bond yields rise, then there is a prob­lem be­cause it means that the in­ter­est cost on the new bor­row­ing is much high­er than was pre­vi­ous­ly the case. The equa­tion go­ing for­ward is such that fu­ture eco­nom­ic growth has to be much faster in or­der to close the gap be­tween rev­enue and ex­pen­di­ture as well as the high­er in­ter­est costs to ser­vice the debt. This is com­ing at a time when gross gov­ern­ment debt to gov­ern­ment rev­enue is more than 150 per cent across the en­tire Eu­ro­zone. Even­tu­al­ly, we get to the ex­treme sit­u­a­tions where bond yields are so high that coun­tries can­not ac­cess the debt mar­ket. It is at these cri­sis points that the mar­kets and the reg­u­la­tors are awok­en from their com­pla­cen­cy.

Tem­po­rary re­prieve

In the case of Eu­rope, the so­lu­tion was two-pronged. In the first in­stance, the Eu­ro­pean Cen­tral Bank (ECB) lent three year mon­ey to the Eu­ro­pean banks which then bought up the sov­er­eign debt be­ing is­sued. This brought yields down to more rea­son­able lev­els as the in­creased liq­uid­i­ty fu­elled a new lev­el of de­mand. In the case of Greece, the debt was re­struc­tured. This was dis­cussed in this space about three weeks ago. The end re­sult is an­oth­er wave of com­pla­cen­cy which has seen the mar­ket ral­ly once again. Now the prob­lem ar­eas are shift­ing from Greece and Por­tu­gal to Spain and Italy. This is where the re­al test will come. In Eu­rope, just as was the case with the sub-prime cri­sis in the Unit­ed States, a liq­uid­i­ty so­lu­tion was of­fered to a sol­ven­cy cri­sis. Up to this point, the US has man­aged to eek its way through the malaise. In my view, this is be­cause the size of the US bank­ing sys­tem is very much com­pa­ra­ble to the size of the US econ­o­my. The as­sets of the top five US banks rep­re­sent about 60 per cent of the US gross do­mes­tic prod­uct (GDP). In the US, the in­jec­tion of liq­uid­i­ty pro­vid­ed a stay which al­lowed banks to raise cap­i­tal.

In ad­di­tion, the re­cov­er­ing econ­o­my, boost­ed by huge in­jec­tions of fis­cal and mon­e­tary stim­u­lus, pro­vid­ed a boost to bank earn­ings thus pro­vid­ing an ad­di­tion­al boost to cap­i­tal. In Eu­rope the sit­u­a­tion is very dif­fer­ent. Many of the large Eu­ro­pean banks dwarf their re­spec­tive home economies and are there­fore im­pos­si­ble to bail out to the point where Spain, France and Bel­gium run a bank­ing sys­tem where the as­sets of those coun­tries banks are more than two times their re­spec­tive coun­try's GDP. The ECB's liq­uid­i­ty in­jec­tions pro­vide on­ly a tem­po­rary respite. What is re­quired is for most of these banks to step in­to the mar­ket and raise cap­i­tal. Ex­cept that in­vestors are not too keen on be­com­ing share­hold­ers. US in­vestors were con­fi­dent that the US Fed­er­al Re­serve had the where­with­al to bail out the US bank­ing sys­tem which they did. In­di­vid­ual Eu­ro­pean coun­tries do not have such deep pock­ets. In ad­di­tion, the aus­ter­i­ty mea­sures and slow­er growth prospects in Eu­rope have lead to talk of re­ces­sion, which is not good for bank prof­itabil­i­ty.

Neg­a­tive loop

It all trans­lates in­to a neg­a­tive feed­back loop. US mon­ey mar­ket funds were a key source of fund­ing for Eu­ro­pean banks. Fear of the un­known means that source of fund­ing has dried up. As de­posits flee the weak­er hands, these in­sti­tu­tions have to delever, which re­duces cred­it for­ma­tion, a key in­gre­di­ent for eco­nom­ic growth. Note well that just as in T&T, Eu­ro­pean banks pro­vide most of the fund­ing for cor­po­ra­tions while in the US, the ma­jor­i­ty of fund­ing comes from the is­suance of bonds. In the end this means more sup­port be­ing re­quired from the ECB and so the game will be played un­til it can no longer be played. Turn­ing to spe­cif­ic coun­tries, Greece debt in a post-re­struc­tur­ing sce­nario are al­ready trad­ing at a dis­count. Here the mar­ket is sig­nal­ly that an­oth­er re­struc­tur­ing is like­ly to be the case in­to the fu­ture.

Go­ing for­ward it is like­ly that Spain and Italy will take turns at­tract­ing neg­a­tive in­vestor sen­ti­ment. Right now the fo­cus is on Spain as last week Span­ish yields have widened over its bench­mark Ger­man coun­ter­parts.

A cou­ple weeks ago, I re­port­ed on Span­ish youth un­em­ploy­ment be­ing at above 50 per cent and this brings with it falling lev­els of do­mes­tic de­mand. Last week the Bank of Spain in­di­cat­ed that non-per­form­ing loans on the books of Span­ish banks is at 7.9 per cent, the high­est lev­el since 1994. Starved for cred­it, fac­ing gov­ern­ment cut backs, slow­er eco­nom­ic growth and a hous­ing mar­ket that is still in de­cline mean Spain's prob­lems are in­tractable and while the ECB will no doubt do all that it can to shore up the sta­tus quo, there is an­oth­er el­e­ment to con­sid­er: in­vestors see­ing signs of weak­ness and seek­ing to prof­it by push­ing Span­ish bond yields high­er. Just as I sug­gest­ed with Greece a cou­ple years ago, watch those Span­ish yield curves go­ing for­ward for signs of dis­tress.

Ian Nar­ine is a bro­ker reg­is­tered with the Se­cu­ri­ties and Ex­change Com­mis­sion.