Comstock Partners, Inc.September 06, 2012
Kicking The Can Down The Road Once Again
In our view the market has over-reacted to another European plan that, at most, will again "kick the can down the road" rather than provide any long-lasting solutions. ECB President Mario Draghi said that the ECB was planning open-ended purchases of short-term sovereign bonds of Spain, Italy or others that may need them. The mere announcement of the plan accomplished the immediate objective of knocking down Italian and Spanish bond yields and boosting stock markets across the globe even before anything is accomplished.
The problem is that implementation of the program in the real world is far from a layup. In order to qualify for the bond buying program a nation must ask the EFSF or ESM for help. To get the help countries would likely have to agree to a number of fiscal and economic austerity measures, and, in the process, give up a significant amount of sovereignty that governments and the population in general may be reluctant to do. Other Euro zone governments would also have to agree. It is therefore easy to see that the terms of these bond purchases will be subject to intense and probably prolonged nation by nation negotiations over the details that could take many months. And even then it is unclear whether the debtor nations can realistically carry out what they agree to.
Assuming all of this happens, the austerity measures that nations accept are likely to result in a shrinking economy. While this part is similar to the measures that distressed sovereigns have historically accepted when being bailed out by the IMF, one very important ingredient is missing. Countries undergoing IMF bailouts (a term that the ECB cannot legally use) devalued their currencies by enough to boost exports to generate growth when domestic demand was being deflated. Since the nations in the Euro cannot devalue, all they are left with is the necessity to deflate their economy. This means that budget deficits actually get even worse as tax revenues drop in a recessionary environment.
Another potential conflict is the intention of the ECB to make the bond purchases open-ended, while at the same time saying that it will sterilize their monetary base. This means that the ECB will have to sell enough short-term paper to offset their bond purchases. This could become a problem down the road and result in either limits on the bond purchasing program or partial abandonment of the sterilization policy.
Most importantly, the program seems aimed at the financial markets rather than the deep-seated problems faced by the sovereign debtors. The ECB and Euro zone governments appear to believe that that the extremely high interest rates on the troubled sovereign bonds was based on unfounded fears rather than fundamentals. In fact the entire program seems designed to boost investor confidence and support the financial markets. In our view this misses the point. The debtor nations are suffering from a combination of lack of growth, under-capitalized banks, strained liquidity, negative trade balances and highly excessive debts. This is real and that's what drove up interest rates. The bond buying program does not do much to address these concerns, and in some cases could even exacerbate them.
Along with the announcement the ECB also slashed its economic growth forecasts for the Euro zone to -0.4% for 2012 and a range of -0.4%-1.4% for 2013. In addition the OECD reduced its forecast for Germany -0.5% for the third quarter and -0.8% for the fourth. It seems clear that the Euro zone will be in recession well into 2013.
In sum, the ECB bond buying program seems like another case of soothing the markets temporarily rather than dealing with serious problems.