Kotok: My Initial Take on Europe

My Initial Take on Europe
David R. Kotok
May 6, 2012




1. Austerity loses all the way around. French, German and Greek elections pile on other European changes. Clearly, Europe’s elected politicians fail when they try to impose austerity by cutting deficits or lessening social payments.

2. Existing low deficit countries will become even stronger. They benefit from a weaker euro, which is certainly going to occur. Germany is the largest beneficiary but others, like Finland, are also rewarded for their “good behavior.” Remember that the euro is comprised of 17 countries and not all of them are weak, profligate spending regimes. That composition is why the euro will not weaken in a free fall. The value of the currency is the value of a composite with some strength and some weakness that is balanced, weighted and then averaged.

3. With austerity diminished there will be more pressure for the European Central Bank (ECB) to print. The ECB is a composite of weights of the 17 members. Political momentum moves toward more monetary ease. We expect another LTRO or some other form of balance sheet expansion before the end of this year.

4. More pressure will be placed on the other members of the G4 central bank coalition. Japan’s political winds blow in favor of more quantitative easing. This latest 10 trillion yen is not the last round. We expect Japan to increase its central bank balance sheet again before the end of the year.

5. No one knows what will happen next in the United Kingdom. They have been very aggressive in enlarging their central bank balance sheet. For the G4 balance sheets, including the UK expansion, see www.cumber.com. The slides are at the bottom of the home page.

6. Lastly, in the G4 we have the Federal Reserve standing pat for the moment. They do not want to do any more QE if they can avoid it. They will play out the announced operation twist, then wait, and watch. However, pressures on the dollar to strengthen and pressures on the Fed from slower labor market improvement will intensify. The Fed will face them in the midst of an election year. The Fed would like to avoid becoming even more politicized than it presently is but the Fed may not be able to dodge this bullet. Now the best guess is that the Fed will make no policy change after June 30. That is only a guess. For sure, the troika of Bernanke, Yellen and Dudley has enough votes to set the policy on the FOMC.

7. Market’s initial reaction is negative to the news in Europe. This is no surprise although the news itself was anticipated. Once markets realize that the political winds are now accelerating toward more easing by the G4, markets will resume an upward bias. We expect the higher-grade sovereign debt to continue to trade at very low interest rates and we expect credit spreads of weaker sovereigns to widen until the ECB enters the market or discusses that it may do so.

8. Monetary policy easing is now the only game in town. Central bankers may not like it but they have no choice about it. We remain fully invested in ETF portfolios and we continue to select spread product over treasury bonds and notes and hedged structures in bond accounts where it fits an investor’s investment objective.

This ain’t over. Yogi Berra is right.


David R. Kotok, Chairman and Chief Investment Officer

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