Good Evening: With the world holding its collective breath this weekend while waiting to see what the ministers and central bankers in Europe would come up with to address the spiraling debt crisis in southern Europe, EU leaders surprised investors the world over with the size and speed of their response. An assorted package of loans, asset purchases, swap lines, and IMF aid totaling nearly $1 trillion poured forth from a meeting that lasted a very un-European single day. Equity markets everywhere surged, causing longs to smile and shorts to reach for the antacid tablets. The key reason this EU rescue package had global risk appetites growling was the pivotal role played by its central bank. Executing a 180 degree pirouette away from its flat-footed policy stance announced only last Thursday, the ECB’s Jean-Claude Trichet essentially agreed to print euros and monetize debt. Like Mr. Bernanke before him, Mr. Trichet has decided to push the QE button.
There is no point in reviewing the economic news, earnings results, or other headlines generated on Monday. They all took a back seat to the European aid package, one aimed not just at Greece but also at the other financially wobbly members that call the euro their own. The ECB’s substantial involvement means that the EU has decided on a reflationary path not unlike the decision made by the Bernanke Fed in March of 2009. They want the euro to survive in roughly its current form, and this move is designed to buy time as EU governments attempt to grapple with their fiscal woes. Credit Suisse believes this move is nothing less than an historic event, one which can be thought of as the forging of a new Europe that has parallels to the 18th century transition by American states to a stronger national government (see above). This stance by CS may be a stretch, but they are definitely passionate in their long term vision for greater Europe, going so far as to invoke a farsighted passage from Victor Hugo.
The reactions by markets overseas and in the U.S. were much more short term in nature in that risky assets were suddenly sought and safe havens were tossed aside. U.S. equities gapped higher by 3% to 4% at the open, drifted sideways for much of the session, and then closed with an upside spurt. The Dow (+3.8%) lagged, while the Russell 2000 (+5.6%) paced the major averages. Treasurys declined and yields rose 6 to 14 bps as the curve resumed steepening. The dollar rose against the yen but fell against most other currencies (though, interestingly, not by much vs. the euro). Commodities were actually mixed. The energy complex was strong, but grains and precious metals lagged enough to hold back the gain in the CRB index to 1.5% on Monday.
The piece you see above is what I wrote immediately following the Fed’s March 18, 2009 decision to begin Quantitative Easing. It was an important policy shift, and though I acknowledged it might help in the short run, I didn’t realize until a few months later just how potent for asset prices would be this dose of money printing by the Fed. The BOE and SNB had already opened the floodgates by the time Mr. Bernanke pushed the button, and now Mr. Trichet and finance ministers across Europe will hope QE does the same trick for the EU. Given that the ECB has now cast aside its Bundesbank legacy, the questions are: 1) will it work, and 2) what are the investment implications?
I feel this aid package can work in the short run, at least if the immediate goal is to buy time by pushing back the gathering forces of deflation in Europe. If governments and their citizens can use this stay of execution and work to put their fiscal houses back in order, then it has a chance of working in the way envisioned by Credit Suisse. What I worry about are two longer term implications of the EU rescue package, namely moral hazard and a potential funding crisis down the road. By trying to solve a debt crisis by issuing more debt, the EU is simply socializing the unsustainable credit issuance by member states over the last decade. If leaders in Greece, Spain, Portugal and elsewhere in Europe think they will be bailed out whenever they get in trouble, they might not have the discipline to enact the fiscal measures needed to stay in the euro. Without this discipline, socializing credit risk at the sovereign level will eventually jeopardize the credit standing of the sovereign employing the strategy. The U.K. and its recent election can be thought of as Exhibit A, and the U.S. might not be too far behind them.
The ECB’s role in helping this process along via debt monetization is more crucial to the short run investment implications, however. Since an immediate deflationary debt spiral in Europe is off the table for now, risk appetites will likely keep expanding after Thursday’s peak in risk aversion. Another leg up in global equities would not surprise me, nor would a rise in commodity prices. Bonds are trickier, since while low yields provide little margin of safety, low policy rates (i.e. carry trades) and QE (direct purchases) should somewhat limit the downside risk (for now). I won’t try to pick a winner among the QE sisters (dollar, pound, euro, and yen), except to say that leaders in Europe apparently would welcome a softer euro. But the Canadian dollar and the currencies of certain emerging nations in Asia and South America should benefit because they are either 1) more fiscally responsible (e.g. Canada); and/or 2) end markets in Europe look like they’ll stay open (e.g. emerging countries).
Lastly, it will surprise few readers when I say this EU bailout and moneyprinting exercise should be quite supportive to the precious metals. Not only is gold the legacy currency no central bank can print, both the yellow metal and the stocks that mine it did extremely well in the months after Mr. Bernanke pushed the QE button. Now that the last major hold out, Mr. Trichet, has also pushed the button, I don’t see why it should be different this time. It’s as simple as Econ. 101: More fiat paper + stable supply of gold = higher gold price.
— Jack McHugh