European doom & gloom: end-game or catalyst for a turnaround​?

Highlights:


End-game or catalyst for a turnaround?
Amid the European doom and gloom and continued German opposition to the Eurobond proposal, market hopes for the Eurozone to pull fresh rabbits out of the hat are quickly diminishing.  Below we consider what are the potential scenarios:

·         Plan A: muddle-through.  A continuation of the status quo, which is for the European policymakers to believe that the economic reality is less dire than what the market is signaling, and to hold to “core” principles eg. Germany’s opposition to Eurobonds as that will be a “monetization of sovereign debt”. Bundesbank President Jens Weidmann also said an expansion of EFSF powers risks increasing the burden on “financially strong countries” and are “another big step towards a collective liability and reduce the disciplining function of capital markets without strengthening control and influence on national fiscal policies in return”.

A recent White House statement suggested that US president Obama and German Chancellor Merkel agreed that “concerted action would be needed in the months ahead to address the current economic challenges and to assure global economic recovery”.  The five key central banks – ECB, Fed, BOE, BOJ and SNB did signal this willingness last week when they assured markets of USD funding across the year-end to tackle the liquidity issues for the European financial system. Beyond coordinating USD funding through swap lines, it is unclear how open the Eurozone policymakers are to taking suggestions on how to handle the crisis, as seen from the immediate rejection of US Treasury Secretary Geithner’s suggestions at the recent Eurofin meeting.

Domestically, Merkel is struggling with holding her CDU coalition together after a string of poor showings at several key state elections amid skepticism whether Greece should and could be saved, especially ahead of elections which are due in 2013. So unless we see a sharp turnaround in Germany’s stance towards the EFSF expansion, Eurobonds proposal, and establishing a Eurozone TARP-equivalent to take over the bad assets (mainly the PIIGS government debt) sitting on European banks’ books, the “muddle-through” scenario will be the default situation, which ironically adds to the risk of a crisis moment.

·        Plan B: Greece defaults. Actually with Greece’s CDS trading above 5980 bps and the 1-year bond yielding above 100%, the markets have already priced in the likelihood of a Greek sovereign default in the imminent future.  The only uncertainty is whether it will be an orderly or disorderly event.  The probability of this happening may be accelerated should the troika reject Greece’s budget-reducing measures as inadequate and withhold the next €8b tranche and the second bailout package, and/or Germany’s lower house Bundestag vote down the EFSF amendments on 29 Sep, when markets take Greece, the troika and Germany to task on this. Kathamerini newspaper reported that Greek PM Papandreou is considering holding a referendum to whether remain or exit from the euro common currency, hoping to use the vote as a mandate for implementing austerity measures required by the troika.

As it is, there are suggestions that the German government is considering a “Plan B” to help shield banks and insurers from losses if Greece defaults. Germany’s biggest lenders and insurers owned about €17.5b of risks relating to the Greek government. Germany’s bad banks may be most at risk should Greece default, namely Hypo’s FMS Wertmanagement and WestLB’s Erste Abwicklungsanstalt who bear €8.76b and €1.21b of Greek sovereign investments and loans, which are more than half of German banks’ Greek debt. In comparison, Deutsche Bank AG and Commerzbank AG hold a combined €3.35b, according to reports compiled Bloomberg.

Nevertheless, Germany’s banking system may fare better off than that for France in the case of a Greek default - BIS data showed that German banks’ foreign claims and other potential exposures on an ultimate risk basis vis-à-vis Greece (both private and public sector) stood at US$23.8b at end-March, of which 59% was to the public sector.  French banks, in contrast, had US$56.9b exposure to Greek debt, of which 24% was in government claims. France also have not set up bad banks to hold their Greek investments. Therefore, Credit Agricole SA and Societe Generale SA had their ratings cut one notch by Moody’s on 14 Sep, while BNP Paribas SA had its Aa2 long-term rating kept on review for downgrade.

·        Plan C:Eurozone policymakers, namely Germany, tackle the sovereign solvency and contagion issues whole-heartedly and holistically.  This would require fundamental changes to the current stance towards the EFSF expansion, Eurobonds proposal, and a Eurozone TARP-equivalent to take over the bad assets (mainly the PIIGS government debt) sitting on European banks’ books.  If this materialises, and the probability looks small at this juncture given the mixed signals by different policymakers, this could spell relief of a more lasting nature.

At this juncture, we remain cautious about the European banking sector. To compare the European banking sector deterioration with the US experience post-Lehman, we overlaid the current Stoxx 600 banking sub-index with the SPX500 Financial sub-index in the pre/post-Lehman period. T = 6 months before Lehman collapsed in the US & Feb 2011 when PIIGS fears resurfaced.

 Assuming that the situation could potentially play out in a similar fashion (so far, the drying up of USD funding, holdings of peripheral European government bonds could sink further etc), the Stoxx 600 banking sub-index could fall further to reach a Lehman trough, assuming that a systemic banking crisis is a real risk for the Eurozone.  Hence, it is still too early to conclude that European banks are “cheap” on a forward PE valuation. The fact that some of these banks’ CDS are already at 3-year highs are reflective of the risk-reward ratio at this juncture.

Mark Faber Warning - Bigger Financial Crisis on the Way

Why Identifyin​g a Bubble Is So Much Trouble: Cochrane

We seem to be surrounded by “bubbles” -- tech stocks, real estate, and now maybe sovereign debt.
You might expect that any textbook would have a precise definition of this phenomenon; some set of characteristics that distinguish sensible high prices in good times from prices that are “too high” or in a “bubble.” Alas, “bubbles” seem to be in the eye of the beholder.
Does that mean it’s all just empty talk? No, and there is solid academic research that helps us to think about what “bubbles” might mean, and how both policy makers and investors might think about them.
Here are the central facts: High valuations are, on average, followed by many years of poor returns, and vice versa. High valuations are not, on average, followed by years of good cash-flow growth, or by ever-higher valuations.
This fact holds across markets:
-- High stock price/dividend, price/earnings, or market/book ratios are on average followed by years of poor returns, not years of higher dividend and earnings growth, or permanently higher prices, and vice versa for low prices.
-- High yield spreads (low prices) on long-term bonds are on average followed by good returns on long-term bonds, not by increases in short-term interest rates, and vice versa.
-- High credit spreads (low prices) on low-grade debt are followed, on average, by good returns on that debt, not a proportionally high bankruptcy rate, and vice versa.
-- High interest rates abroad relative to the U.S. are followed, on average, by good returns to U.S. investors in that debt, not by foreign exchange-rate depreciations, and vice versa.
-- High house prices relative to rents are followed, on average, by flat or declining house prices over many years, not by increases in rents, and vice versa.
No one substantially disputes these facts. The question is: What does all this tell us about why prices are high or low in the first place?
The facts don’t support the theory that prices are high because people always expect a “greater fool” to pay a still higher price. If that were true, high prices would have no connection on average to subsequent returns or cash flows, and would correspond to forever higher prices. We just don’t see that.
The data also deny the simple discounted cash-flow view. If investors think that dividends and earnings will grow strongly in the future, they will be willing to buy a stock for a large multiple of today’s earnings. Although those bets won’t turn out right every time, on average, high price ratios today will be followed by good growth in dividends or earnings. They aren’t.
So what’s going on?
‘Macroeconomic Risk’
The “macroeconomic risk” view holds that the discount rate for a given cash flow can vary over time. Price booms come in good macroeconomic times, when the average investor is “searching for yield” and willing to take on some extra risk. Such investors bid up the price of unchanged cash flows.
Price busts come in horrible macroeconomic times, such as those we are enduring. In these periods, the average investor may rightly say, “I understand returns are better going forward, and there is the buying opportunity of a lifetime in junk bonds. But I’m about to lose my house and my job, the bankers are about to shut down my business, and I can’t take any extra risk right now.” Such investors drive prices down until the same prospective cash flows can deliver returns large enough to overcome their justified fear.
Over-Optimistic Investors
The “irrational” view is that investors’ required returns don’t change, but they simply get it wrong. Sometimes they get over-optimistic and bid up the price as if cash flows are going to be great. Sometimes they get irrationally depressed. In either case, they don’t learn from the centuries of experience.
“Macro risk” researchers note the strong connection of prices to economic events, captured by explicit and rejectable economic theories of discount-rate variation; they complain about ex-post storytelling. The “irrational” camp points to puzzling surveys. For example, investors who bought Amazon.com at the height of the tech boom reported mathematically impossible cash-flow forecasts.
But surveys are easy to misinterpret: “Expect” and “risk” in casual conversation have very different meanings than “conditional mean and variance” in our models. And economics was meant to explain behavior, not self-perception. Rats in mazes do a good job of obeying the laws of economics, but they’re not so good at responding to surveys.
Financial Frictions
A new view says market swings are all about financial frictions, not mass risk aversion or psychology. In the financial crisis many assets seemed to fall in value because of the run in the shadow banking system, or temporary illiquidity in markets. The question is whether this view can explain broad movements across many directly held assets like stocks, or whether it’s confined to specific smaller markets.
A final view is tantalizing. Every “bubble” has also featured a “trading frenzy,” from tulips in the 1600s to tech stocks in 1990 to condo-flipping in Miami in 2006. Perhaps traders hold high-priced assets despite low average returns because the assets are useful in helping them to profit from small bits of information, just as we hold money despite a low return because it’s useful for buying things. If so, the rest of us should stay away from “bubble” assets.
Research has, at least, given a lot of structure to the “bubble” question. We know that variation in price ratios corresponds to discount-rate variation, not to changes in expected cash flows or the ability to find a greater fool. The challenge is to understand that discount-rate variation. A focused debate, based on clear facts and explicit theories, is real progress.
(John Cochrane is the AQR Capital Management Distinguished Service professor of finance at the University of Chicago Booth School of Business and a contributor to  Business Class.  A survey of much of the research mentioned in this essay is included in his recent article “Discount Rates,” in the Journal of Finance. The opinions expressed are his own.)

http://www.bloomberg.com/news/2011-09-22/why-identifying-a-bubble-is-so-much-trouble-john-h-cochrane.html