Posted By: Matthias Paul Kuhlmey
The scorecard is on the table. Recently, we wrote that the impressive October equity rally was most likely a function of significant short-covering. According to recent reports and data from the New York Stock Exchange (NYSE), nearly 2 billion shares were covered in the past month – a multi-year record. Thus, what felt really good (to be true), was actually the counter-effect of something not so good in the first place. With the utmost modesty, we must mark our assessment with an A on our scorecard.
Do not be fooled again. This morning, markets show signs of great relief, after the European Central Bank (ECB) acted as the market participant of last resort in purchasing Italian and Spanish Sovereign Debt. As the situation in Italy very much took a turn for the worse yesterday, with yields of the 10-yr Italian Sovereign bond having reached levels around 7.3%(!), something had to be done. Here is the catch: The ECB, by definition, had no mandate to make such purchases. The European Treaty is indisputable: Article 101 prohibits the ECB from lending to Governments; Article 103 states that the Eurozone should not become liable for the debts of other member states; interestingly enough, this aspect was recently confirmed by newly appointed ECB President Signore Mario Draghi (did it matter just a teeny tiny bit that Mr. Draghi is an Italian national?).
OK, now let us be more practical. We have often argued that the ECB has many more cards left in their pocket, when compared to the FED. Euroland, even if difficult to perceive today, can go “Anglo Saxon” and inflate problems away for years to come. It will require the formation of a Fiscal Transfer Union, which, indirectly, considering today’s ECB action, is already underway. Consider also that the ratio of all outstanding European Sovereign Credit to European GDP is not out of the ordinary, given today’s debt-ridden Developed World. With a combined GDP of $16 trillion in 2010 (vs. $14.7 trillion for the U.S. economy), and a Debt-to-GDP ratio of 85% in 2010 (vs. 100% for the U.S.), the Eurozone and its single currency Euro are actually in pretty good shape, on a relative basis.
What market observers, especially on this side of the great pond, need to be reminded of is the domestic “time bomb” still ticking here. Wasn’t it just yesterday that Alabama’s Jefferson County declared the biggest Municipal Bankruptcy to date? We should not be looking with pity and judgment at the current situation in Europe, as the correlation between growth of the European and U.S. economies are correlated at 86%. If Europe hits a significant recession, the U.S. will likely head down the very same path. For now, we are comfortable with a defensive position in our clients’ investments.