The Beginning of the End of the Euro…for Cyprus?

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Perhaps being rational is not a goal of the European Central Bank or the International Monetary Fund, but it seems providing Cyprus with an ultimatum to generate their share of a bailout for their financial sector within four days’ time would not be the optimal strategy. These were the same officials, however, that thought it was a good idea to instigate the panic that created the possibility of a bank run. Thank goodness Cyprus enforced a bank holiday for the last week, because if it was not the lack of liquidity that would of caused their banks to fail, the policy makers would have accomplished this in the form of a bank run through their initiatives.

As of last Sunday, not since the lessons learned from the Great Depression and the utilization of a scheme known as deposit insurance has the idea of a bank run ever even been so credible. Quite simply, a banking crisis stems from the issues of solvency and liquidity. When a bank does not have sufficient assets to cover their liabilities, they run into the issue of solvency. When they have trouble borrowing to satisfy their short term liabilities, there is the issue of liquidity. As of late, the ECB has been providing Cypriot banks with Emergency Lending Assistance (ELA) in order to ensure the liquidity of their financial institutions, and they threaten to halt this lending next Monday. It is important to decipher though between solvency and liquidity, as central banks only aim to assist in the latter. It is not their intended mission to float insolvent banks, but they are walking a fine line with Cyprus.

And it’s their troubled banks that last summer put Cyprus in a similar situation to Greece, Ireland, Spain, and Portugal. The lack of liquidity in their financial system required the Cypriot’s to request a bailout. There is a stark difference between the little European Nation that contributes a mere 0.2% of total Eurozone output to prior rescued nations, and that is with regards to whom their debtors are.

The fact that the majority of the large depositors are Russians and not predominantly other Eurozone nations somewhat alleviates the fear of contagion. Not to come across as overly simplistic, but the escalation of the Euro crises a few years prior was due to the fact that member nations held one another’s debt. Once the first domino fell, contagion quickly spread. That same fear is not as apparent with the situation in Cyprus.

Maybe Cyprus could very well be the first nation to leave the Euro currency, but unlike the rash deadline imposed by the IMF and ECB, this event will not unfold quickly. The total public and private external debt, meaning from lenders outside of Cyprus is approximately five times the country’s GDP. And half of that debt is short term deposits, hence why this situation is serious, yet will not unfold quickly. Banks may reopen as early as next week, but that is unlikely. What is likely is accounts will be frozen; depositors will have limited access to their money. If they did have access, they would withdraw their funds only to exacerbate the problem.

The question with Cyprus is no longer if and when they default, but how they default. This is nothing short of a very unfortunate situation for the citizens of this tiny Mediterranean country; however, if there is not some willingness of collective compromise no one gets their money back. Rest assured, there will be compromise because it will be forced. Two initiatives will have to remain in place. One we heard yesterday; the Cypriot Central Bank guaranteed deposit insurance would remain intact on accounts less than €100,000. This will hopefully provide the foundation to prevent a bank panic. The second is that some sort of haircut is taken on deposits or other form of sacrifice takes place. For example it might be in the form a deposit being converted into a long term bond.

There can be rallies in the street and turmoil surrounding government buildings, but plain and simple, when the numbers don’t add up the options are extremely limited.

Canada versus the US

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We have been so preoccupied by the return of the US markets that we have failed to notice how far behind our own TSX truly is. The Toronto Stock Exchange is not accompanied with the same level of optimism that is present in the United States; its current level is not much different than a few years ago, and it is 15 percent below its peak in 2008.

As US markets have been driven by the resurging strength of their private sector, led by their financial institutions, it’s been a diminishing demand for commodities that is largely seeing our market trade lower. And as lower commodity prices have been triggered by a waning global demand, our market has lost the link to that of the US.

S&P vs TSX

As the above graph illustrates, in about September of 2011, two markets that exhibited a relatively higher level of correlation began to diverge. Since then, it was the US indices that have been supported by the initiation of the second round of quantitative easing and stronger corporate balance sheets. By falling vulnerable to the slump in global demand for commodities, it was our mining sector that was particularly impacted. Furthermore, as the junior mining sector struggles not only with the weaker demand, but also less than attractive precious metal prices, the continued outlook seems rather bleak.

Bloomberg put out a piece this week that discussed the slump in the price of the yellow metal and it makes it very clear why stock prices have been discounted with lower prices. In addition to the negative light on the mining sector, there have been record sales from the very ETF’s that allow investor to gather easy exposure to the price of gold. But to do with mining, large mining companies estimate the cost to take an ounce of gold out of the ground is 993 USD. What’s important about that number is that this is the cost for what would be a “blue-chip” company that likely mines both more efficiently and cost effectively. As the junior market struggles and prices hold at these lower levels, their margins will get slimmer and slimmer.

But it’s the respective returns of the two stock markets that exemplify the difference between our two respective economies. The Canadian economy, and more so the Canadian stock market, depend on the health of our natural resource sector. And it’s no surprise that a stall in global economic growth like we saw in the period between 2010 and 2012 has caused our indices to trade sideways and not present a positive outlook.

The challenge, though, is trying to determine what lies ahead. The United States sits with a monumental opportunity thanks to their abundance of oil and gas reserves. This is something that is not only favorable to the US consumer as they likely face lower energy prices, but this abundance of supply keeps downward pressure on global energy markets as well. As the US looks to be self-sufficient in terms of energy, which is a stark difference from a few years prior, Canada’s need to search for alternative trading partners increases. Keystone is important along with crude and gas production currently going to the US, but Canada’s opportunity for growth is elsewhere.

Risk On

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Investors have not been this optimistic about the global economy since the financial crises. And as of late, there have been a consistent number of positive economic reports that have continued to contribute to this rally in the equity markets. With the yield on US 10 year bonds back up over 2 percent today, it is evident that a risk on play is continuing to develop in the markets. And as safe haven sovereign debt sells off, metals have benefited from this trade.

I think it’s in my blood to be a skeptic, and that side of me will overcome the joyousness shortly, but it is important to start with the positives in this market right now. Despite the rejigging of corporate balance sheets and the profits that prevailed from businesses vastly cutting costs, the US private sector looks to be optimistic about the economy, and for that reason they are hiring. The job numbers released this morning (which are looked upon with caution because of their volatility) are for the first time since the financial crises one level above mediocrity. Given the US labor market requires growth of anywhere between 90 to 120 thousand jobs a month to keep up with population growth, seeing payrolls add over 220 thousand positions is very positive and hopeful for economic growth.

It is also the hope and optimism of investors that has continued to fuel this rally in the stock markets. The Dow Jones Industrial Average took out its previous high set in October of 2007, and came back from the low of below 6,500 in March of 2009. There were many pundits who did not seem to care because of the Dow being an outdated and undiversified index, and in a sense they are all correct, but the real reason it is attracting this much attention is because the valid S&P 500 will shortly tell a similar story.

There is no question these markets have come back from some very dark days, and right now it’s hard to argue that equities are not the place to be, but there is more than the optimism of investors that is carrying this market. Since its bottom in March of 2009, equities have been lifted by the operations of the US Federal Reserve as they ensured liquidity in the US financial markets. It was the fact the Fed could act as a back stop for creditors, and guaranteed to borrowers that interest rates would not skyrocket that there is this level of optimism in the market. Referring to the graph, the highlighted time periods represents purchases of treasury bonds and Asset Backed Securities by the US Federal Reserve and the actions of their efforts is quite clearly evident.

S&P and QE

With this much optimism in the markets it does not take too much time for the typical economists or analysts of other views to raise warning flags. Nouriel Roubini, the economist known for calling the housing market collapse believes the crash from this bubble in this bond market will be greater than the previous crash of financial markets in 2008-09. There is no question as to whether or not there is a bubble in the bond market, especially when you have the world’s most powerful central bank suppressing interest rates and holding up prices. The question is instead, what’s there exit plan?

US stock markets have come back from the lows of 2009 and that is great. And broadly speaking, US stocks do represent the opportunity in this market at the moment. But instead of trying to make my case myself, I’ll quote former Citi CEO Chuck Prince.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” That was in July of 2007. Refer to the graph above to see what happened next.

Deficits and Downgrades

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In August of 2011 when Standard and Poor’s downgraded their rating of US government debt, markets were shocked. The downgrade came on a Friday after the market close, and when the US markets opened the following Monday morning, the three indices fell between 5 and 7 percent over the course of the day. What a reaction.

The ultimate safe haven that day was of course the US dollar, which is the ultimate paradox of financial markets, but funds flew into the very US government bonds that had been downgraded three days prior. Over the past week we witnessed both Moody’s downgrade the sovereign debt of Great Britain, and Fitch issuing warning on debt and lack of budget and entitlement reform in the United States. These are two ostensibly apparent issues, yet the equity markets really seemed to shrug these warnings and downgrades off.

Its seems that the markets have finally grasped the idea of “not fighting the Fed” by continuing to move money back into equities and risk assets in lieu of sitting idle in cash or savings. This is despite what might be some investors concerns over the return of their capital verses the return on their capital. The Organization of Economic Cooperation and Development (OECD), however, offer another opinion for reason why we would not expect a market reaction. They suggest the rating agencies have a “poor track record of sovereign risk pricing over the past twenty years;” furthermore, “any downgrades should be carefully scrutinized, and not taken at face value.” There is plenty of evidence to back up this claim, but the fact that the rating agencies often are late to the party (or in some instances completely miss it) doesn’t mean there is no concern for the alarming debt levels in the worlds advanced economies. Moreover, it is often the case with the complexity of these issues pertaining to sovereign debt, there lies more to the equation than we see.

Latest estimates for the United Kingdom’s Debt-to-GDP ratio are for roughly 81 percent. Though that ratio is much higher as we look across the peripheral Eurozone or perhaps Japan, it is not the ratio itself that worry’s analysts, but the UK’s ability to reign in their debt burden over the next few years. Particular to the UK, and also as an aside is the massive threat their financial sector continues to pose as some estimates have their liabilities at 2.19 times the country’s GDP.

Ultimately though, this has become ‘the debate’ in economics with respect to a nation’s macro economy and what importance should be associated with their debt load. More liberal economists don’t see this number as particularly important because when a country faces recession or slow growth, there are more concerning issues with long term unemployment and workers losing the skills to advance in the work force and develop the economy. The other side to that coin is that by monetizing or inflating a country’s debt only acts to discourage saving and creates a burden for the rest of the economy by only delaying an inevitable problem.

One thing is clear that continuing to finance government expenditures by running continued deficits limits the reach of government and exhausts their ability to successfully stimulate the economy when the next shock hits. We literally have a conundrum with countries like Great Britain or the US because austerity measures need to be imposed to bring balance back to their budgets; however, these draconian cuts have serious consequences for economic growth in the near term, and as witnessed daily, they are both socially and politically unpalatable.

Without manageable debt levels, a central government’s ability to react and respond to crisis is hindered by its over-encumbered promises of the past. Regardless of debt rating agencies raising the red flag, this is an ongoing problem with no clear solution in site.