Week 36/2011: French, Italian Banks Approaching Insolvency; Eurobond Solution Gaining Acceptance

Summary:

George Soros believes the Eurozone is careening towards a financial meltdown and another Great Depression, unless co-ordinated intervention happens fast. Soros is calling for a pan-European treasury with powers to tax and therefore borrow. In effect, he is recommending the ECB issue Eurobonds to raise capital to shore up the European financial system.

The model portfolio returned +0.7% last week. Equities gained +0.0%, bonds rallied +0.9% and gold in euro terms added +2.5%. There is no change to the 60% equities / 20% bonds / 20% gold split.

In August, the model portfolio returned -1.2% compared to -5.7% for the average managed fund. Equities declined -7.4%, bonds rallied +3.9% and gold in euro terms added +12.4%.

YTD through end-August, the model portfolio has returned -0.9% compared to -7.3% for the average managed fund. Equities returned -10.2%, bonds rallied +4.0% and gold in euro terms gained +19.6%.

DJIA	10,992	Dollar Index	$77.20	CRB Index	334.25
DJTA	4,369	CAD/EUR	1.3610	Gold	$1,856
DJUA	420	USD/EUR	1.3655	Silver	$41.20
NDX	2,468	JPY/EUR	106.00	Copper	$4.00
S&P 500	1,154	JPY/USD	77.60	Oil WTI	$87.40
ISEQ	2,444	USD/GBP	1.5885	Natural Gas	$3.92
FTSE	5,215	10 Yr. Tsy.	130.90	Soybeans	$14.35
Nikkei	8,738	30 Yr. Tsy.	141.30	Corn	$7.38

Equities:

Pythagorean theorem: 24 words

Lord's prayer: 66 words

Archimedes' Principle: 67 words

Ten Commandments: 179 words

Gettysburg address: 286 words

US Declaration of Independence: 1,300 words

US Constitution with all 27 Amendments: 7,818 words

EU regulations on the sale of cabbage: 26,911 words

This is the result when you put a group of politicians in a room and ask them to come to an agreement on a particular issue. They fight and bicker and try to look after their own self interests instead of a common cause. Every man for himself. We see the same thing happening today as the pan-European banking and sovereign debt crises reach boiling point.

It is virtually impossible to implement a co-ordinated effort to resolve the current crises when everyone is looking out for themselves. We may get to a United States of Europe some day, but it is a long way off. In the meantime, the Eurozone banking system is imploding. Irish banks have already hit the wall. The French and Italian banks could soon follow. Here are a few charts of the key players – Societe Generale, BNP Paribas and Unicredito – which are under enormous strain. Exposure to Greek sovereign debt is the noose around their collective necks.

Soc. Gen., with an equity market capitalisation of just $12 billion, is holding $1.13 trillion in assets, so this fine institution is 94 times leveraged. BNP Paribas holds $2 trillion in assets, 65 times its market cap. It's the same story in Italy, where Unicredito and Intesa are 77 times and 50 times leveraged respectively. If Eugene Sheehy or Brian Goggin can speak French or Italian, they should head to Paris or Milan, touting their conservative banking track records. Another unbelievable fact, these banks are holding their Greek sovereign debt at book value, when market values are 60% less. These banks are certainly not going to be able to trade their way out of this mess. In France's case, total banking assets amount to $8 trillion while French GDP is a mere $2 trillion.

George Soros put forward a possible solution to the Eurozone crisis this week that included a Eurozone exit for Greece, Portugal and maybe Ireland. He discussed transforming the current European Financial Stability Facility (EFSF) into a pan-European treasury with the power to tax and therefore borrow. This would mean issuing Eurobonds and would require German approval. Issuing eurobonds (a.k.a. 'money printing') is the most viable short-term solution and the one that I think will be followed. It is the only way the Eurozone project can hold together. The other option is austerity, but this is a debt-deleveraging crisis and you can't cut your way to long-term-growth.

Soros concluded: "leaving the euro would make it easier for them (Greece, Portugal and Ireland) to regain competitiveness; but if they are willing to make the necessary sacrifices, they could also stay in. In both cases, the EFSF would protect bank deposits and the IMF would help to recapitalise the banking system. That would help these countries to escape from the trap in which they currently find themselves. It would be against the best interests of the European Union to allow these countries to collapse and drag down the global banking system with them.

It is not for me to spell out the details of the new treaty; that has to be decided by the member countries. But the discussions ought to start right away because even under extreme pressure they will take a long time to conclude. Once the principle of setting up a European Treasury is agreed upon, the European Council could authorize the ECB to step into the breach, indemnifying the ECB in advance against risks to its solvency. That is the only way to forestall a possible financial meltdown and another Great Depression."

From a technical perspective, we broke long-term support last month but have recently regained the upper hand, barely. Since markets are oversold to such an extreme – there are fewer stocks above their 50DMA's now than at the March 2009 bottom – I want to give this market a little more time before moving to a defensive position. Like I said, markets should be close to turning around here and crash-type events are low probability outcomes.

Bonds:

The current term structure of interest rates for the German, US and UK government bond markets are summarised in the following table.

Current Yields	German Bunds		U.S. Treasuries		U.K. Gilts
3-Month	0.46%		0.00%		0.52%
2-Year	0.61%		0.19%		0.56%
5-Year	1.09%		0.93%		1.32%
10-Year	1.92%		2.04%		2.51%
30-Year	2.83%		3.31%		3.69%

Fair value yield estimates for 5, 10 and 30 year government bonds for the German, US and UK fixed income markets are as follows:

Fair Value Yields	French Bonds		U.S. Treasuries		U.K. Gilts
5-Year	4.30%		4.40%		5.30%
10-Year	4.40%		4.50%		5.30%
30-Year	4.40%		4.50%		5.30%

Government bond yields remain significantly below fair value, particularly for 5 and 10-year government bonds, hence the continued bearish view on this particular asset class. Now, let's take a closer look at the trend in 10-year yields for Germany and the peripheral Eurozone debt markets.

Commodities:

Gold closed on Friday at $1,856/oz, -1.4% for the week in USD. The USD rallied +3.9% versus the EUR over the week, so gold in euros gained +2.5%. Year-to-date, gold is up +28.0% in euro terms.

Model Portfolio:

The model portfolio returned +0.7% last week. Equities gained +0.0%, bonds rallied +0.9% and gold in euro terms added +2.5%. There is no change to the 60% equities / 20% bonds / 20% gold split.

In August, the model portfolio returned -1.2% compared to -5.7% for the average managed fund. Equities declined -7.4%, bonds rallied +3.9% and gold in euro terms added +12.4%.

YTD through end-August, the model portfolio has returned -0.9% compared to -7.3% for the average managed fund. Equities returned -10.2%, bonds rallied +4.0% and gold in euro terms gained +19.6%.

Top Ten Investment Ideas for 2011:

	Top 10 For 2011	28/01/2011	Comment
1	Long Gold	$1,337	Conservative inflation hedge
2	Long CEF.A	$18.95	ETF backed by 50% gold, 50% silver
3	Long NEM	$55.00	Miner leveraged to rising gold prices
4	Long EGD	$4.20	Mining services company that sells equipment to the sector without taking the exploration risk.
5	Long GDXJ	$34.60	Junior miners ETF – when gold hits bubble territory, GDXJ will best capture the mania that follows.
6	Short 30 Yr Treas.	$121.45*	28 year bond bull market over, with US 10-year yields troughing at 2.4%.
7	Long MSFT	$27.75	The cash machine of the technology sector; single-digit P/E with double-digit EPS growth.
8	Long CAD/ Short JPY	JPY 82.00	JPY must decline so Japan can regain competitiveness and reduce its massive debt burden (200% of GDP).
9	Long Sugar	$0.34/lb	Commodity play with strong supply/demand imbalance
10	Long Soybeans	$14.05/ bushel	Commodity play with strong supply/demand imbalance

* Incorrect price listed in week 4 update and amended above.