Week 46: How Long Before a Two Tier Eurozone?

SUMMARY:

Debt deleveraging processes take a long time to complete, perhaps a decade, perhaps more. I'm not sure the Eurozone bond markets are prepared to wait that long. The crisis is accelerating. ECB money printing is one possible solution; a Eurozone break-up is the other. There isn't a third. This week I discuss how I think this crisis plays out. The model portfolio returned -2.1% last week. Equities fell -2.4%, bonds fell -1.4% and gold in euro terms declined -2.0%. There is no change to the 60% equities / 20% bonds / 20% gold split. In October, the model portfolio returned +3.6% compared to +4.6% for the Managed Fund Index. Equities gained +6.3%, bonds fell -2.9% and gold in euro terms gained +2.0%. YTD through end-October, the model portfolio returned +0.7% compared to -5.0% for the Managed Fund Index. Equities returned -6.6%, bonds rallied +2.2% and gold in euro terms gained +16.5%.

DJIA	11,796	Dollar Index	$78.00	CRB Index	312.20
DJTA	4,841	CAD/EUR	1.3900	Gold	$1,724
DJUA	442	USD/EUR	1.3525	Silver	$32.35
NDX	2,573	JPY/EUR	104.00	Copper	$3.42
S&P 500	1,216	JPY/USD	76.90	Oil WTI	$97.65
ISEQ	2,607	USD/GBP	1.5805	Natural Gas	$3.32
FTSE	5,363	10 Yr. Tsy.	130.30	Soybeans	$11.75
Nikkei	8,348	30 Yr. Tsy.	142.80	Corn	$6.25

EQUITIES:

Demands for ECB money printing are getting louder, yet the Germans appear to be digging in their heels. Is Merkel about to call Europe's bluff? This is a game of This would allow them to avoid making the hard austerity decisions, and also would transfer  project alive. tually happens, ithigh stakes poker with massive consequences for those ending up holding a losing hand. I have always thought that the European central bankers and government officials would do everything in their power to keep the euro project alive. However, Germany is becoming increasingly reluctant to backstop the European bond markets and become the lender of last resort. I don't know how much longer it will take before the Eurozone bond markets and the banking system simply collapse in the absence of massive ECB intervention. Time really is running out and the action in the equity, bond and commodities markets over the last five days is making me quite nervous. I am getting increasingly concerned that inaction will be the order of the day and that if/when intervention eventually happens, it will be too little, too late.  
Italy must borrow close to €350 billion in 2012, while Spain has a borrowing requirement of €150 billion next year. This is a combined €0.5 trillion for just two countries in 12 months. Spanish and Italian 10-year bond yields are now approaching 7.0%, so funding via the bond markets is no longer an option for those countries. If Italy, Spain, Ireland, Portugal, Greece, Belgium, and maybe even France, can no longer access funds at reasonable rates, they will not be able to pay their debts as they fall due, nor fund their public services on an ongoing basis, so the risk of sovereign default(s) rises considerably. It is that simple.

We also know that the banking systems of the Eurozone countries are all joined at the hip, through the inter-ownership of each other's sovereign debts on their respective balance sheets; and the numbers are big. France's banking system is 400% of GDP. The Dutch banks are 458% of GDP. For Belgium, the number is 380%, Austria 345%, Spain 310%, Germany 251% and Finland 246%. As a comparison, the US banking system assets are 85% of GDP. So, there is a real risk that rolling sovereign defaults could bring the entire system down.

In a recent article in the London Telegraph, attributed to the German Finance Ministry, the author recommended that bankruptcy should be an option available for all euro members "unable to achieve debt sustainability. There must be an option of an orderly default to reduce the burden on taxpayers". It is understandable that Germany is balking at the massive bill they face and are attempting to reduce it the best they can, but this strategy just won't work. The problem is too big. Large scale ECB intervention is the only solution if the Eurozone is to remain intact.

So, how could all this play out? 

Germany will resist the money printing option for as long as possible and the ECB will continue to buy moderate levels of sovereign debts in an attempt to keep a lid on government bond yields. This approach will not work and the crisis will deepen. At some point in the not too distant future (next 12 months), this crisis will reach an acute stage and the ECB will be forced to act. Germany will be outvoted by the other member states on the ECB Council and the ECB will be given a mandate to print money, using the proceeds to buy massive quantities of Eurozone sovereign bonds in an attempt to drive down long term rates. I expect this event will be the trigger for Germany and maybe a few other countries to leave the Eurozone and form a new "strong euro". Likely members will include Germany, Netherlands, Austria, Finland and Luxembourg.

The remaining "weak euro" countries (Italy, France, Spain, Portugal, Ireland, Belgium, Greece, Slovakia, Slovenia, Cyprus, Estonia and Malta) will then be allowed to print money to their hearts' content. Government debts of these countries will convert to the new currency. Bank deposits will also convert to the new "weak euro", enabling banks to match their assets and liabilities. The "weak euro" will float and trade at an immediate discount of 30-40% to the "strong euro". In the run up to this transition, banks will close and/or limit the amount of cash that can be withdrawn on a weekly/monthly basis in order to prevent a bank run. This is the future as I see it. The bond markets are starting to price in this inevitability. Eurozone bond investors are going to feel some pain, either through sovereign default or, more likely, a sharp currency devaluation as the Eurozone splits in two.

Despite the negative scenario described above, the outlook for stocks remains positive in the short-term, though we need to see a turnaround in equity markets soon. From a technical perspective, we broke long-term support in August but regained the rising trend in early September. The primary trend continues to support a bullish outlook for stocks. Many of the other technical indicators I follow are also constructive and signalling that the market should be moving higher in the months ahead. That said, as I write, the S&P futures are indicating another weak start to this week's trading. Thanksgiving week and the run up to Christmas are usually quite positive for equities, so, until I get a sell signal on the models I follow, I will stick to my favourable outlook through yearend. 2012 is another matter though. I think next year, the chickens will come home to roost and we will see a resumption of the bear market for stocks. I'll explain why in a few weeks time.
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	0.21%		0.00%		0.48%
2-Year	0.40%		0.27%		0.47%
5-Year	1.01%		0.88%		1.07%
10-Year	1.88%		1.95%		2.18%
30-Year	2.53%		2.92%		3.14%

The Asset Allocation Team currently maintains the following fair value yield estimates for 5, 10 and 30 year government bonds for the French, US and UK fixed income markets:

Fair Value Yields	German 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%

The above government bond yields remain significantly below the fair value estimates of the Asset Allocation Team, 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.

German 10-Yr Yield at 2.15% UP from 1.89% last week

French 10-Yr Yield at 3.69% UP from 3.39% last week

Irish 9-Yr Yield at 8.80% UP from 8.08% last week

Italian 10-Yr Yield at 6.97% UP from 6.45% last week

Greek 10-Yr Yield at 29.05% UP from 28.45% last week

Spanish 10-Yr Yield at 6.55% UP from 5.85% last week

Portuguese 10-Yr Yield at 11.30% DOWN from 11.63% last week

COMMODITIES:
Gold closed on Friday at $1,724/oz, a fall of -3.6% in US dollar terms over the past week. The euro declined by -1.6% versus the USD over the same period from $1.3750 to $1.3525, so gold in euros fell -2.0% for the week. Year-to-date, gold has gained +20.1% in euro terms.

MODEL PORTFOLIO:

The model portfolio returned -2.1% last week. Equities fell -2.4%, bonds fell -1.4% and gold in euro terms declined -2.0%. There is no change to the 60% equities / 20% bonds / 20% gold split. In October, the model portfolio returned +3.6% compared to +4.6% for the Managed Fund Index. Equities gained +6.3%, bonds fell -2.9% and gold in euro terms gained +2.0%. YTD through end-October, the model portfolio has returned +0.7% compared to -5.0% for the Managed Fund Index. Equities returned -6.6%, bonds rallied +2.2% and gold in euro terms gained +16.5%.

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.

YTD PERFORMANCE OF 2011 BEST IDEAS:

		28 January 2011	18 November 2011	2011 Return YTD
1	Long Gold	$1,337	$1,724	28.9%
2	Long CEF.A	CAD 18.95	CAD 22.88	20.7%
3	Long NEM	$55.00	$65.46	19.0%
4	Long EGD	$4.20	$3.75	-10.7%
5	Long GDXJ	$34.60	$29.24	-15.5%
6	Short 30-Year Treas.	$121.45	$142.75	-17.5%
7	Long MSFT	$27.75	$25.30	-8.8%
8	Long CAD/Short JPY	JPY 82.00	JPY 74.85	-8.7%
9	Long Sugar	$0.34	$0.24	-29.4%
10	Long Soybeans	$14.05	$11.75	-16.4%

2011 Top 10 Ideas Average Performance:                                                           -3.8%

Managed Fund Index:                                                                                       -7.0%

FTSE AW Developed Index:                                                                              -8.3%

PERFORMANCE OF 2010 BEST IDEAS:

		01 January 2010	31 December 2010	2010 Return
1	Long Gold	$1,097	$1,421	29.5%
2	Long Silver	$16.88	$30.91	83.1%
3	Short 30-Year Treas.	$115.38	$122.10	-5.8%
4	Long NEM	$47.31	$61.43	29.8%
5	Long PAAS	$23.81	$41.20	73.0%
6	Long DVN	$73.50	$78.51	6.8%
7	Long CAD/EUR	CAD 1.5100	CAD 1.3356	11.5%
8	Long Nikkei	10,546	10,229	-3.0%
9	Long Sugar	$0.27/lb	$0.321/lb	18.9%
10	Long Soybeans	$10.54/bsl	$14.09/bsl	33.7%

2010 Top 10 Ideas Average Performance:                                                           27.8%

Managed Fund Index:                                                                                       12.0%

FTSE AW Developed Index:                                                                              20.1%