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The World is too Intertwined

Gijsbert Groenewegen
Nov 17, 2011

Europe cannot be rescued and thus the US and the Rest of the World. The world is too intertwined

The world is more intertwined than ever before and contagion and counter party risk will rule in the next breakdown hence why we favor US treasuries, a US$10trn (liquid) market, physical gold and silver, diamonds, agricultural land and water reserves.

CDS offers no insurance in case of voluntary haircut: more uncertainty

Greece with 2·y interest rates above 80% is technically in default. It is only for cosmetic and political reasons that it has not been officially declared a default, although every day we are getting closer to the unavoidable outcome. By the way how crazy is it that the ISDA has deemed that a "voluntary" haircut of 50% on Greek sovereign debt doesn't trigger a payment from the CDS or Credit Default Swaps. In other words no insurance can be obtained against so called voluntary haircuts. What we are witnessing is increased intransparancy and instability. Politicians are losing popularity because of the austerity measures they have to take resulting in their resignations (Papandreou, Berlusconi) only to be replaced by the next batch of politicians. The strong medicine needed to cure the debt disease will not be any different. So unless the new people in charge have a lot of credibility and charisma the outcome for the new politicians, resignation will not be different. Monti (Goldman school as is Draghi) might be a technocrat and have sound ideas how to tackle the problems and gain the trust of the member states but he still will have to deal with the Roman civil servants. Ideas is one, execution is another. We believe more instability, uncertainty and unrest is in store.

Unrest will be common denominator going forward

We believe that unrest will be the common denominator going forward, all for different reasons. In the Western world insurmountable debt and pensions that can't be paid, "freedom" of dictatorial and not democratically elected regimes in Northern Africa and the Middle East, and (food) inflation in the Emerging Countries, more specific also, the corruption and unaffordability of housing in China with more than (non·reported) 100,000 riots a year. We will see unrest worldwide before we will see better times.

No decisiveness in Europe

The entire process of the much needed unanimous agreement of the 17 member states of the EMU is too much of a hurdle to decisively solve the serious problems we are witnessing. The downgrade of Italy in October from A+ to A also confirms the inability of the politicians to swiftly and boldly put a believable and effective austerity plan in place, hence Berlusconi's resignation. The countries can't even agree on the functions and powers of the different bodies such as the ECB, EFSF, IMF and SPV. They are demanding asset sales of ¤5bn from Italy!! What is ¤5bn going to do on a total debt of €1,900bn? According to a Banca d 'Italia report published December 2010, at the end of 2009 net wealth of Italian households was estimated to be some €8,600bn vs a public debt mountain currently of €1,900bn. The Italian problem is one of solvency and not liquidity. Around 50% of Italian Government bonds are in domestic hands according to Credit Suisse. According to international standards, Italian households have relatively little debt, only 78% of disposable income, versus 100% for France and Germany, and 130% for the US and Japan. In Italy the problem clearly lies with the State with a Debt/GDP ratio approaching 120% but also with the lax tax morale, as we have also witnessed in Greece. Although Italy has a high savings rate, which means that its domestic banks have customarily been able to pick up most of its government debt, their ability to do so is coming under pressure. There has been a constant erosion of the investor interest for Italian debt, both inside and outside the country.

The black economy in Italy and Greece are estimated to be between 25·27% in 2011. So why should the frugal countries such as Germany, the Netherlands and others have to bail out Italy and Greece, who have lived beyond their means and haven't made enough effort to collect taxes to the favor of the net wealth of in particular the Italian and Greek households.

Countries contributing to the EFSF in need of rescue themselves!

Assuming a bail·out of Italy, next to the €250bn that is remaining of the original €440bn assigned to the EFSF €139bn must be put in by Italy. How crazy is that? Italy's 10·y bonds were yielding an unsustainable 7.48% on November 9, 2011, and Italy would have to contribute €139bn whilst they most likely will have to be rescued. The EFSF, which could barely raise €3bn the other day, and the way the member states are (not) addressing the problem are a farce. It will not work. It is too little too late.

If anything, the strong countries in the Euro zone better look at injecting the proposed EFSF contributions into their own banking system instead of throwing good money after bad. The contributions are too small to rescue the PIIGS that, as illustrated by their rising interest rates, are already beyond the tipping point. In the end even a 50% haircut, "reducing" the Greek debt from €355bn to €175bn will not get Greece out of their troubles, with a contracting economy and a tax morale whereby everybody is looking out for themselves to survive. And last but not least surrounding economies, also in dire straits, won't be able to pull the Greek economy out of its rut. Moreover if the results of the Greek rescue would be "contained", which money would be left to deal with the other countries in a similar situation, be it the size of the total debt (Italy €1,900), unemployment (Spain 21.5%) or Debt/GDP ratios (Italy 120%). In the end the banks holding sovereign debt still wouldn't be rescued. In the Spanish region of La Mancha the Government owes the pharmacies some €150m for dispersed drugs and the Spanish Government is not paying its bills to help "reduce" its budget deficit. What does that tell you? In our point of view it shows that the problems in Spain are running very deep. Five banks in Spain are not complying with the required capital ratios. The Spanish population, unlike the households in Italy, is highly leveraged due to mortgage debt and still grossly overvalued housing. Banks have only assumed 15% write offs in residential housing prices, whilst 50% is probably a more accepted figure. Telefonica's reported its first quarterly loss in 9 years reflecting the very weak Spanish marketplace. Spain, with unemployment of 21.5% (and 45·50% for the 25 year olds and younger) so far has been able to avoid an attack on its sovereign debt though is most likely next in line.

A sovereign debt crisis affects the banks and visa versa

As we know, the problem with the default of Greece and other European countries is that the banks have a lot of sovereign debt on their books which will incur significant losses following official defaults. As above mentioned the reason the other European countries are not declaring default on Greece is that the banks would have to take the losses on their Greek sovereign debt portfolio which will weaken their balance sheet and capital ratios.

According to the BIS, Bank of International Settlements, US banks alone have an exposure of €478bn or $665bn to Greece, Ireland, Italy, Portugal and Spain. Greece has €355bn in sovereign debt (160% Debt/GDP), Ireland has €148bn in sovereign debt (96%) , Portugal €161bn (93%), Spain €637bn (60%) and Italy €1,900bn in sovereign debt outstanding, representing 120% of GDP. That adds up to approximately €3,3trn or $4,5trn in questionable European debt.

The bail out of the troubled Belgian/French bank Dexia in October very clearly illustrated what will be in store for Europe. On Monday, October 10, Moody's warned of a possible downgrade of Belgium as the country moved to bail out troubled bank Dexia. " Moody's Investors Service placed Belgium's Aa1 local and foreign currency government bond ratings on review for possible downgrade." Moody's said: "The likelihood for the need of additional government measures to support individual banks or the system has increased, as illustrated by the significant challenges now facing the Dexia Group. "It is unclear how far additional support measures would be likely to weigh on the balance sheet of the government." Belgium "rescued" Dexia with a €4bn injection and created a €100bn bad loan entity.

France clearly got the message and agreed additional austerity measures with a five year €65bn savings plan consisting of tax increases and spending cuts. They reflect President Nicolas Sarkozy's concern to bolster the country's public finances and preserve its triple A credit rating ahead of presidential elections in April. The new package envisages an additional €7bn in savings next year and €11.6bn in 2013. The 2012 total contrasts with an announcement in Germany on Sunday of a €6bn tax cut next year. The new savings came less than three months after a previous round of supplementary budget measures worth €11bn in 2012, announced in August.

The measures also included bringing forward by one year to 2017 the introduction of the increase in the minimum retirement age, to 62 from 60. The package is aimed at ensuring the government meets its target of reducing the budget deficit to 3% of gross domestic product in 2013, from 5.7% this year, after the euro zone's second biggest economy reduced its forecast for growth next year to just 1 per cent of GDP. Mr Fillon, French prime minister, stressed that the measures would enable France to eliminate its deficit in 2016 and stick to its aim of cutting public debt, set to peak at more than 87 per cent of GDP in 2012.

Other measures included the temporary freezing of indexation of income tax brackets and other taxes and the increase of taxes on dividends and interest to 24% from 19%. Spending cuts included de· indexing of some social benefits and cuts in state spending, including on state medical services. The purchasing power and "social (complacent) security", especially of the middle class, will be severely tested.

The sovereign defaults, reducing the value of sovereign debt holdings of the banks, or bank defaults will influence the creditworthiness of the banks and the countries and create a death spiral. When countries such as Greece and other PIIGS need to be rescued, haircuts will weaken the balance sheets of the banks which in turn either need to raise money or be rescued by their governments. The Governments that rescue the banks, will need to raise money to rescue the banks and thus risk to be downgraded which will lead to increased interest rates, which will lead to higher budget deficits and lower bond values, which in turn, will lead to further write downs on government bonds. Why is this death spiral unavoidable? Because we don't have a buffer as when we have normal functioning economies. The overall debts are just simply too big and are overshadowing and pulling down any possible economic growth. We have passed the tipping point. In our point of view the triple A countries in the Euro Zone better use the money to strengthen their own banking system instead of throwing it at countries that haven't shown any financial responsibility and are lost anyway.

The situation in the US is not much different hence why the US $ is where it is

Contrary to what a lot of anchors of CNBC are saying "it is all Europe's fault that the Dow is down triple digit" the US situation is not that dissimilar. With 17% unemployment and with 50m people living below the poverty level. If the US was in such a good shape we wouldn't experience the contagion in the US markets. US exports are about $1.3trn, of which 22.5% went to Europe in 2010. MF Global exposed the faults and contagion in the US. Making a bet of $6bn speculating on the outcome of Europe's resolve, showed how the contagion is reaching US firms. Next on that, the counter party risk, which will be paramount, in the soon to be expected sell off in the markets, surfaced with the non·segregation of accounts? And last but not least if there is no supervision you can have all the regulation in the world and it still will not work. And all these guys, Corzine, Dudley (NY Fed) and Gensler (CTFC) went to the same school (Goldman Sachs), what a coincidence!

The Super Committee has until November 23 to reach an agreement to save $1.2·$1.5trn over the next 10 years!! We just extended the debt ceiling with $2.1trn, which probably will be used up by the end of 2012. And we are going to save $2.5trn over 10 years, someone explain to me the logic/mathematics of this and good household accounting!

The contagion is spreading to the triple A European countries, the Far East and other emerging countries

Last but not least we can't exclude ourselves from the contagion effect on the Far East and emerging economies. At present the spreads on the triple A countries in Europe are even blowing out. European banks are good for approximately 21% of all loans outstanding to the Far East. When credit tightens it will force up interest rates and affect the emerging markets. Things are changing in China, profit margins are narrowing rapidly whilst double digit food inflation and increasing unrest are testing the state controlled economy. Apparently also capital flight from China is accelerating. We wonder if that is a sign of what is to come.

Conclusion: We live in societies marked by complacency and lack of responsibility

Anyway although Berlusconi state that the restaurants in Italy were full and New York is still booming and Porsche and Audi sales in North America are exceeding expectations we believe there is something sincerely wrong in the world we are living in. The top 10% of the US population is good for 30% of US consumer spending and of all the luxury sales in the US, totaling $65bn, one third is consumed in Manhattan. In other words these sales are very concentrated and thus vulnerable. According to the law of physics action is reaction in other words we first need excesses before we can have a falling off the cliff event and all tools in the toolbox need to be exhausted. Many governments are collapsing under the weight of the enormous sovereign debt as a result of many years of irresponsible behavior (budget deficits) and unrealistic forecast pension pay·outs. We live in complacent societies without leadership, which we often witness at the end of an era, nobody is being held responsible for wrongful acts and negligence, the same applies to the management of companies, Merrill Lynch and MF Global being prime examples. If nobody is held responsible how can we improve things? We believe that we first need to experience shock and awe and exhaustion and a breakdown of civil services before we can change the DNA of the societies we are living in. Till then we want to make sure we preserve capital and invest in assets that have intrinsic value and no counter party risk: physical gold and silver, oil and gas, agricultural land and fertilizers and water resources.


Gijsbert Groenewegen

Groenewegen Report

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