euro01 greece exit, who is next?

David Rosenberg Discusses The Market With Bob Farrell, Sees Europe's Liquidity Crisis Becoming Solvency In Q1 2012

Submitted by Tyler Durden on 12/14/2011 10:57 -0500

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For the first time in while, Gluskin Sheff's David Rosenberg recounts his always informative chat session with Bob Farrell and shares Farrell's perspectives on the market ("his range on the S&P 500 is 1,350 to the high side and 1,000 to the low side. He was emphatic that there is more downside risk than upside potential from here. His big change of view is that we have entered a cyclical bear phase within this secular downtrend (he sees the P/E multiple trough at 8x). Rosie also looks at Europe and defines the term that we have been warning against since May of 2010: "implementation risk" namely the virtual impossibility of getting 17 Eurozone countries (and 27 broader European countries as the UK just demonstrated) on the same page when everyone has a different culture, language, history and religion... oh, and not to mention animosity to everyone else. So yes: Europe in its current format is finished, but what will it look like in its next reincarnation? And why does he think the European liquidity crisis will become a full blown solvency crisis in Q1 2012? Read on to find out.

First, Farrell on markets:

I had the opportunity to lunch with the legendary Bob Farrell yesterday, and he is as bearish as I've seen him in the past two years. At this time last year he said the market would peak in the spring and then struggle, and to avoid the banks — a very early call on that last point but a prescient one nonetheless.

 

Bob strongly believes the cyclical peak was turned in April. He advises selling into any rally. His range on the S&P 500 is 1,350 to the high side and 1,000 to the low side. He was emphatic that there is more downside risk than upside potential from here. He still sees this as a secular 20-year bear market and we are in year 12. His big change of view is that we have entered a cyclical bear phase within this secular downtrend (he sees the P/E multiple trough at 8x).

 

Bob sees a market now characterized by distribution rather than accumulation; in other words, more selling than buying pressure. He is disturbed by the lack of follow-through in the intermittent rally phases we have seen of late. The extreme volatility is not consistent with a bull market. He favours companies in defensive sectors, good management, low cost structures and strong balance sheets. Portfolios should step up in quality. He likes what he sees in terms of secular chart action in big pharma, large-cap tech, and automotive.

 

Interestingly, he talked about how the deleveraging cycle has caused the traditional presidential cycle equity performance to turn topsy-turvy. Normally, the market does not double in the first two years of a presidential win as the White House first adopts the "unpopular" measures, then enacts populist pro- growth policies in years 3 and 4. This time, all the stimulus has already happened. Bob thus thinks that next year is a down year for the market, especially given election and tax uncertainty, let alone lingering European problems.

 

The only positive he sees is that sentiment is quite negative, and thus should help contain the downside. He is watching put-buying activity along with sentiment surveys and mutual fund outflows. But the negative sentiment is not yet extreme enough to turn him more constructive.

And Rosie's "thots" on Europe:

What a reversal yesterday — the reversal in the S&P 500 totalled over 24 points and the swing from the intra-day high to low on the Dow was 243 points. While improved tone to the German ZEW and the U.S. NFIB small business indices helped overshadow a ho-hum U.S. retail sales report (restaurant sales are a notable leading indicator and it fell 0.3% in what was the first decline in seven months; note as well that auto sales look to have sputtered in December for the first time since August), it was likely the fact that the Fed offered no clue of a future QE3 program to a market that, like a child, needs mummy to hold its hand.

 

The Fed acknowledged in a mark-to-market exercise that the economy was on a firmer footing, but the press statement was so laden with caveats that it is obvious that Bernanke is not a buyer of the sustainable economic growth view. Foreign-related growth risks were cited as was a comment pertaining to a slowing in the pace of business investment. So not only did Bernanke not play the role of Santa (or Judah the Maccabee for that matter) but the market continues to digest last week's EU summit and is now coming to the conclusion that the deal is littered with complications that go far beyond Britain's veto (and likely exit from the EU as a result).

 

First, the ECB has refused to give in to demands to embark on debt monetization. So far, the 208 billion euros of bond buying by the central bank amounts to just 1/10 of what the Fed has done in its cumulative interventionist activities to date. Moreover, while it is nice for the banks to borrow three-year funds at 1% from the central bank, going out and loading up on sovereign bonds can hardly be a priority right now seeing as they themselves have 1 trillion euros of deleveraging in order to meet their stipulated capital-asset ratios.

 

Did anyone expect all 17 sovereigns to be put on CreditWatch as the stock market rejoiced last Friday over the fabled 'grand bargain' initiated by Mer-kozy (or that Italian bond yields would top 7% again this quickly)? And now we have Sarkozy all but acknowledging that France is on the road to a downgrade, which will impede the firepower of the EFSF.

 

The 200 billion euro loan from individual central banks to the IMF to then be used to assist peripheral countries with funding problems falls about 400 billion short of what is needed if both Spain and Italy are ever shut out of the capital markets like Portugal, Greece and Ireland were. As it stands, the Bunde*****ank has already said that this provision deserves parliamentary approval in Germany and we already have Socialist candidate Francois Hollande (who is now in the lead in the polls) saying that he would seek a renegotiation of the deal struck last Friday.

 

Indeed, what the markets did not factor in right away but are now, is the high degree of implementation risk. Besides the Bunde*****ank's comments on German legislature approval for the country's 45 billion euro stake (one-quarter of its FX reserves, by the way), the Irish government is deciding now whether a referendum is going to be needed to accept the pact; the agreement will most certainly require parliamentary approvals in Sweden, Hungary, the Czech Republic, and, according to the WSJ, quite possibly Denmark. Is there not a reason to be skeptical?

 

There was little special about this deal that fell so short of blazing the trail for a true fiscal union and for growth strategies that could help contain the erosion in credit quality. Instead, countries will have to cut into bone on the fiscal front at the same time recessionary pressures begin to build — and likely to backfire. So ... it is becoming apparent that once again we have a summit that promised a lot and actually delivered very little. Time is running out, folks, especially when you look at the eurozone government funding needs in February and March, in particular.

 

The unthinkable is on the table too, at least it should be, which is a Greek exit from the monetary union. We see in the NYT that Nomura and UBS have already published detailed reports on this topic — a 50-60% drachma devaluation would likely ensue, alongside capital flight, social unrest and chaos. The markets are then figuring who would be the next to go and what happens when a CDS event is then triggered? And what then happens to the ECB's balance sheet, which owns 60 billion euros of Greek debt. It would suffer the most.

 

What signs are out there pointing in the direction of a possible Greek exit? How about the fact that 40 billion euros of deposits have fled the country's banking system in just the past year. This is equal to 17% of GDP! More than 30% of that outflow took place in September and October alone. This remains a powder keg situation and what is clear to us is that the Euro area is not at all close to resolving its problem of excessive debts, insufficient growth and competitiveness (Germany aside), glaring country-by-country current account- savings imbalances and an ever-growing lack of confidence. As we saw with Lehman, once entities reliant on wholesale capital markets for their funding lose confidence among the investment community, a liquidity crisis can morph into a solvency crisis and do so very quickly. This all promises to come to a head sometime in the first quarter of the new year, in my opinion.