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Whats Next for the Eurozone?

AN UPDATE TO OUR SOVEREIGN DEBT DICHOTOMY THEME (Originally Published in 2Q10)


Thursday, September 22, 2011
THIS PRESENTATION WAS PREPARED BY: THE HEDGEYE MACRO TEAM

Disclaimer
Hedgeye Risk Management is not a broker dealer and does not make investment recommendations. This presentation does not constitute an offer to sell, or a solicitation of an offer to buy any security. This research is presented without regard to individual investment preferences or risk parameters; it is general information and does not constitute specific investment advice. This presentation is based on information from sources believed to be reliable. Hedgeye Risk Management is not responsible for errors, inaccuracies or omissions of information. For more information, including Terms of Use of our information, please go to www.hedgeye.com

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The creation of the euro was a long and tedious process In less than a decade, many of the key criticisms made at the outset of the union have manifested themselves Since the crisis began, more than a year ago, solutions have been stop-gap at best A final solution will take time and its implications are unknown The solvency of the entire European banking sector will come under increasing scrutiny A neutered banking system plus pervasive austerity will lead to slowing growth and easing monetary policy in Europe
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1. Origin of the European monetary union 2. Tragedy of Greece 3. The future -> September 2011 to 20??

Source: Eurostat

The 4 convergence criteria under the Maastricht Treaty (1993) were:


1. Inflation rate no higher than 150 bps the average 2. Annual deficit to GDP no greater than 3%; 3. Two years under the exchange-rate mechanism with no devaluations 4. Nominal long-term interest rate no greater than 200 bps of the average

The primary objective of the European System of Central Banks (ESCB) shall be to maintain price stability. -Article 105 of the Maastricht Treaty

The Governing Council is the main decisionmaking body of the ECB. It consists of:
6 Executive Board members including a president, vice-president, and four others 17 governors from each euro area national central bank (NCB)

Executive Board members are appointed by the European Council for a non-renewable term of 8 years NCB governors have a minimum term of office of 5 years and can be re-appointed by the state
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Europe exemplifies a situation unfavorable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe. -Professor Milton Friedman, The Times, November 19th, 1997 The single currency is the greatest abandonment of sovereignty since the foundation of the European Community ... it is a decision of an essentially political nature. We need this United Europe ... we must never forget that the Euro is an instrument for this project. - Felipe Gonzalez, Socialist Prime Minister of Spain from 1982-1996, May 1998

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Proponents to the euro:


Transaction costs decrease Exchange rate risk eliminated within EMU Tourism accelerates Cross border investment and trade grows

Outcome: higher and more efficient growth Opponents to the euro:


Currency exchange rates balance trade With no fiscal or political union, monetary union is weak There is no means to enforce provisions of Stability and Growth Pact Potential to create inherent advantages for some regions

Outcome: Disparate growth and potential fiscal crisis

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Inspiration for the symbol itself came from the Greek epsilon () a reference to the cradle of European civilization and the first letter of the word Europe, crossed by two parallel lines to certify the stability of the euro. European Commission

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1. Origin of the European monetary union 2. Tragedy of Greece 3. The future -> September 2011 to 20??

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Greece restates 2009 deficit-to-GDP from 12.7% to 13.6%. Initial estimate 6 7%.

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2010 Real GDP Growth Rates

Germany 3.7%
Italy 1.2%

Greek -4.5%

Source: Eurostat

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Country Portugal Italy Spain Greece Ireland


Source: Eurostat

2010 Deficit / GDP -9.1% -4.6% -9.2% -10.5% -32.4%

2010 Debt / GDP 93.0% 119.0% 60.1% 142.8% 96.2%

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February 2nd, 2010 The Greek govt outline austerity package to take deficit to GDP to 3% by 2012 March 8th, 2010 Portugal announces new budget cuts April 11th, 2010 Finance ministers from Eurozone agree that Greece can borrow up to 30 billion from fellow members at 5% May 2nd, 2010 Eurozone and IMF agree to 110 billion loan for Greece May 9th, 2010 Europes Finance Ministers approved a comprehensive rescue package worth 750 Billion by creating the European Financial Stability Fund May 12th, 2010 Spain announces they will cut public sector wages Oct 18th, 2010 German and France agree that future bailout fund can require sacrifices from bond holders Nov 28th, 2010 Europe seals a bailout of Ireland after a series of austerity measures are passed February 4th, 2010 Germany and France call for pact for competitiveness March 11th, 2011 EU leaders agree on rules for permanent 500 bailout fund May 2011 The Eurozone and IMF approve a 78 billion euro bailout for Portugal July 11th, 2011 Agreed at a EU summit that Greece should receive loans at a lower rate of 3.5% and second bailout of 109 billion August 7th, 2011 The ECB says it will buy Italian and Spanish government bonds to try and bring down borrowing costs 25

1. Origin of the European monetary union 2. Tragedy of Greece 3. The future -> September 2011 to 20??

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Source: NY Times; Bank for International Settlements

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1. Strong countries leaving the Eurozone 2. Weak countries getting booted from the Eurozone 3. Increased fiscal integration 4. Collapse of the Eurozones monetary union 5. Two-tiered monetary union 6. Passage of ESFS

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Probability : Low in the short term Germany has proven the benefits of being the strongest nation of weak monetary union Rapid appreciation of strong national currencies, which would hurt exports and trade Banking system could be negatively impacted by having assets in one currency and liabilities in another

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Probability : Low in the short term Currency would dramatically depreciate leading to massive default on euro dominated debt Potential for trade zone tariffs in a rapid depreciation Run on the banking system in advance of the currency conversion

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Probability : Low in the short term, longer-term may be the best alternative This would incorporate Brady Bonds for Europe and centrally managed government spending Currently, limited political will or public support to proceed Additionally, would require lengthy approval process parliament by parliament On the positive side, would shift the risk assessment of Europe to the strongest nation from the weakest

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Probability : Low in the short term, but popular unrest should be noted Would involve a mass departure by nations from the relevant treaties based on internal popular unrest Without doubt, this is every nations back up plan As witnessed in the U.S., the prevailing political wind in a democracy can shift very dramatically
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Probability : Low in the short term, but higher in the longer term Nations with lower fiscal discipline get kicked to the lower tier Associated cost of capital increases and other incentives to improved fiscal profile to move back to Tier 1 Alternatively, kick the dominant party out (Germany)

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Probability : Strong in the intermediate term, but the will to solve is the issue Smaller versions of ESFS have been tried and failed Not clear that the broad political will exists to implement currently Burden would be born largely by Germany, which would require a quid-pro-quo

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Who do I call if I want to call Europe?


Dr. Henry Kissinger
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Euro / USD German DAX European Financials U.S. Financials SP500 Gold Commodities

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This presentation was prepared by Keith McCullough, Daryl Jones, Howard Penney, Darius Dale, Matt Hedrick, & Kevin Kaiser For more information and a complete listing of research please see: www.hedgeye.com or email: sales@hedgeye.com
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