Postponement, Draghi, And Accounting - Mark J. Grant

The last year in the financial markets may be defined by several words which include “postponement, Draghi and accounting.” These are the underpinnings of what occurred in the last twelve months and they are the bedrock for what is likely to take place in 2013. We begin the New Year from where the old one left off and the future will be defined by how the utilization of these three words gets enacted.

I do not like to make things complicated. In fact, I try my very best to make things simple. During my career on Wall Street I have been confronted numerous times with economists, much to my chagrin, who try to make things more complicated in an effort to prove their vast intelligence I would guess but, in the end, most institutional investors, very bright people themselves, are alienated by this exercise as I am. If you can understand where you are standing and what is going on around you then the next steps are not that complicated and the winning strategy of last year is often the losing strategy of the next which is why it is so critically important to gauge your current surroundings correctly.

Postponement

The world has done everything humanly possible to put off any tough financial decisions and that is especially true in Europe and in America.
The leaders on both Continents just cannot take the heat and so everything possible has been pushed forward in the hopes that economies will improve and that growth will cure the ills brought on by the lack of any real leadership. Unfortunately this has not been the case and so the central banks of the world have picked up the slack which has been an interesting exercise but one fraught with consequences. With all of the central banks on the planet engaging in this exercise and no place to invest off-world the possibilities for the use of capital were constrained and hence our very low yields.
The Fed is pumping $95 billion a month into various markets and the combined actions of all of these central banks means that eighty percent of all new supply is soaked up by these institutions leaving a small window for private capital. It was in the spring of last year that I suggested buying long maturities of whatever credits you could stand and this strategy has been a winning one that continues because there is no place else to go; the compression has been unrelenting. You cannot fight city hall and you cannot fight the worlds’ central banks and so regardless of other fundamentals that would function in normal times the ability to print money and then use it in various known and only guessed at ways wins the battle.

Draghi

The centerpiece of the success of lower yields in all of the countries in Europe rests squarely upon Draghi’s “Save the World” plan where the ECB will backstop everything. This speech was the single most important one of 2012 by any stretch of imagination and its ramifications define the economic landscape in Europe from then until now. Mr. Draghi’s promise, attached to the condition of the entire European Union backing the concept, has not been put to the test but I fear it will during this year. It will then depend upon various individual nations and whether they will go along with using their citizen’s money to pay for the debts of other nations. Any rise in nationalism may thwart Mr. Draghi’s promise but this will all play out as one nation after another hits the wall which they will because there is no longer enough free capital in many nations to prevent it. A careful examination of the numbers and the possibilities limit what can be done in 2013 and the countries in question are Greece, Portugal, Cyprus, Spain and Italy. In each of these nations the government has raided public sector funds, pension funds, any monies that will not impact the national debt to GDP ratios and while 2012 allowed them latitude; 2013 will not because each of these nations has about exhausted what was available. I predict that 2013 will put the Draghi promise to the test and there will be considerable rancor during the process. The other side of the coin here is social unrest that I believe will surface in the spring so that the present general belief that things have improved in Europe is nothing more than a hope which is fashioned by political design. In other words; don’t count on it.

Accounting

The debt to GDP ratios for each nation in Europe are nothing more than gimmickry. They lack any semblance of truth. It is not a matter of they could be legitimately counted one way or another because the not counting of liabilities, contingent, actual and those belonging to various branches of the government do not change the fact that they must be paid for in the end. If Bankia’s debt at the ECB are accepted because they are guaranteed by the government of Spain and then Bankia cannot pay them who do you think will be forced to pick-up the bill? This example is happening in Greece, Portugal and now Spain so that the shifting and cover-up of liabilities will come to the fore as the debts must be paid and the capital of the sovereigns, without question, will diminish. Phony accounting does not change the facts; it just tries to fool investors as the primacy of its goal.
In normal circumstances this would not be enough for any longer duration of time to prevent a return to higher yields but when the central banks act in concert with this scheme and hand out money like manna from heaven then the plan succeeds as demonstrated by what took place last year. I caution you however, one year’s winning strategy can be the next year’s disaster and as Spain, Greece and Portugal line up again for more and more money the political considerations may change the course of events. All that stands between the two vicious sirens of the running out of money and the demands for more of it is an untested promise made by Mr. Draghi which will be put to the test in 2013 I believe. Those of you that represent the large battleships of the investment world will be strained and perhaps constrained by your size in moving assets. You will have to be way out in front to prosper in my view and the shift will likely be painful. Longer dated floating rate notes and bonds tied to inflation may well hedge some of the aggravation as newly printed capital to bail-out the sovereigns curtails any inflow of money into the equity markets.

The central banks, phony accounting and a promise by the ECB may well have saved 2012 from an implosion but 2013 brings a new set of circumstances that are far less appealing than last year. Stay safe!

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