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Can Europe Be Saved?

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Can Europe Be Saved?
Wednesday, May 12, 2010

The EU dropped a bomb on global speculators when they unveiled their nearly $1 trillion aid package.

I’m sure South Park fans on trading desks the world over heard the EU’s roar as Cartman’s favorite catch phrase “Respect my Authority!”

Make no mistake: The Europeans are fighting for their financial lives. They faced fiscal annihilation going into last weekend, and were compelled to violate the terms of their own constitution to put this package together.

Of course they won’t tell it that way -- maybe that’s why they are structuring this as “off balance sheet” financing and placing it in an Enron-made-famous vehicle called a "special purpose entity".

The only question worth asking at this point is, will it work? Is it enough to pull Europe back from the brink? Could it be enough to reignite the equity bull market?

As it currently stands, it looks to be enough to postpone the cascading effect of systemic risk that looked about ready to engulf Europe. So score one for the Europeans on avoiding a total melt down.

The big bailout buys the EU time, but it solves none of the deeper problems facing the so called PIIGS (Portugal, Italy, Ireland, Greece, Spain) countries. It’s going to take sustained economic growth, along with austerity measures, to get the PIIGS back on a solid financial footing.

The EU action should prevent any Sovereign defaults, but it will also slow the process of change that a sovereign default would have wrought. Ultimately it’s a negative for the Euro currency, and without a significant rebound in the global economy, Europe will find itself dealing with magnified versions of the same problems sooner than they think.

It’s also going to cause political and social unrest as more productive Europeans are compelled to shoulder the burdens (via higher tax rates) of less productive Europeans.

Another fly in the global growth ointment happens to be China. While their trillion dollar stimulus plan helped them avoid the 2008 recession, it may have all been in vain.

Always remember that the cure for a recession is the recession itself. Recessions are needed to reset asset valuations, wash out poorly managed enterprises, and set the stage for the next cycle of demand. You can’t avoid them -- they are an inherent part of the capitalist process.

Anyway, back to China. Over the last few months, China has been desperately attempting to cool inflation via government intervention. Additionally, it appears that up to 440 billion dollars worth of Chinese government stimulus money has either been looted or lost through bad bank loans. So we face the distinct possibility of a Chinese banking crisis, matched with a government engineered slow down of the Chinese economy.

Such a possibility does not bode well for commodities, especially if the US Dollar continues to move higher, which I expect it will.

Another country that stands to get hurt by a Chinese slowdown is Australia. The resource boom driven by the industrialization of China has been very beneficial to Australia. Any hiccup in China is sure to be felt in Australia’s equity markets as well as in their currency, which is why both look like prime shorts.

Australia is compounding the effect of a potential China slowdown by trying to get a 40% tax passed on all companies that mine in Australia. In the best of times this would be, as the kids say, an “epic fail” policy, but in this environment it could prove disastrous to the Australian economy if the big mining firms decide to shelve their expansion plans.

Amid all of these tragedies and pitfalls, the good old US of A actually looks comparatively attractive. The jobs report from last week was surprisingly good, interest rates look flat to down, and the US Dollar looks like it wants to keep trading higher.

While US equities are currently under pressure, on a relative basis I fully expect US equities to outperform all other equity markets. And so long as this pullback does not turn into a melt down, we may see the US pull ahead of the global pack. The two keys will be the strength of the recovery and the severity of the current pull back.

While I think it’s too early to try and buy equities on this weakness, in my opinion it would be a mistake to say that the US equity bull market is dead.

Don’t try and be a hero here. Let the market play out and look for either a successful retest of the lows on the S&P 500 or a break to new highs before committing new money to equities.

Of course, the inverse of that is also applicable ... an unsuccessful test of the lows should be used as an opportunity to increase short positions.

Don’t try and guess what the market will do next. Wait for the appropriate confirmation signal, then back your signal and make sure you use a stop or a hedge to protect your down side.