Here's the the full Merk Insights letter below:
Greek Prime Minister Papandreou is throwing in the towel: by calling for a popular vote on austerity measures now, we believe he is almost assured a no vote. This allows Papandreou to say that he tried everything he could to avoid a default, but the people have spoken. Having said that, as we write this analysis, Papandreou appears to be changing his mind and may cancel the idea of a referendum as quickly as it came about. Still, the message is clear: a default is coming.
The sad part is that Greece has not been able to eliminate its primary deficit (the deficit before interest payments), so that it could have the potential to bounce back upon a default. On the contrary, Greece may fall into chaos or anarchy. The threat of such a scenario, in turn, may prompt European policy makers to instigate a Marshall Plan to rebuild Greece. While we can ponder about the Greek drama, it’s paramount to contemplate the consequences for the rest of Europe and the euro.
First, the good news: market pressures should accelerate reform. Specifically, we expect bank recapitalizations will both be accelerated and increased in scope; if you can’t save the sovereigns, at least make the banking system robust enough to absorb defaults. That’s better than any insurance scheme policy makers can come up with.
Expect dramatic actions by policy makers, akin to those seen in October 2008. Just as policy makers did not initially heed the markets then, the pressure is now on to follow through with substance after last week’s sketchy plan to save Europe, and ostensibly, the world. Specifically, pressure on Italian Prime Minister Berlusconi is mounting rather dramatically to engage in real pension reform. In comparison to both Spain and Ireland, which have seen relative market improvements, the markets have scolded Italy. While it is possible to turn the tide, the longer the wait, the more the market will demand.
What would alleviate the pressure is a commitment by the European Central Bank (ECB) to be the lender of last resort for Italy and Spain. However, that’s unlikely to happen, at least not in the short term. As of today, the ECB has a new leader, Mario Draghi. As an Italian, he will be under pressure to be rather hawkish. His first press conference is this Thursday. He could announce a program to buy unlimited Eurozone debt, and sterilize such activities. However, such a move would take the pressure for reform away. And a central bank’s role is not to make the life of policy makers easy. If Draghi were to pursue the route of least resistance, he could easily be labeled as, well, Italian, in his approach to central banking.
Any revised bailout fund for Italy is likely to cost France its AAA rating. France itself also has lots of homework to do. The lesson here is that policy makers always wait until the last minute to engage in reform; some day down the road, the market will focus on the U.S.; at that stage, the U.S. dollar may be under severe pressure: the U.S. dollar is more vulnerable given the significant current account deficit.
So for now, the drama continues. To summarize, expect more on bank recapitalization and reform. A wild card is whether the European Financial Stability Facility (EFSF) is going to be bolstered in earnest. For those politicians that still believe Greece can be held afloat: stop believing in fairy tails and move on. The market will.
As far as our positioning is concerned, we had increased our euro holdings ahead of the summit last week. We have since reduced it. We had also substantially reduced the yen ahead of that summit. Our outlook calls for substantial volatility in all currencies, except for possibly the yen; as such, our risk assessment is currently favoring the yen disproportionally. As October 2008 has taught us, though, rational investors may be forgiven for changing their view of the world on a daily basis… Stay tuned and subscribe to Merk Insights.