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Worried? Savvy Investors Prepare for the 'Unknowns'

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Tuesday, 24 Jul 2012 01:19 PM Current | Bio | Archive

The eurozone trouble arsenal is making headlines again. By the day, it is becoming clearer to everyone who is not in a state of denial that Europe is losing its battle against the crisis and the much-vaunted European firewall is clearly failing. That is extremely important to all investors.

On Sunday, former German Finance Minister Peer Steinbrück (Social Democratic Party of Germany), and possible opposition chancellor candidate in next year’s federal elections, said in an interview he has growing doubts on whether all member states could remain in the eurozone.

Among a lot of other clear negatives, he was particularly unsettling when he stated that the euro crisis could become a threat to democracy in Germany.

Long-term investors should keep that in mind that 2013 could easily surprise on the downside and much deeper than most can even imagine and, therefore, probably are not prepared for.

Putting aside the usual comments of the concerned parties, Moody’s Investors Service on Monday made its own warning headline by being the first of the big three U.S.-based rating agencies to lower its outlook for Germany’s Aaa government bond rating from stable to negative. Moody’s also extended these warnings to the Netherlands and Luxemburg, which are also part of the Aaa countries of the eurozone.

Moody’s said “the level of uncertainty about the outlook for the euro area, and the potential impact of plausible scenarios on member states, are no longer consistent with stable outlooks.”

In addition, the material risk of Greece’s exit from the eurozone “exposes core countries such as Germany to a risk of shock that is not commensurate with a stable outlook on their Aaa rating.”

Moreover, Moody’s said, “German banks have sizable exposures to the most-stressed eurozone countries, particularly to Italy and Spain, and the risks emanating from the eurozone crisis go far beyond the banks' direct exposures, as they also include much larger indirect effects on other counterparties, the regional economy and the wider financial system.”

It is also an undeniable fact that German banks have only a limited loss-absorption capacity and their structurally weak earnings make them vulnerable to a further deepening of the crisis.

Not surprisingly, Germany’s finance ministry said in a statement, “The eurozone risks that Moody’s mentions are not new. … The very sound state of Germany’s own economy and public finances remains unchanged.”

One could say that Moody’s call is its ultimate warning to the eurozone core, because it will be these Aaa-rated euro area sovereigns’ balance sheets that would be expected to bear the main financial burden of support. France’s review is expected to be published at the end of this quarter.

Besides, the just released Markit Flash Eurozone Purchasing Managers’ Index for July suggests the eurozone downturn is showing no signs of letting up and is consistent with gross domestic product falling at a quarterly rate of around 0.6 percent. The downturn is being led by an increasingly severe slump in manufacturing, where output is falling at a quarterly rate of around 1 percent. Germany is now contracting at the steepest rate for three years, while the rate of decline in the periphery is also among the highest seen since mid-2009.

Companies across the region are cutting staff numbers at the fastest rate for 2.5 years as the outlook darkens. Service providers are now the gloomiest since March 2009, while manufacturers are slashing their inventories of raw materials in the expectation of ongoing weak sales in coming months. Companies also cut prices to the greatest extent since early-2010 to help boost ailing sales, which should help alleviate inflationary pressures, but may hit profits.

Somewhat better is the China HSBC Flash Manufacturing PMI, which picked up modestly in July to a five-month high of 49.5, suggesting earlier easing measures could be starting to work. Nevertheless, the below-50 July reading implies that demand still remains weak and employment is under increasing pressure, which calls for more easing efforts to support growth and jobs. All will depend on where inflation goes in the coming months and if the already high food inflation allows further growth-supporting actions.

Regarding international capital flows, we see continued strength of U.S. debt purchases, while the mix of European flows highlights the principle cause of the eurozone malaise. We see solid demand for German debt, which shows little sign of abating per yesterday’s negative-yield bill auction. And that is mirrored by continued aversion toward Spanish and Italian markets, and in view of Spain’s growing predicament, such trends appear unlikely to change course anytime soon. Indeed, across the market, it might be said that there is a growing anticipation of some kind of a denouement in the eurozone crisis given the patent failure of the European Union’s efforts to segregate the weaker periphery from its core Northern members.
 
All that said, investors should keep in mind that the United States is not out of the woods yet, and the resilience we have seen lately of the dollar might not be as solid as it seems at first glance. During the fourth quarter of this year, I expect the focus to shift to the United States, where the election season and weak economic growth could bring the “fiscal cliff” sharply back into focus and when the value and not only the function of the dollar could start to matter once again. But that is not a worry for now. Nevertheless, keep in mind that in August of last year, Standard and Poor’s lowered the U.S. long-term rating to AA+ from AAA on political risks and rising debt burden and said the outlook on the long-term rating is negative.

During the third quarter, investors will have three evolving important issues that will require close scrutiny: 1) the eurozone crisis, 2) the Syrian conflict and 3) China’s once-a-decade political transition. These issues could evolve (I am not saying “will”) into real threats of dismantling decades-long political constructs in Europe, the Middle East and the Far East. It remains anybody’s guess, in case the related threats were to materialize (I am hoping not), if Europe, Syria and China would be able to stave off the harsh, but unavoidable, consequences if such events were to happen.
 
From a long-term investor’s standpoint, it will be extremely important to be prepared for “unknown” unknowns. The Iran nuclear threat is, in my opinion, a “known” unknown.
 
No doubt, patience will be needed. Safe, highly liquid, U.S. dollar-denominated universal cash equivalents remain part of my preferences, as do physical gold and the Norwegian kroner.

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2012-19-24
Tuesday, 24 Jul 2012 01:19 PM
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