The summer of tail risk: How we're playing FX, bonds, commodities

The EU's attempts at extending-and-pretending their way out of the debt crisis are running out of time and policy wiggle room. The short term issue is that Germany can't ratify the ESM before at the earliest September (when the German Constitutional Court will make a ruling) and intervention through the EFSF is ineffectual.

The Spanish yield has no upper limit and most people forget that the Spanish sovereign debt market is no longer a real market. There are only two net buyers: the ECB and Spanish banks using liquidity from the ECB. This is a closed circuit in which less and less real money interacts.

The Bank of Spain this morning highlighted that growth is disappointing with Q1 growth of -0.4 per cent and -1.0 per cent expected for Q2. It will take a miracle for Spain to reach its projected and promised deficit of 3.0% of GDP this side of 2015 and even 2020 without major reforms.

A Europe of Entitlements

In Spain, and to some extent also in Italy and Greece, the problem is not necessarily that the right policies weren’t in place all along. Rather, it has been the unwillingness and inability to apply the letter of the law that prevented so many in Europe from doing “right thing”. Europe over the last ten years became a Europe of Entitlements. The same “social welfare” model which Europe freely try to impose on “less fortunate” nations, has now moved from supporting to undermining the societies of Europe. The problem with entitlements is inherent in the definition of the word itself. An entitlement is a benefit many feel they automatically have the right to, whether you have earned it in any way or not. Rather than something that is given to the weak in times of need or temporarily to a wider group during a time of recession, entitlements have become something too many feel they have the right to enjoy all the time.

As Europe has become entitlement Europe, it means it must fail almost by definition. The big “majority” of entitlement holders: the pensioners, the unemployed, the businesses needing state support, is growing day by day as the system fails. So now we have a growing class of people wielding tremendous political power that are trying to get more entitlements from a shrinking financial and economic base. To continue to finance the pressure on the sovereigns, meanwhile, the central banks are printing money and thus bailing out those who made bad decisions in the past and took on too much debt while also confiscating the savings of those who never asked for entitlements in the first place. In the end – everyone gets poorer in such a dynamic.

Giveaways in France

The situation is aggravated by a lack of political consensus in Europe. The French president Hollande is trying to get away with what in economic terms is a suicide mission - lowering the pension age again, forbidding lay-offs and social reforms in the country in Europe which already spends the most on its pensioners. The odds of this program succeeding are lower than Spain reaching its budget targets! Meanwhile, Ms. Merkel and Germany (and most of Northern Europe by its side) tries to dictate austerity-based reform programs that would see the periphery saving its way to prosperity. When your are in a debt deflation spiral – keeping the debt alive while trying to save on public outlays at the same time is a recipe for sure disaster. The extend the debt and pretend we can pay for it game must stop: the sooner we take the loss, the lower the final cost.

Add to this situation an Italy that will soon be without a government and has a refinancing need in the trillions over the next two years, plus a US which is reluctant to engage in QE3 based on its less than obvious success with QE and QE2 and we have what we the conditions for what we have coined a 'Summer of discontent'.

Assets are priced on macro tail-risk

Assets are not priced on their micro attractiveness (p/e, growth, market share, or cash flow generation) but only by the metric of macro tail-risk. This tail risk is increasing with the ever higher financing cost for Club Med countries (as in dearer funding, bigger deficits, lower growth cycle).

This is a the price for extend-and-pretend: The good micro story becomes diluted by the bad macro story. That's the lesson the market has been trying to tell the policy makers, but they continue to give empty promises and non-plans for plans.

When we finally see a real 'meeting of the EU cardinals', only then will we have seen the low in EURUSD and the Stoxx50 and the high in Club Med yields – not a day before. But if the above fails to occur, do not book a ticket on Noah’s Ark. The world is not ending. Micro will be back and with micro comes reason, profit and logic. The system is being tested as it should be, but it’s not collapsing, merely changing.  

Strategy:

Tail-risk rules. The tail-risk is increasing not decreasing, thus a defensive mode is needed. The market will be like the European summer this year; cold and changing with occasional sun.