Capital Markets Update

By Louis S. Barnes                                                   Friday, June 15th, 2012

Now we wait. At 2:30 ET Sunday come Greek election results and who-knows-what explosion at the opening of Asian markets Sunday night. More likely: a few more frozen days to digest the results, and any number of empty cans kicked into nearby walls.
     The biggest event next week will be the Wednesday conclusion of the Fed's meeting. The stock market this week began to trade up on bad news (a small rise in unemployment claims, a dinky drop in industrial production) on the assumption that bad news would mean QE3 from the Fed, which must be good news for stocks no matter how ugly the reality might be.
     Last week I compared this market-think to trained seals, and today I apologize to seals everywhere. Pick a more appropriate critter. If you took Psych I, you discovered that you could get a lab rat to sell its soul for a dozen Rice Krispies. Rats conditioned to central bank action are found not just in neckties at the NYSE, but all over the globe.
     Since WW II, the immense economic strength of the US combined with reslove at all central banks to avoid a Depression replay has enabled rescue from all severe financial crises. All rats and non-rats assume that rescue is just a flip of switch. An unpleasant crew on the Right and righteous Libertarians think that rescue corrupts the morals of rats, but given the raw material, why worry? Rescue when we can is right and proper.
     Europe's situation today is different from all other financial crises in the last 70 years. Some day a crisis was bound to come along that could not be rescued, and this one has a crucial marker: tectonic strain has built ever since the misbegotten euro rolled out, and efforts to meliorate have resulted only in more strain.
     What will the ultimate breach look like, and what is the hazard here?
     I may be the only optimist alive!
     There is a small chance that Europe, looking over the precipice will decide that the whole can adopt German behavior, and that Germans can become Californians. However, that adaptation would take many, many years, and might well inflict greater drag and hazard on the world than an all-at-once reset.
     The vastly more likely fault-line lurch would take place in one of two general ways. The orderly way: one Friday afternoon after US markets close, announce a euro-wide bank holiday, then a skip-Monday re-open in local currencies. The disorderly: stay in denial until markets pull the plug, and then a holiday.
     Chaos and losses follow, especially to anyone who expected repayment in euros by non-Ger/Neth/Aus/Fin entities. However, healing would  begin instantly. Local currencies would trade wildly for a few weeks, but find levels; all local central banks still exist; all senior business management knows local-currency trade and hedging; and all local political structures can again make local decisions.
     As most of Europe will devalue, exporters to Europe will either have to devalue or to sell less and slow. China would feel the worst bind: devalue versus the dollar to stay with Europe, and risk US trade war? Or keep the dollar-peg, slow, and begin to reform?
     Japan might be the worst exposed, but its vulnerabilities are local: its banks and citizens own 95% of government debt, and its ultimate default will be internal.
     Emerging nations -- Brazil-Russia-India -- would feel the breakdown in the unsustainable global-trade conveyor. However, the good-news effect: pretense exposed, rationalize their economies to reality as best they can.
     Here. Here? Falling commodity prices remove any threat of inflation, and free the Fed to take any measures necessary. Our banks are not at run-risk: they are drowning in stable deposits. We are less reliant on exports than any large nation. Our housing market is turning, applications for purchase loans up 13% last week. New data are on the flat side, but the economy is more uncertain than foreshadowing rollover.
     A euro-breakup would mark the end of a painful and irrational time, and resolution to the paired plagues of the last twenty years: unsustainable sovereign debt funding unsustainable trade. Long past due, inevitable, and a good, good thing.