The market action of last week repeated a lesson that many a punter appeared to have forgotten. Never run a bearish book into a European summit and especially not one where expectations for a result are as lows as they were going into Friday's meeting. Risk assets went up like a rocket with especially oil releasing heavily oversold momentum and you really could not do much wrong if you were running even moderately net long.
Above Expectations in Europe
Obviously, the market is buying the rumour and not the fact. In traditional summit fashion we got a lot of road maps and promises but very little concrete effort. Details were exceedingly sketchy and to talk about game changers is premature. We usually do not get game changers from the EU, but merely fudge cakes. Alpha.Sources would however like to remind investors that such fudge cakes may be enough to quell the market's sugar addiction for several weeks.
Three points are worth making.
Firstly, the ESM appears to get the ability recapitalise banks directly and the door has also been opened up for the ESM/EFSF to buy peripheral debt without implied seniority. This is a big step in breaking the link between banks and the sovereign. Ireland and Spain in particular will be the beneficiaries of this. Alpha.Sources remain skeptical that the broadcasted notion of no conditionality will hold, but at least in principle there is a now a negotiated result which seems to allow countries to get help for their banks with little or no conditionality on the sovereign and no addition to sovereign debt to GDP. This is a significant step towards risk mutualisation through a banking union and ultimately a fiscal union. Alpha.Sources would note however that without applying haircuts to bondholders of both sovereign and private debt, One link is broken but another one is created between core Europe and the entire European banking system. While such a link may be stronger through the effective backing of the whole eurozone balance the key question is how far Germany and the EU will go. This question is particularly relevant (and binding) as it will inevitably become clear that whatever initial amount of euros ceded to the ESM/EFSF to sprinkle over Europe's barren financial markets, it will almost surely be too low.
Secondly, the electorate and political establishment in Greece have every right to be perplexed. Greece has thus spent the past 3 months under an effective threat of being kicked out of the eurozone only to watch Spain and Italy get away with what is essentially preferential treatment. The fact that systemically important entities, sovereign as well as private, are given special treatment in this crisis is nothing new, but it remains a democratic problem in the EU. Like Portugal who remains the only country ever to get fined under the Stability and Growth Pact even as virtually every country violated the rules, Greece may rightfully feel a sense of injustice.
Alpha.Sources would then venture the claim that a Greek exit is now out of the question in the short run (i.e. in 2012). Even as Germany may still move to extract its pound of flesh from Italy and Spain, there is now little chance that Germany and the EU can play hard ball against Greece in the coming negotiations with the Troika. Greece could obviously still become the whipping boy, but the continuing argument that Greece is special is now so worn that even European politicians must be able to see that they can't use it anymore. On this background, Alpha.Sources can't see the ECB shutting off Greece from the ELA while the ESM/EFSF is loading up on Spanish bank equity as well as non-senior Italian and Spanish sovereign debt.
Thirdly, the modest but clear movement towards official creditors not being considered senior could potentially go a long way to break the doomsday loop by which once a country enters bailout proceedings it will never access the market again. Alpha.Sources emphasizes potentially here however and for now, Alpha.Sources will stick to the main rule that whatever we might constitute normal market access the eurozone periphery is far from it, but there is another silver lining to this. Consequently, in Greece it will alleviate the pressure on the ECB, EU and the IMF as it is clear that the country will need a second write down of its debt which will inevitably involve its official sector creditors.
As a general conclusion, the summit results implies a very large degree of risk mutualisation which it is unclear that Germany will ultimately go for, but multiple conclusions are not possible at the same time and so far the market and punditry seem to view this, rightly or wrongly, as victory for Hollande, Monti and Rajoy. This also means that the decoupling of Bunds from US treasuries and Gilts as well as the recent steady increase in German CDS is set to continue. This is also why Alpha.Sources believes that unlike the German national team who might have to wait two years and the World Cup to redeem itself, Merkel will get her shot much sooner.
One thing Germany will push for is the fiscal compact rules to be put in motion at a fast track pace and also, if the ESM is to take direct and equal ownership of European banks Alpha.Sources feels certain that this will come with extended EU supervision of the involved banks.
Unimpressed in Japan
Another seemingly important political result this week was the approval of the increase in Japan's consumption tax, an increase which has been debated consistently for 5 years in Japan. If the final tax bill is passed, the tax rate will increase from the current 5% to 10% in two steps from to 8% in 2014 and 10% in 2015.
While the consumption tax has long been touted as the first step to put an end to the fiscal train wreck of Japan's public finances Alpha.Sources believes that the measure will ultimately be counter productive. Japan's fiscal problems consequently do not stem from a lack of revenue, but rather from too much spending. Trying to extract more revenues from a domestic economy where aggregate demand is already chronically weak due to an ageing population will only steal consumption from a future which is, in an almost literal sense, not there.
In this piece written on a similar VAT hike in Germany, yours truly presented a relatively simple economic framework for what it means to increase indirect taxes in the context of a rapidly ageing economy. In a nutshell, the argument is that while there will be a pure statistical effect on inflation readings as a result of the tax hike as well as positive effect on consumption as the purchase of durables is pushed forward, the end result is likely going to be deflationary.
The following quote, while requiring a little bit of basic microeconomic intuition, presents the argument,
(...) students of applied microeconomics learn to distinguish between the point of impact and point of incidence of a tax. The former constitues the party who actually levies the tax towards the government whereas the latter denotes the party who actually supports the tax. In the case of a value-added tax (an indirect tax) the point of impact would then be the consumer who (through an intermediary; e.g. a retailer) levies the tax towards the government. However, it is much more interesting in this case to discuss the point of incidence of the tax that is who actually supports the tax. In order for us to do so we need to introduce yet another economic concept, namely supply and demand elasticities of the tax hike. Consequently, the party with the highest relative elasticity (i.e. flexibility) towards the tax will also avoid supporting the lion’s share of the tax increase. What this means in the concrete case of the German tax is of course very difficult to asses. Yet, since for example consumers’ demand elasticity in this case can be operationalized as the relative fraction of disposable income which is consumed and saved (i.e. the MPC and MPS) we might actually be able to sketch a framework which suggests why the VAT hike in fact should not have been expected to rapidly push up inflation in the first place. The point would then be that the consumers’ demand elasticity towards consumption and thus flexibility towards avoiding the tax relative to businesses would be positively correlated with the marginal propensity to save.
In a rapidly ageing society, the attempt to extract tax revenue through consumption taxes fundamentally misunderstands the consumption and saving dynamics in the context of population ageing.
Still, we should expect higher consumption in Japan and also, ironically, that inflation may nudge its way up close to the 1% mark set as the target for the BOJ. It would be tragic if this prompted the central bank to lay down its guard because the end result would almost surely be more deflation and contraction.
With that dear reader it seems that just as Italy spearheaded by the enigma that is Balotelli managed to exceed expectations against Germany (only to come crashing down in the final!), so did we also get a number of political results which, at a first glance at least, were above expectations. In Europe, Alpha.Sources harbours a scant hope that the seeds layn may provide a little calm in the coming months however fleeting this might be while in Japan, the sentiment here at this blog is decidedly unimpressed.