Financial markets have enjoyed a strong start to 2012 after a very difficult 2011. Investors have begun to believe that the Eurozone crisis is being brought under control by Mario Draghi, the new head of the European Central Bank (ECB), who has taken a much more proactive approach than his predecessor Jean-Claude Trichet. But the crisis is only experiencing a temporary reprieve; the global financial system is leveraged to an unprecedented extent and is truly in an unprecedented situation.
Among the programs that have been implemented under Mr. Draghi is the LTRO (Long Term Refinancing Operation), which has stabilized the funding of European banks. Under this program, the ECB loaned almost €500 billion of 1% 3-year money to the banks in December and reportedly will be making a second, larger loan this month. European bank stocks have rallied in response to this program, which has removed the risk of imminent failure for these institutions. There has also been a drop in the borrowing costs of these institutions, as well as those of most European sovereigns (with the notable exception of Portugal). The market reaction is encouraging; the question is whether it is short-sighted.
The LTRO addressed the problem of short-term liquidity and gave the banks an opportunity to borrow cheap money and lend it out at higher rates and earn a profit on the difference. But the amount of money involved is insufficient alone to turn insolvent and unprofitable institutions around. In fact, the question that deserves to be asked is how the banks that are borrowing under the LTRO will be able to repay these loans when they are due in 3 years?
The banks are operating in countries experiencing austerity, which means they will see slow to negative growth. As a result, they are going to struggle to generate profits while continuing to wrestle with the bad loans that are crushing their balance sheets. While the LTRO loans are helping them with their current liquidity problems, in the long run they are merely adding more debt to the already overleveraged balance sheets of insolvent institutions.
Europe faces a truly difficult financial future. An entire generation of young people is experiencing epic levels of unemployment, sowing the seeds of discontent with government. On the other end of the demographic scale, Europe has a rapidly aging population that is placing serious pressures today and will place even greater burdens in the future on the social safety net. While many Americans question whether the United States is facing a Japanese future, it is actually Europe that possesses demographic similarities to Japan in terms of an aging population and a shrinking work force to support its retirees. The prospects for any significant economic growth in Europe outside of Germany (and perhaps the Nordic countries) are very poor.
Moody's Investors Service again downgraded six European countries on February 13 and cut the outlook on three other countries to negative. Spain, Italy, Portugal, Slovakia, Slovenia and Malta were downgraded and their outlooks remained negative. This was done despite Moody's saying that it welcomed the reform measures adopted by these countries. Spain's Finance Minister Cristobal Montoro was highly critical of this decision, saying in a radio interview: "They say that yes, they welcome them [the reforms] and then they decide the opposite according to their criteria, it is fairly paradoxical."
While the Minister's frustration is understandable, the point of Moody's action is twofold. First, until the reforms are actually implemented, the current financial condition of Spain does not meet the criteria of the previous, higher rating. The rating agency wants action, not promises. And second, it is unlikely that the reforms, significant as they are, are sufficient. European economies require radical reform that includes reducing the prerogatives of politically powerful groups such as labor and the wealthy.
Moreover, austerity is likely to weaken these economies rather than strengthen them, particularly if unaccompanied by pro-growth reforms of the tax systems. Italy's proposed reforms probably come closest to what is required, and even Italy was downgraded. The bottom line is that Europe has used up all of its good will with the rating agencies and is going to have to win it back with strong actions and better results.
The world's four largest central banks - the Federal Reserve, the ECB, the Bank of England and the Bank of Japan - have grown their balance sheets from $3.5 trillion at the time of the Lehman bankruptcy to over $9.0 trillion today. Before the current easing cycle is done, their balances sheets could easily reach $12.0 trillion or more. We are in uncharted waters. We don't know what will happen when central bank support starts to be withdrawn, or whether it even can be withdrawn without sending the global economy into a downward spiral.
For the moment, the LTRO has stabilized the Eurozone banking system. European leaders should use this moment to build consensus for the types of reforms that can lead to long-term economic sustainability and growth. If they fail to do so, the next crisis will come sooner than most people expect and will make the last one look like a walk in the park. And for that reason, investors should put their champagne glasses away and invest conservatively in order to preserve their capital and avoid putting too much at risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
