The Last Optimist – Alive and Kicking

There’s an old saying amongst investors that claims that the market bottom is reached only when the last optimist turns pessimistic. Former Goldman Sachs European analyst, now UniCredit chief economist, Erik Nielsen, is a natural-born optimist. And he’s still hanging on, still looking for something positive to tell his clients… God bless his soul!

“While few people like to see their individual benefits being cut, or their individual taxes hiked, the broader sentiment in Southern Europe is that people want core-European quality-institution and stability.”

Erik Nielsen

“Big political changes are now sweeping through the euro zone, putting, at least for now, the many skeptical political observers to shame.  I can’t tell you how often I have been told by investors and economists during this crisis that its only a matter of time before Southern Europe refuses the adjustment medicine and brings into power radical political forces which will eventually take them out of the euro zone, and that Germany will soon refuse to lend any further money to the south.  Interestingly, some 90% of those having predicted this outcome happen to be residing outside the euro zone,” Nielsen points out.

Here’s the rest of Mr. Nielsen’s commentary, published at today:

The Case for Optimism

Well, so far it is moving in the opposite direction: In Greece, Lucas Papademos was sworn in as prime minister, and Italy is about to hand power to Mario Monti.  And next Sunday when Spain goes to elections, and assuming the opinion polls are remotely accurate, Spain will elect the conservative Partido Popular with a wide absolute majority.

What’s the common picture in these three countries? People want more Europe, not less.  While few people like to see their individual benefits being cut, or their individual taxes hiked, the broader sentiment in Southern Europe is that people want core-European quality-institution and stability. 

Meanwhile, in Germany, Stern magazine rewarded Angela Merkel‘s performance during recent weeks by putting her on the front page – her picture tattooed onto the bicep of a strong arm and with a sub-title of “how Merkel runs Europe”.  Stern’s weekly ranking of politicians sent her top of the group, followed by – equally important – other pro-European opposition politicians, with the more sceptical ones (the Left and FDP) way down.

For us believers in the European project, this is clearly good news. 

But will the market appreciate it?  Well, one day it will, but I am not completely sure that it will get it quite yet.  At the end of the day, we are living through this highly peculiar period where investors will rather buy bunds or gilts with a virtually guaranteed erosion of real wealth, than being paid 6%-7% for an equivalent Italian bond with a virtually certain better outcome in two years.  But with leverage and mark-to-market and a year of generally poor performance, two years is a long time.

Everybody in the asset management industry seems preoccupied with career risk. 

It is a sad reality, sad because when the collective guardians of our savings prefer negative real return rather than maximizing return on capital, then this will come with a cost to long run growth.

What should be the policy response this bizarre state of affairs? 

So far, the European response has been out of the good old text-book, to which I still subscribe:  When you have an excessive fiscal imbalance, then you adjust it as fast as you can, accepting the short-term pain for the longer term gain.  And until very recently, the market subscribed to the same philosophy, discounted the future benefits of the tougher policy, and rewarded the faster adjustment over the slower one.  

Now, however, markets seem to like slower, or no, adjustment over the fast adjustment, predominantly because investors have turned themselves into pseudo political scientists, predicting a demise of the politics in the countries undertaking tough reforms.

So far, the common political “wisdom” on Europe on Wall Street has been wrong.  Will it change now on this latest evidence?  I don’t know.

If it doesn’t, then I would propose the following: if markets do not properly reward fundamentally good adjustment policies in a country, which the Troika deems sufficient and therefore eligible for a credit line, then it would be only reasonable for the ECB to draw a line in the sand and announce a maximum funding cost for that country for a period of time. 

For example, if Italy puts into law the required structural reforms, and the market does not bring funding costs down sufficiently on the back of the prospect for better growth in the future, then – with a Troika approved credit line – the ECB ought to tell the market that during the next year (or two) and so long as those policies remain in place, the 2-5 year sector of the Italian curve shouldn’t be above, say, 4%. 

I suspect that the ECB would not have to spend much money getting that result, if any. 

The parallel is the Swiss National Bank’s decision to change their exchange rate policy “from leaning against the wind” with a clear and defendable floor of 1.20 Swiss Francs against the euro. 

It was a gutsy call by the SNB, which suddenly  everyone agreed with once implemented and successful.

I suspect the same would be true if a member of the European Central Bank‘s executive board were to propose a temporary ceiling on yields of 4%.

This would quickly put to an end the current phase of the crisis – and, almost certainly, the build-up of sovereign debt on the ECB’s balance sheet.

By Erik Nielsen, chief economist of UniCredit.

1 Comment

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One response to “The Last Optimist – Alive and Kicking

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