How Europe chooses to deal with the problems of the countries on the edge, among them Greece, Spain, Portugal and Ireland, may determine the future political shape of Europe, and the future of the euro itself.

World markets sank Thursday in the face of signs that skittish investors were growing more fearful of lending to Portugal. That country had to scale back a short-term borrowing plan, something Europe is not used to seeing.

If investors were to walk away, or demand truly exorbitant interest rates, that would put pressure on France, Germany and others in the euro zone to decide just what they would do. Would they bail out their troubled neighbors? Or would they simply allow them to default — an outcome that would have major repercussions for Europe and financial markets worldwide?

For a long time ( 10 years aprox.)  optimistic forecasts said  that European countries, faced with the unavailability of currency devaluations, would liberalize their economies to make them more competitive but that proved to be wrong.

If anything, the opposite happened. A common currency, with closely linked interest rates, made it possible for countries to postpone changes, or to try to do them so gradually that they made little difference.

It is not easy to persuade politicians to take steps that are likely to lead to them being voted out of office !!!

If the euro problem does turn into a crisis, however, 2010 could turn out to be the year of the currency fights. The United States and Europe are both showing more irritation at China’s refusal to allow the Rimminbi to appreciate against the dollar, a decision that makes the Chinese export economy more competitive when it is already running large trade surpluses.

So turbulent times with many possible outcomes… Watch out

The yield on 10-year Greek bonds rose to 7.15 percent yesterday, the highest level since October 1999 and up from 4.99 percent on Nov. 30. The yield is more than 3.9 percentage points higher than benchmark German bunds, the biggest gain since October 1998.

The nation’s government bonds are the world’s worst performers in January, losing 4.19 percent in local currency terms and extending their decline over the past three months to 10 percent, Bloomberg/EFFAS indexes show. Credit-default swaps tied to Greece trade at about the same levels as Dubai when it got a $10 billion bailout from Abu Dhabi in December.

The cost of insuring the country’s debt against losses rose to a record yesterday, with credit-default swaps jumping 40 basis points, or 0.4 percentage point, to 414, CMA DataVision prices show.

The swaps have risen from 121.8 basis points in October, and compare with 433.4 basis points for Dubai in the weeks before it received cash from Abu Dhabi on Dec. 14 !!!

“I am not sure that a Greek default is inevitable, but the clock is ticking with regard to difficult policy choices,” said Marc Seidner , a portfolio manager at Pacific Investment Management Co. in Newport Beach.

“Any financial aid from other European nations would be conditional upon the government introducing new measures to clean up its public finances”, Le Monde said. Help would consist of bilateral loans from European governments in the absence of a mechanism for a euro-region bailout, the newspaper said.

Portugal and Spain, watch out !!!

We would like to present today  This Time is different from  Carmen M.Reinhart and Keneth S.Rogoff . They have catalogued over 250 financial crises in 66 countries over 800 years and then analyzed them for differences and similarities.

The book gives evidence that we have a lot of pain to experience because of the bad choices we have made. This is the entire developed world, and the emerging world will suffer, too, as we go through it. It is not a matter of pain or no pain. There is no way to avoid it. It is simply a matter of when and over how long a period.

In fact, Reinhart and Rogoff’s research suggests that the longer we try to put off the pain, the worse the total pain will be. We have simply overleveraged ourselves, and the deleveraging process is not fun, whether on a personal or a country basis.

And they say :

“But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”

“This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk – if only they do not become too drunk with their credit bubble – fueled success and say, as their predecessors have for centuries, “This time is different.”

Well, well, we have never believed that this time was different , and for sure, we advocate that this time it will take a lot of time, effort and courage  to navigate  through these turbulent times…

On January 1 , 2010 ,Spain took over the six-month rotating presidency of the EU. Spain’s biggest ambition for its turn is the launch of a “2020 strategy” for Europe. This is a ten-year plan for boosting competitiveness and growth to help pay for Europe’s generous welfare systems. It follows another ten-year plan, the old “Lisbon strategy”, which failed in its aim of making the EU “the world’s most competitive and dynamic knowledge-based economy” by 2010.

But EU members reaction has been unenthusiastic. Spanish unemployment is heading close to 20% (double the average among euro-zone countries), following the popping of a huge housing bubble,  worsened by a two-tier labour market in which a hard core of permanent workers is almost impossible to sack, passing the pain onto those on temporary contracts, all too often meaning the young and immigrants.

So please give us a break !!! Let´s start by applying to ourselves what we want for the rest of EUROPE.

IT IS DELEVERAGING STUPID !!!

The reason this recession is different is that it is a deleveraging recession ( depression kind ?). We borrowed too much (all over the developed world) and now are having to repair our balance sheets as the assets we bought have fallen in value (housing, bonds, securities, etc.). A new study by the McKinsey Global Institute found that periods of overleveraging are often followed by 6-7 years of slow growth as the deleveraging process plays out. No quick fixes.

The process of deleveraging from what is still a near-record debt overhang is going to take a long period of time and exact a toll on economic activity along the way.

As David Rosenberg says “ALL debt as shown in the chart above is going back to $60,000 in real terms, and if it’s going there, and we get a withdrawal of stimulus at any time, then the credit contraction is going to gain some serious momentum.  This is a big reason to be defensive and yield- oriented in the portfolio”.

And finally, FT in the Lex Column “it may be economically and politically sensible for governments to spend money on making life more palatable at the height of the crisis.  But the longer countries go on before paying down their debt, the more painful and drawn-out the process is likely to be.  Unless, of course, government bond investors revolt and expedite the whole shebang.”

So, who said this game was over ? Let´s see what Bond Vigilantes have to say…

“Security researchers said they have discovered software capable of stealing information installed on computers in 103 countries from a network that targeted government agencies.The software infected more than 1,200 computers, almost 30% of which were considered high-value targets, according to a report published Sunday by Information Warfare Monitor, a Toronto-based organization”. Said WSJ.

“Google has said it will end the controversial censorship of its search service in China and risk being thrown out of the world’s most populous internet market, following what it claimed were Chinese-based attempts to hack into its systems and those of other international companies”. Said FT

The apparent attacks are the latest to suggest cyberespionage is on the rise. Last year, Kevin Chilton, commander of the U.S. Strategic Command, said “military computer networks are increasingly coming under attack from hackers trying to steal information, many of whom he said appeared to have ties to China”.

PHOTO: AP  CRASH 1929

Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus.Interest rates of 1% or less in America, Japan, Britain and the Euro zone, have persuaded investors to take their money out of cash and to buy risky assets.

For all the panic last year, asset values never quite reached the lows that marked other bear-market bottoms, and now the rally has made several markets look pricey again.

Low rates have persuaded investors to move money out of cash. Investors withdrew $468.5 billion from money-market funds in the course of 2009. The “carry trade”—borrowing in low-yielding currencies to invest in high-yielding ones—is back in full swing. The Australian dollar has been a popular beneficiary.

But our problems still there. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall Act, we keep in power the same people who missed the problems the last time, ETC,ETC,ETC…

So let´s be careful with the coloured glasses that we use to see the World because that may change…

Since 2005 China’s interest in Africa has intensified. In November 2006, Beijing hosted a Sino-African summit at which it promised more than 40 of the continent’s leaders a new era of co-operation.

Beijing has offered more than long-necked symbolism. In 2006 alone, it signed trade deals with African countries worth $60bn. Investments, which often include a resources-for-infrastructure element, have poured in thick and fast. China’s stock of foreign direct investment has shot well past $120bn. In 2006, Angola temporarily overtook Saudi Arabia as China’s main supplier of oil, and Africa now accounts for nearly 30 per cent of China’s oil imports.

In 2007, Industrial and Commercial Bank of China, the biggest bank in the world by deposits, paid $5.6bn for a fifth of South Africa’s Standard Bank. Two years ago Beijing pledged $10bn of new low-cost loans to Africa. It also promised to eliminate tariffs on 60 per cent of exports and to forgive the debt of several countries. Trade between Africa and China has already risen spectacularly: in 2009 it jumped 45 per cent to $107bn, a tenfold increase over 2000.

Beijing’s engagement with Africa has caused much hand-wringing. China is no philanthropist, but its rise may still represent Africa’s best hope of escaping poverty. In the eight years to 2007, before the financial crisis, African countries were growing, on average, by more than 4 per cent a year, far higher than previously. That was thanks partly to better economic management, debt relief and increased capital flows (some from China), but also to the higher commodity prices driven by Chinese demand.

Much of the criticism of China’s influence rings hollow. As Chinese and Japanese officials point out, the west’s track record is less than exemplary. European contact with Africa can best be summed up as decades of naked rapaciousness followed by a spectacularly unsuccessful attempt to make amends. During the cold war western governments supported dictators across the continent, from President Mobutu Sese Seko to Idi Amin.

Finally, China is not alone in seeking opportunities on the continent. As well as the west, India, Brazil and Russia are also looking for business.

This is the time of the year when strategits  make annual forecasts. We have already seen a wide range of forecasted outcomes but we would like to summarize the consensus :

• Muted Recovery but Recovery
• Equity Markets up
• Short Long Term Bonds
• Long Commodities
• Certain Volatility
• Inflation

We do not see the economic events of the last two years as a classic Recession/Recovery phase. So we think that the possible outcomes are very uncertain.

But let´s try to Forecast  (do not forget that we are humans ) :

This recession was unlike any other we have experienced since the Great Depression. Typical recessions are inventory-adjustment recessions, caused by businesses getting too optimistic about sales and then having to adjust. You get temporarily higher levels of unemployment as inventories drop, and then you get the rebound. It is not quite as simple as that, but close enough. This time is more about credit expansion and contraction.We are in a post-credit collapse that is ongoing…

This recession was caused not by too much inventory but by too much credit and leverage in the system. And now, we are in the process of deleveraging. It is a process that is nowhere near complete. While the crisis stage is over (at least for now), there is still a lot of debt to be retired on the consumer side of the equation, and a lot of debt to be written off on the financial-system side. And this is true in US and in Europe as well.

Given the high rate of delinquencies and charge-offs of all sorts of debt in US, it is unlikely that we are going to see growth in loans in 2010. Consumers are working hard to reduce their debt. The New Frugal is part of the New Normal.

Past post-recession expansions have been built on growing credit and leverage. That will not be the case this time. We are going to see reduced lending and borrowing. Even though the federal government is running massive deficits ( US ), the stimulus portion of the debt will be running down in the latter half of 2010. There will be little political will to continue with massive stimulus and deficits. While this is good in the long run, in the short run it will reduce GDP.

Perhaps Inflation is a consensus forecast but Deflation is the present day reality and often lingers for years following an asset and credit bubble and further collapse.

We see the range of outcomes in the financial markets and the economy to be extremely wide at the current time.But a clear strategy is being defensive and minimizing volatility and downside risks and focus on where the secular fundamentals are positive such as equity sectors that lever off the commodity sector.

We are going to take a break for the next two weeks and recharge batteries, but we will be ready to go as 2010 comes around.

We wish you Happy Holidays and a great Year ahead…

THE PIGS ( Portugal, Ireland,Greece & Spain )

As it is well known, the biggest problem economies in the Euro-area are Ireland, Spain and Greece, all of which are mired in debt and economic malaise.

The Irish economy, with a debt-to-GDP ratio forecast to rise from the current 66% to 96% by 2011, is obviously in miserable shape, but at least the government appears willing to take painful and politically risky measures–massive wage cuts and income reductions are being implemented across the spectrum, in tandem with proposed tax increases on income and levies on public sector pensions.

In Spain and Greece, by contrast, the governments still appear resistant to hard choices that might help them tackle their debt, which in Greece’s case is forecast to rise from the current 112% to 130% of GDP by 2011. Within weeks of winning the country’s elections in October, the Greek socialist government raised the budget deficit forecast to 12.7%, twice the previous government’s forecast.

Spain’s debt to GDP ratio at 55% is below the European average, but it is suffering the ongoing effects of a major housing bubble implosion. Yet unit labor costs in Spain rose +0.4%YoY in the third quarter despite an 19.3% unemployment rate. More worrying are the fears that European banks in general and Spanish banks in particular have been slow to write off bad assets (how could Spanish banks have managed to largely avoid Spain’s massive housing bust?).

With these concerns coming, we see another reason to sell the Euro vs the US$, though the coming decline of the Euro from the current very overvalued levels will not provide countries like Ireland and Greece much relief in the near future.

After all, in terms of their real effective exchange rates, these two countries, along with Spain, have appreciated the most in the past decade.