On the Verge of Implosion

by Addison Wiggin & Ian Mathias

• Eurozone “on verge of implosion”… our macro adviser’s take on the latest developments
• Markets of the world react: euro, stocks -- even Brazil -- mired with debt woes
• Chris Mayer offers one funny anecdote to sum up the China investment conundrum
• Plus, readers pile in… more of your thoughts on the BP oil spill

  “We are now on the verge of declaring the eurozone implosion,” Rob Parenteau wrote Richebacher Society members late Friday. Rob was the last to publish before the holiday… and after this three-day weekend, the implosion is upon us.

  First, Fitch stripped Spain of its AAA credit rating Friday. We’re a bit surprised the stock market sank 1% in response… Fitch seemed to be the last group of ivy MBAs in the world that still saw Spain as AAA.

Then, over the weekend, the European Central Bank ECB) issued a nasty edition of its twice-yearly Financial Stability Review. Turns out, European banks are not stable (!).

By the ECB’s count, banks around the continent will need to refinance debt exceeding 800 billion euros by the end of 2012. That’s just shy of $1 trillion. Under current euro meltdown conditions, that might be “challenging,” the bank admitted. Uh, yeah.

So the ECB suggests eurozone banks set aside 228 billion euros for the coming pain over the next two years. For some perspective, European banks bolstered loan loss provisions by 238 billion euros during the 2007-2009 crisis.

If you’ll allow us connect the dots: The ECB just announced the “Credit Crisis -- Part Deux.”

“In 2008, concerns about the viability of U.S. banks brought the financial system to the brink of collapse,” commented The Christian Science Monitor yesterday, also citing Mr. Parenteau’s work.

“‘You've got the ingredients for a major banking crisis... There is a contagion effect.’ Hedge funds, pensions and professional investors, driven by the lure of profits, will bet against highly indebted European nations, one by one, driving up their borrowing costs until they pass credible austerity packages.”

"They've done Ireland already and Greece," Mr. Parenteau told CSM. "When they're done picking the U.K. clean, they're coming over here. And once they're done with us, they'll probably go to Japan."

  “The next stage of the eurozone crisis,” Rob continued in his weekly advisory, “will involve the recognition by investors, and possibly (no doubt belatedly) by policymakers as well, that a banking run is unfolding in slow (but accelerating) motion in the eurozone, and it will not be restricted to the banks of the GIIPS.

“In addition, this banking run, once fully recognized, will speed up the capital flight from the eurozone, barring a minor miracle or two, and hence is likely to take the euro to parity with the U.S. dollar by summer’s end.”

For urgent coverage of the spreading contagion, please subscribe here.

  Evidently, Rob’s not alone in his forecast. Currency traders took the euro down to a fresh four-year low this morning, to $1.21.

  That’s a boon for the ol’ dollar index, just shy of a one-year high at 87.4.

  The plot thickens: Italian municipalities are taking banks to court, instead of facing $1.4 billion in losses on bad derivatives deals, Bloomberg reports.

Just like… well… everywhere else in the world, banks snookered Italian municipalities into complicated interest rate swaps over the last 10 years. And just like everywhere else, the bankers (who understood what they were selling) made money while towns and cities (who did not do their homework) are getting pinched.

So Italy has chosen the “sue the bastards” route. It is currently in court with UBS, Deutsche Bank, JP Morgan and Depfa. The Italians have a formal investigation into Bank of America deals too.

What an interesting lineup of banks, no?:

Deutsche -- Biggest bank in Germany, second largest in eurozone
UBS -- Biggest bank in Switzerland
JP Morgan -- Healthiest mega bank in the U.S.
Bank of America -- Biggest bank in the U.S.
Depfa -- Nationalized by Germany last year

Heh… Italians take on the world! Buona fortuna, boys, you’re going to need it.

  This theme -- banks suckering municipalities into bad debt deals -- is going to be with us for some time. It’s a key component of the latest issue of our Apogee Advisory, in fact. (We got a little off schedule with our new project, thanks to our investment expedition in China. But we’re back in business now… and the new issue will be in your inbox very shortly. Make sure you’re on the list, here.)

  Stock markets around the world will follow the euro down today. The Dow opened down 1% this morning in New York.

Leading the way down today, of course, oil companies. Namely, BP and Transocean, which both opened down over 10%. As you’ve no doubt heard, neither the “top kill” nor the “junk shot” worked, despite reported success last week.

Both companies are left with more spilling oil, public ire and government entanglement. The failure of their latest attempt to stem the flow of oil into the Gulf just cost BP another $17 billion in market cap. The market will surely do what many readers wish the criminal justice system would do instead… fun reader mail, below.

  With markets falling apart both here and in the old world, you can always turn to the emerging markets, right? Maybe not.

“In Brazil, like in many other emerging market economies,” Nouriel Roubini told Bloomberg over the weekend, “there is now evidence of overheating.”

The Brazilian government’s latest debt sales inspired his forecast, as the treasury abandoned two separate bond auctions after receiving no satisfactory bids.

“Expected and actual inflation is starting to rise,” says Roubini, “and that implies that over the next few quarters there has to be a tightening of monetary policy, gradually but progressively, in order to make sure that inflation expectations remain anchored."

  “We overheard one story while in Beijing,” Chris Mayer writes, fresh back from our escapade to the Middle Kingdom, “that captures in a nutshell the challenge in getting a handle on China:

 “‘I was in an antique store, negotiating for this antique knife,’ our China contact told us. ‘I was about to make the deal when the guy looked at my Rolex watch and offered to exchange. I was ready to do it, but I knew my Rolex watch was a fake, and I didn’t want to take advantage of this guy. So I told him I didn’t want to trick him and that the watch was a fake. He said to me, ‘That’s OK, this knife is fake too.’

“That’s one thing about China that is tough to untangle,” Chris continues, “figuring out what’s real economic growth and what’s fake. Walking around in Beijing -- seeing all the new buildings, the traffic and the bustling stores -- makes you wonder how much is due to natural demand and how much is artificial stimulus. If it’s more of the latter, then much of what we’ve seen is unsustainable.

“There are two important parts of the macro backdrop that are important to understand about China. First, there has been a tremendous increase in bank lending since the end of 2008 -- it’s up something like fourfold. And we know from experience that when banks grow that fast, bad things tend to happen later. What happens when banks grow that fast is that they slide down the credit quality spectrum. In short, they make tomorrow’s bad loans.

“Secondly, we know that the Chinese government has put in place a huge stimulus plan. And again, we know from experience that when governments invest money, you inevitably wind up with ‘bridges to nowhere’ and all kinds of boondoggles. The money doesn’t flow to its best economic uses, but to political ends.”
 
But China isn’t all a bubble about to bust. It’s got plenty of legitimate growth issues -- like how to feed and power 1.3 billion souls hurdling into modernity. Chris will brace his Special Situations readers accordingly… stay tuned.

  An index of Chinese manufacturing unexpectedly fell in April, the Chinese government reported this morning. Its purchasing managers index slipped from 59 to 58.

The Shanghai Composite fell for the third day in a row on the news, down nearly 2%.

  There aren’t too many nuggets today’s 5 that don’t bode well for gold. Even a rising dollar can’t keep the spot price down today. It’s up to $1,225, about $25 shy of its record high.

Oil’s holding its own, too, all things considered. A barrel goes for about $74 today, right where we left it Friday.

  Last today, a question: Will the BP spill affect gas prices? Not that we want to know exactly, just that we heard it posed over and over and over again on the news over Memorial Day weekend -- a time of decadent motoring across the U.S.

“If it gets into the estuaries and spreads,” Matt Simmons, notable oil industry consultant, told our friend Jim Puplava on the Financial Sense Newshour over the weekend, “it'll end up affecting the water that goes to the refineries. It takes three gallons of water to create one gallon of gasoline.
 
“One of the alarming statistics that came out from the EIA's weekly petroleum inventories is that our finished gasoline stocks dropped under 80 million barrels. That's now several million barrels lower than the stock levels we had the week before Hurricane Ike hit Houston in September 2008.

“Within hours after Hurricane Ike shut Houston down, we had service station outages starting to spread east. They spread all the way through Arkansas, Louisiana, Mississippi, Tennessee, Alabama, all the way down to central Florida, right up the East Coast to Maryland. We're lower today than we were then, and we're about to go into the beginning of our driving season.
 
“Now we're going to start to see some impact in the next few weeks, almost certainly, of the gunk starting to clog up shipping lanes. One of the things we should be doing in Texas is putting up a barrier so it can't get into Galveston Bay. If we do that, then we block the ships coming in for our imports.”
 

  “You attack someone for demanding something be done about the -- at best -- criminally negligent actions of the BP executives,” a reader writes, “and dare suggest that this was merely a whoopsie? Yes, we all need oil, and accidents can and do happen, but is turning a blind eye to criminal negligence now part of the package?

“You owe your reader an apology.”

The 5: “Owe” him? How about if we just give him the floor for the next 41 seconds.

  “Really? Is that the best that pops into your heads?” writes the gentleman who got the conversation started on Thursday. “Yes, let's fall on our knees and thank the God of Capitalism that got us to this point because, by golly, that's our only way out. Talk about idiocy.

“Of course, there's no moral component to capitalism. That's the problem with it! And in case you haven't noticed (apparently you haven't), many people have ‘hit the reset button’ and are flocking to local, sustainable systems. What was once a trickle is now a flood, as people have realized that the old paradigm is rotten. You wouldn't understand this, because in your world, people need leaders (like you need corporations), but this is not a leader-based movement. So your analogy to Mao is as wrong as your attempt to paint me as a communist by association.

“You're also wrong about being ‘ungrateful.’ I'm absolutely grateful for all that ‘technological innovation’ capitalism has brought us: the rape and destruction of precious natural resources, never-ending wars to open up new markets, advertising propaganda, slave labor, pesticides, birth defects, toxic air and water, poisonous drugs, untested Frankenstein-foods and, possibly worst of all, the mental and physical subjugation of people as merely ‘human resources’ to be used up and discarded.

“Finally, I have every right to cast my ‘moral approbation’ on you since I didn't just climb on my high horse yesterday. I don't own a car, and haven't for over 15 years now, and ride a bicycle for transportation (year-round in Michigan), volunteer at a food co-op, counsel young adults about staying out of the military, eschewing employment in the corporate world and avoiding all the material garbage that you think we can't do without.

“I've been advocating that corporate slime like those amoral reprobates at BP (and every other irresponsible corporation) be thrown into prison for years now (it's a great place to think, and maybe find their ‘souls,’ if they still have one) and will certainly continue. We'll give them the same sort of defense that the victims of their toxic industry and ideology have had: that is, none at all.”

The 5: Well, we weren’t suggesting you are a communist. But, like Mao, you think you have the answer to history, and by extension, everyone who doesn’t agree with you is a criminal. And note that even if you aren’t yourself “a leader,” there are plenty of people in government and academia who share your disdain for enterprise.

We support the effort to localize and your right to freely choose to do so. We’ve been outspoken about materialism and consumption for years. Unfortunately, there are more than enough people in positions of “authority” who’d rather impose their will at the point of a gun. And we fear that trend is on the rise… otherwise, we probably wouldn’t have included your response to these letters at all.

  “Here-here!” writes a third, with a slightly less arrogant approach to the issue. “We have all benefited in large measure from oil exploration and the wide variety of products oil makes possible.

“We have two things in this spill -- the obvious first: You can't expect to pump oil from 5,000 feet down without some spills. This one is bigger, but there have been dozens. Does anyone expect to create a masterpiece in any field without making a few mistakes?

“Of course not. Failure is the only way to success.

“Which brings us to No. 2: This should teach us not to imprison the leaders of the companies selling us legal products we demand. Instead, we need to learn to provide better emergency facilities.

“Why blast BP out of existence? From now on, BP will probably be the best-prepared company on earth for this type of problem. Other companies are far more likely to cause these problems, lacking BP's experience.

“I commend The 5 and Mr. Wiggin et al. for correcting your errant reader(s). Perhaps they will spend a few more minutes thinking before they imprison everyone who takes a risk to sell a widely needed product.”

The 5: They’re clearly too far gone for that kind of reflection.

Cheers,

Addison Wiggin
The 5 Min. Forecast

P.S. The Dow industrials closed out their worst May in 70 years on Friday.
 
But "Options Hotline readers didn't do so bad," writes Steve Sarnoff. "Here are the new highs set in May. Along with the prices and percentage gains, you can see the recommendation dates and the dates the highs were set, giving our subscribers ample opportunity to profit. 

 
   
The 5: Remember, these are the highs and the dates they hit following Steve's recommendations. Actual results from any of these trades depend on your appetite for risk and the price at which you exit the trade. Still, during a rough month in the stock market, these are some remarkable returns. Bravo.
  
If you're not an Options Hotline subscriber, you can try it out free for 6 months, right here.