I am back after a very good week in Abu Dhabi at the International Festival of Falconry (http://www.falconryfestival.com/). It does not feel like very much has changed. In the US, politicians are still wrangling over the extension of various fiscal measures, with the latest plan to extend them for two months likely to meet resistance from Republicans in the House. In Europe, politicians are still nowhere close to doing enough to end the crisis. One thing that has changed is that the EUR has dropped, putting my short EUR/USD trade further into profit, and a risk-off week has put my short S&P 500 deeper into the black.

Events in Europe have unfolded roughly as I expected. With respect to ECB action, on 8th December I said that I did not expect the ECB to start buying PIIGS bonds in a big way: “I think the ECB is going to continue to try to force a fiscal solution and that the market has misinterpreted the comments of a new central bank chairman — as so often happens.” This was consistent with my long-held views. On 13th September I said ECB bond purchases were, “something that the ECB is likely to resist strongly, and given its recent form I expect that it would dig in its heels as soon as politicians began to move away from fiscal solutions to Europe’s problems. That means that it is likely to be part of the solution, but only as long as [EFSF expansion] is pursued.” 

With respect to fiscal action, on 6th December I said: “To be effective, any fiscal transfer plan needs to be large enough to create a credible firewall… the market may be setting itself up for disappointment on this score.” The market was duly disappointed, and the EUR and risk assets fell. Looking at the bigger picture, on 13th August I wrote: “The pattern I expect to see in the future is the same as the playbook for the current episode: poor economic performance raises PIIGS spreads again; politicians agree to expand the powers or capital of the EFSF to deal with the problem; and once agreement is reached, the ECB buys sovereign bonds to prevent a self-fulfilling crisis in the short term.” This is a pretty close approximation to the latest round of action, with the ESM being brought forward and further loans to the IMF (I wrongly focused on the EFSF and neglected the other vehicles that were available, but the basic idea is the same). Europe’s latest agreement represents a shuffle towards fiscal union, but not much more. This lack of movement was also not a surprise. I said of fiscal union on 13th September that it was, “only a plausible outcome on a multi-year time horizon.”

So what is likely to happen next? 
  1. The ECB will not buy peripheral bonds in large enough quantities to end the crisis single-handedly. It will buy enough to prevent collapse as long as governments continue to pursue fiscal solutions.
  2. Austerity will continue to depress the European economy, leading to further misses of deficit/GDP targets and further episodes of spread widening.
  3. In response, governments will continue to buy time with inadequate increases in fiscal transfers through the available mechanisms (presently EFSF, ESM and IMF).
  4. There will be further movement towards fiscal union but it will be slow and volatile. This will confuse the markets.
  5. If the government response is inadequate at any point, the ECB will act as necessary to prevent a financial collapse, including by buying bonds in unlimited quantity — whatever Mario Draghi says at the moment.
Turning to today’s news, the Europeans are debating how to deal with the EUR 200bn that they have pledged to the IMF in order to allow it to lend more to the Eurozone. EUR 150bn will apparently come from “national central banks”, but since national central banks, taken together, form the Eurosystem, for which the term “ECB” is the generally-used shorthand, I am not sure how this can be right. The ECB does not have a balance-sheet of its own; the “ECB balance sheet” is the consolidated balance sheet of the Eurosystem. Since the ECB has pledged not to lend to the periphery, even through the IMF, I am not sure what is going on here.

Bloomberg had a headline this morning that contained the words: “Goldman sees commodity rally.” Goldman Sachs is always long commodities (except, in fairness, when it calls a short-term profit-taking opportunity) so this is not really news. I am constantly amazed at the number of stopped-clock opinions that are reported as news.

The latest Chinese house-price data have been released. Taking a crude average of the 70 cities surveyed, existing house prices had their largest fall this year. Median change was -0.3%. But the decline from the peak is still less than 1%. Existing house prices are still up on a YOY basis. New house prices had their first significant fall, but are also up on a YOY basis. Transaction volumes remain high. This picture is hard to reconcile with the tone of some of the reporting on China, which suggests a property bust is in progress. Neither anecdote nor data can be trusted in China, but it is helpful when they at least present a coherent picture. The state of China is one of the most important variables at present but I am finding it very hard to get any clarity.

Data Last Week:

UK core CPI declined to 3.2%, d.e., Nov. I do not expect UK inflation to remain high.
US retail sales 0.2% d.e. Nov.
UK unemployment fell to 8.3%, b.e. Nov.
China HSBC flash PMI rose to 49.
Eurozone flash PMI rose to 46.9, b.e.
Eurozone flash services PMI rose to 48.3, b.e.
UK retail sales -0.4% d.e. Nov.
Eurozone CPI held steady at 3%, a.e.
Initial claims fell to 366k, the lowest since the crisis. The US labour market continues to improve.
Capacity utilisation 77.8% ~a.e.
IP -0.2% d.e.
CPI fell to 3.4% YOY d.e. 0% MOM d.e.