European trade imbalances and China, in this week's Market Wrap

Scott Schuberg

As frustrating as it is to watch equity markets continue to chop sideways while a theme of European uncertainty remains in place, I’m not sure much will change until large holders of stinky European debt securities (Portuguese, Irish, Italian, Greek & Spanish) finish orchestrating an adjustment phase, whereby they exit positions and write down asset values while there is adequate liquidity to do so.  It was the short, sharp liquidity shocks in 2008 that pushed the US banking sector to a point of bankruptcy, whereas major US banks that took part in the USTroubled Asset Relief Program--including Wells Fargo, JP Morgan, Goldman Sachs and Morgan Stanley--managed to repay government loans and get themselves out of a bind in a matter of one to two years.

Using the US example, Europe may be right to draw out the process of its debt crisis for as long as possible, purely to save its banking sector from collapse at a time when governments are far less equipped to bail out corporations than they were following the global economic boom that helped markets rally between 2003 and late 2007.

In a great demonstration of the fickle nature of markets, widespread optimism came about last week as the press pushed the story of China being the saviour (buyer) of distressed European debt.  The answer to Europe, however, is not in buying the debts of countries that have unsustainably poor profit and loss outlooks transposed over tragic balance sheets; rather, China needs to give other countries’ export industries a chance by allowing a natural approach to currency movements and curb its dramatic trade surpluses.  This series of charts that I found (http://www.nytimes.com/imagepages/2011/05/20/business/20110521-CHARTS-POPUP.html), published earlier this year by the NY Times, shows Europe’s trade imbalances (see the top right chart), largely driven by the world’s inability to compete with cheap Chinese labor and a yuan that does not appreciate naturally, due to its US dollar peg.

If China really wants to help the Europe Union, it needs to allow its member states to become more competitive exporters by allowing its own currency to appreciate, and, indeed, start importing more goods from countries like Greece, which the chart suggests exports US$0.10 worth of goods for every US$1.00 worth of Chinese imports.

To conclude, there are no quick answers to the European problem; countries, like businesses, must have sufficient revenues in order to pay for their operations, which, in turn, need to perform and allow them to grow.  How can a country like Greece repay its debt when:

1. Its own fiscal management (collecting revenue and efficiently employing it to grow) is broken;
2. It is tied to a single currency that is not being priced according to its own economic weakness, thus making its exports grossly uncompetitive; and
3. The world has become so reliant on China as a source of growth that it allows it to unfairly trade using a depressed currency that is, in turn, pegged to an artificially devalued US dollar, thus giving the rest of the world the option of: a) intervening with their own currencies by devaluing them; or b) retaining honest, traditional monetary policy and letting their export industry get hung out to dry

So all of these controlled, unnatural measures are leading to various economic imbalances that are being combatted using extraordinary methods, such as the Swiss National Bank’s decision to cut interest rates to zero despite a booming economy and peg its currency, the Swiss Franc (RivSec: USDCHF Spot, EURCHF Spot), to the euro, at a level where 1.20 Swiss Francs buys one euro. Click on the chart above to see the effect these central bank moves had on the Swiss franc versus the euro, and consider the move’s effect on trade across the Swiss/Eurozone border.

As I’ve written before, we equity traders can expect the theme of volatility to continue because of these imbalances; however, we’re yet to be provided with sufficient direction to say that all of this will flow through to the development of a particular trend.

In company and market news: After having a great 144-point run from Wednesday’s close to the end of the week, our S&P 200 (RivSec: Aussie 200) got a poor lead this morning and finished closing down 67.9 points at 4,081.5 today.  This lead was not from a negative night on Friday, but from weekend developments that point to continued disagreement among European policymakers on what to do with Greece.

The Aussie dollar (RivSec: AUDUSD Spot) has fallen back to US$1.024 and gold(RivSec: XAUUSD Spot) remains well bid at US$1,822, which reflects a bit of caution re-entering the market.