In this article a year ago, I wrote: “Europe is simply screwed. Several large countries are close to default: Portugal, Spain, France, UK. Smaller countries are at risk too, but there's no way the EU can absorb a large default.”
Now, a year later, most of these countries (and others, including Italy) have been downgraded. Portugal has a junk rating, and Italy's 10 year benchmark is flirting with 7.0%.
The market has awakened to the European problem, and this problem isn't going away any time soon. Other issues I flagged as potential blowups did not materialize in 2011. Municipal bonds, for example, strengthened throughout the year. The Federal Reserve continues to manipulate bond markets and encourage yield chasing.
I still think that all the issues described in last year's review are still threats today.
Credit markets have been deteriorating throughout 2011 and I expect this to continue in 2012. Bond selloffs started with low grade European sovereign debt (Greece, Portugal) but spread to other European bonds (Italy, Spain, etc). Now, virtually all European government debt is under selling pressure. Even German bunds have come under pressure, with a poorly subscribed bund auction in November 2011 that raised just 65% of the target amount.
Sovereign debt problems quickly started having an effect on financial institutions. Dexia (EU) and MF Global (USA) both failed in 2011. Many European banks have also been downgraded, and bank funding problems are steadily rising. We have a banking crisis now, and many institutions may be insolvent.
This is unravelling very much like the sub-prime crisis. In 2007, credit markets in low grade mortgages started deteriorating. The problem started at the margins and worked its way through the system; the same thing is happening today.
Here's what comes next, I think. I'm not sure how much of this will happen in 2012:
Credit markets continue to deteriorate
Banks have increasing financing troubles. Money markets come under pressure.
More banks and financial institutions face solvency challenges
Due to counterparty exposure and the derivatives market, institutions in both Europe and the USA collapse
Central banks aggressively print money, further devaluing currencies
Somebody blames short sellers again for all market problems
Banks are unable to lend, and the global economy sharply contracts
My positions are largely unchanged since June.
It doesn't really matter where, exactly, these problems originate (mortgages, sovereign debt, etc). Thanks to global addiction to high leverage and insane derivative exposure, banks will become insolvent. We will go through this fun process repeatedly with different crisis seeds, until – finally – large banks are actually allowed to fail in the true sense of the word.
- Perpetual Bull, email@example.com