We have a confession; we’re bullish!  On U.S. Housing, that is…See our latest thoughts below.

This morning I had a call with one of our London based consultants who has a particular focus on Europe.  Before joining his current firm, he spent several years at the UK Treasury, the last two of which he was tasked with “understanding the lessons of the crisis.”  Below are my notes from the call (with my comments in italics):

• Banks are still under tremendous funding pressures.  Europe is already in recession, however, he expects considerable tightening in credit (exacerbating the situation)
• Expect a new Stability and Growth Pact, despite the first SGP being completely discredited (with Germany being one of the worst offenders on budget deficits prior to the credit boom, which substantially benefitted German exports)
• The new pact will likely include sanction and veto authority.  He expected more resistance from France on this.  In effect, budgets will have to be presented to Euro technocrats prior to their own parliaments.  Ireland attempted this following their bailout and it was a disaster
• The austerity packages being put in place are 15 years too late.  )Austerity in a fixed-currency regime is destined to be disastrous and will do nothing to alter the situation with debt levels remaining too high)
• He doesn’t believe the ECB will push the “nuclear button” (i.e. massive unsterilized bond purchases).  While they are likely to step up their purchases, the members of the ECB’s Government Council is still very resistant to this, including the non-Germans.  The statement from the ECB will likely be along the lines of “we’re prepared to do more.”  (Germans remain fundamentally opposed to Anglo-Saxon style QE)
• Any plan from Dec. 9^th is unlikely to clarify “who is going to pay” for the previous excesses.  There will still be no direct transfer union
• Greece’s deficit is running around 10.5% (so clearly austerity isn’t working).  It will never fall below 3% while in the euro so default is nearly inevitable.  While the market may be comforted temporarily by a new plan, expect contagion to increase when Greece exits the euro.  (Consider the impact on banks, etc.)
• Once Greece begins to recover following an exit from the euro, other peripheral countries will be tempted to do the same
• Issuance in 2012 will be far greater and treacherous than 2011.  Italy has significant funding pressure in Feb so overall funding pressures will resurrect even if they fade in the near term
• The ECB may cut to 50bps, which they were highly resistant to do in 2008 (for fear of a liquidity trap).  (This may help the periphery some via lower mortgage rates)
• However, inflation is still uncomfortably high in Europe, complicating the ECB’s decision making.  (As a philosophy, the ECB is deeply concerned about inflation and does not believe in the output gap model the Fed and BOE relies on)
• He has noticed more investors becoming concerned about the UK (for good reason).  The UK shares many of the same domestic imbalances as Europe in addition to massive financial vulnerability.  Banks have enormous exposures to France.  Also, UK housing prices entered the ’08 crisis at very high levels—they fell 10%, then rose 15%.  Now many homeowners are refusing to sell since they can’t receive the pricing they would like.  Lower prices could create significant problems for the UK banks and strains in the global economy, particularly the US, will create strains in UK housing (assets in the UK are highly correlated with the US)
• The BOE has done two rounds of QE, however, the most recent round has been in isolation (whereas the previous was coordinated alongside the Fed and other central banks).  It’s unclear how effective this has been
• If Europe were to just have a recession, the UK (and the US) could arguably be okay.  However, if we have a European financial crisis, both will be engulfed
• Investors are only now realizing the huge influence of European banks in the US.  French banks in particular have borrowed massively via MMFs and recycled the proceeds back into US assets
• In terms of the endgame, we’ve essentially been operation with 2 material currency blocks, which have been a disaster for the global economy:
• US-China, which the US has been an involuntary participant as a result of China’s peg
• Northern & Southern Europe (via the euro), which was voluntary
• Stage 1 of the crisis was subprime (i.e. the result of the first currency block) and Stage 2 is now clearly Europe.  He believes Stage 3 will be China
• His final comment was that you must be “quite brave to believe policymakers will ultimately stem contagion in Europe”