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*** 30-Jul-16 World View -- Fearing more Brexit-like votes, EU abandons fiscal rules for Spain, Portugal, Italy

This morning's key headlines from
  • Portugal and Spain will not be fined for breaching deficit rules
  • Italy's Monte Paschi bank gets 5 billion euro bailout from other banks
  • Earnings fall, but central bank liquidity floods markets, pushing up stocks

**** Portugal and Spain will not be fined for breaching deficit rules

[Image: g160729b.jpg]
Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem makes a face during a European Union finance ministers meeting in Brussels on July 12 (Reuters)

The European Commission, supported by the Eurogroup of individual
nations' finance ministers, has chosen to cancel fines that Spain and
Portugal owed for breaching EU fiscal rules requiring that their
deficit be lower than 3% of GDP. The budget deficits of both
countries are considered excessive under EU rules. Spain and
Portugal’s deficits last year hit 5.1 percent and 4.4 percent,

Markus Ferber, a German member of the European Parliament said "this
is not only disappointing, but it destroys the confidence and
credibility of our rules — it is a bad day for our common currency."

Pierre Moscovici, a French politician and currently the European
Commissioner for Economic and Financial Affairs, Taxation and Customs,
said "This proves that we can be at the same time credible and
understanding. It’s not the end of the story. We will have to see
what [Spain and Portugal’s] draft budgetary plans are for 2017. So
credibility is fully there."

France is the next country in line for close scrutiny by the European
Commission, with budget plans due by October 15. In the past, France
has been accused of receiving preferential treatment. Earlier this
year, Jean-Claude Jüncker suggested that France should not face
punitive action for its inability to meet EU expectations, "because it
is France."

This love-fest for France was criticized by Ferber, who said: "I don’t
like Jüncker’s comments on France. The country is performing badly and
will have to see the same treatment. Nothing in the rules allows for
the differentiation of member states."

According to one analyst: "This will strike some as a negative in
terms of credibility, but the enforcement of the fiscal compact has
always been political in nature, and the decision is a pragmatic one.
Europe doesn’t need another crisis to deal with right now. Amid the
migrant crisis, the terrorist threat, the Brexit vote, and rising
populism, it doesn’t need a conflict over fiscal rules as well."

In fact, this is clearly a case of "kicking the can down the road,"
something we saw repeatedly in Greece's financial crisis which,
incidentally, is still far from being resolved. Spain and Portugal
are now going to be set new deadlines and required to follow austerity
rules that they've failed to follow in the past. Reuters and Politico (EU) and Fitch Ratings

**** Italy's Monte Paschi bank gets 5 billion euro bailout from other banks

As expected, Italy's third-largest bank, Banco Monte dei Paschi di
Siena (MPS), founded in 1472, and the world's oldest operating bank,
failed the European Central Bank (ECB) "stress tests," whose results
were scheduled for release on Friday. ( "5-Jul-16 World View -- Italy bank crisis more dangerous to EU than Brexit"

Not only did MPS fail, it got by far the lowest score of all 51
European banks tested. The purpose of the "stress tests" is to
examine the bank's liabilities and assets, including bad loans, to
determine whether the bank could survive a recession. With $55.2
billion in bad loans, MPS was never going to come close to passing the
stress test.

After failing the stress test, ECB rules require MPS to lower its
portfolio of bad loans, and selling the bad loans to a third party
would only get 20% of face value, and this would require a major bank

As we described in the previous article, there are two ways that MPS
could get a bailout:
  • The state (Italy) could bail out the bank out of public funds.
    What the experience with Greece has shown is that if the state bails
    the bank itself out of its financial crisis, then the state itself has
    a financial crisis. The Greece experience caused the ECB to issue
    regulations making it illegal for the state to bail out a bank.

  • The people who purchased bonds and shares issued by the bank could
    "take a haircut," meaning that the values of the bonds would be
    reduced, while ordinary savings accounts would be spared. Italy
    actually used this method last year with four small regional banks,
    but it caused a major scandal because salesmen at these banks had
    aggressively sold high-risk subordinated bonds to people in lieu of
    savings accounts, saying that they were perfectly safe, as safe as
    savings accounts, with a much higher return. The result was that some
    130,000 shareholders and junior bond holders lost money in the rescue,
    including many pensioners.

On Friday, MPS found another way to get a bailout, while still staying
within ECB rules. MPS will be bailed out by other banks, who will
lend MPS 5 billion euros.

The banks being named are: Santander, Goldman Sachs, Citi, Credit
Suisse, Deutsche Bank and Bank of America. The deal will require MPS
to sell off 27 billion euros of the bank’s bad debt, repackaged into
securities worth a much smaller amount, 9.2 billion euros.

The bailout plan will give MPS 5 billion euros on which to survive,
but this is the third such loan in two years, and MPS has already
burned through 8 billion euros from the two previous bailouts.

So, once again, it's been necessary to "kick the can down the road,"
until the next episode of the crisis. Reuters and Politico (EU)

**** Earnings fall, but central bank liquidity floods markets, pushing up stocks

We truly live in magical times. Earnings have been falling, but the
stock market keeps going up. It's as if the law of gravity has been
repealed. Or perhaps the alchemists have finally found a way to turn
lead into gold.

[Image: g160729c.gif]
S&P 500 Price/Earnings ratio at 25.03 on July 29, indicating a huge and growing stock market bubble (WSJ)

Let's start, as I often do, with price/earnings ratios, also called
stock valuations.

According to Friday's Wall Street Journal, the S&P 500 Price/Earnings index (stock
valuations index) on Friday morning (July 29) was at an astronomically
high 25.03. This is far above the historical average of 14,
indicating that the stock market bubble is still growing, and could
burst at any time. Generational Dynamics predicts that the P/E ratio
will fall to the 5-6 range or lower, which is where it was as recently
as 1982, resulting in a Dow Jones Industrial Average of 3000 or lower.

The last time I wrote about this, the P/E ratio was a mere 24.23.
That astronomically high number has now shot up to 25.03. That's
because stock prices have been staying steady or going up, while
earnings have been falling so that the ratio (price/earnings) goes up.

Why are stock prices going up? It's because central banks around the
world are "printing money" through quantitative easing (QE) at huge
tsunami rates.

According to Deutsche Bank, the European Central Bank (ECB) and Bank
of Japan (BOJ) are together buying around $180 billion of assets a

And that's not the end. The ECB is expected to increase its QE to
$110 billion, and the BOJ is expected to increase its QE program to
$80 billion. The Bank of England (BoE) is expected to reactivate its
QE program, and supply $197 billion more QE.

It's mind-boggling beyond anything in history. There's never been
anything like it. It's a credit bubble of such enormous size that
it's impossible to predict the enormity of the disaster that will
ensue when it finally implodes -- which it certainly will.

Here's a quote from someone on tv described as a "tenured university
professor of economics at University of Maryland." It's one the
stupidest things I've ever heard, so I transcribed it:

> [indent]<QUOTE>"Companies are learning how to use capital much more
> effectively. So central banks may have printed a lot of money,
> they are using money more efficiently, which lowers the price of
> capital, and essentially raises P/E ratios. We are now trading at
> about the 25 year average, but the long-term average the moving
> average over time is trending up. My feeling is that we could be
> looking at P/E ratios that are stable at 30 or 35 long-term. The
> average historically is 25, and that's where we are
> now."<END QUOTE>

Since I hear stupid things all the time on financial news channels,
let's pull this apart for educational purposes.

First, the P/E ratio now is around 25, but historically it's around
14, not 25. You'd think a "tenured professor of economics" would have
a clue about that.

Next, a P/E ratio is not stable at 25, and will certainly never be
stable at 30-35. So let's explain what's going on here, and why the
tenured professor is so confused.

The P/E ratio is actually the reciprocal of a low-risk investment
yield or interest rate. That is, the historical value of the P/E
ratio is 14, and its reciprocal is earnings/price, which is
historically around 1/14, or around 7%. This value, 7%, seems to be
some sort of natural constant, the natural value that investments pay
in "normal" times. That's why, in the decades after World War II, you
had investments that paid around 7%, and you had mortgage rates around
7%. Savings accounts paid a little less, because banks had to make
money, and government bonds paid a little less, because they were
considered as safe as cash.

So now you have a P/E ratio around 25, which corresponds to a 4%
investment yield, and is far below the "natural" value of 7%, but is
possible because bond yields are now close to zero or are negative in
many parts of the world. At such low yields, an average investor
(without access to the huge floods of government money) is not willing
to invest his money. That's one reason why investments are so low
today. Who wants to invest in a shoe factory, if the most you can get
is 4%, and you could lose everything if the shoe factory fails?

So the tenured university economics professor says that he thinks the
P/E ratio will stabilize around 30-35, pushing the investment yield
down to 3%. That would only happen if much more of the world's
government bonds go to negative interest rates, and that can't
continue forever, meaning that a 30-35 P/E ratio is far from stable.

So this really is truly a magical, marvelous time to be alive. Enjoy
it while it lasts, Dear Reader. Reuters and MarketWatch

KEYS: Generational Dynamics, Portugal, Spain, Jeroen Dijsselbloem,
European Central Bank, ECB, Markus Ferber, Pierre Moscovici,
Jean-Claude Jüncker, Greece, Italy, Banco Monte dei Paschi di Siena, MPS,
Bank of Japan, BOJ, Bank of England, BoE

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John J. Xenakis
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Phone: 617-864-0010
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