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The effects of the French and Dutch veto against the EU constitution are numerous, far-reaching, uncertain, and highly consequential. This article will discuss the short term as well as the possible long term ramifications of the vote. The European Union program started over 50 years ago as a way to economically unite specific countries in Europe. By reducing costs associated with trade and immigration, the goal was to spark economic activity. Although the basic tenents of the EU were excellent, the experiment was doomed to fail. Economic unity without political unity causes people to blame the economic integration for their loss of jobs and loss of wealth whenever things go bad, as they inevitably will from time to time during capitalism. Give these people a vote during a time of recession - you now have dissension, with no clear path. So the major question on people's minds is: now what? What will Europe do and how will the rest of the world react. The possibilities are endless, but I will venture a few guesses here. If a recession starts in Europe over the next few months, let there by no mistake: It was not caused by the no vote. People voted no because things have already started to go bad. What happens from here is the question. I believe the politicians are making a huge mistake by declaring that 'Europe has no future.' By trying to scare their constituency into changing their minds about the EU, exactly the opposite will occur. There
will be a flight of capital out of Europe, as people question if the Euro has any future. People will take their money out of European stock markets and put it in safer investments, such as US bonds. A recession will occur and even more hatred towards the EU will appear. Within 5 years, I expect the Euro will no longer exist. Italy's Bersculloni has already campaigned to bring back the Lira, after just one week of trouble. Imagine what six months of a recession will bring. This disintegration is a repeated pattern of behavior throughout history, although the EU may be the first that had economic unity without political unity. Similar plans were made in Latin America and the ASEAN nations to follow the European Union model. Many had predicted that within 50 years, only four currencies would exist. I believe all these plans will fall by the wayside. Housing Market The housing market has been outrageously hot on an international scale, effecting every continent. The US has experienced 20% year over year gains, while Britain, Australia and many other countries have performed even better. The average South African house climbed nearly 40% in just under 12 months. Regular readers of this newsletter know that I am watching the housing market very carefully, as it has been the engine of growth in the world over the past few years. While the US is still performing well, Britain seems to have topped out in December. Since then, the UK housing market has seen 5 consecutive months of declines in the average house price. I believe we are nearly at the top of the housing market in the United States for several reasons that I have discussed before. Excess speculation, steady incomes and rents despite increasing prices, heavy reliance on adjustable rate mortgages, etc. Now, allow me to introduce probably the best predictor of the housing market top: the flattening yield curve. U.S. bonds are issued for incremental lengths: 1 month, 3 month, 2 years, 10 years, etc. Short term interest rates on these bonds are very closely related to the Federal Reserve action which has been raising rates steadily for many months. Long term bond yields, such as the ten year bond are set by market rates. The difference between the yield on the long term bond and the short term bond is known as the yield curve. Banks, as an institution, make money by borrowing short (the interest you receive on your savings account) and lending long (the interest payments you make on money borrowed for houses, cars, etc.) As the Fed increases short term interest rates, banks are forced to increase the savings rate offered to their clients. Anyone who's checked out their savings account recently can see they're getting much better interest rates than they were a year ago. This costs the bank money. However, long term interest rates have actually decreased in the past year! We can borrow money from them cheaper than we could before. This scenario puts a squeeze on the bank. They are having to pay more to obtain the money and they receive less when they lend that money. Banks are about to suffer big time. A good play on this would be to short banks such as Countrywide Financial (CFC), a specialist in sub-prime lending. As the Fed continues to increase rates, the possibility of a negative yield curve exists. This is when short term interest rates are higher than long term interest rates. If this happens, it will destroy the housing market, not to mention everything around it. If banks have to borrow from you at 5.25% (short term interest rates) and they can only lend money out to you at 5% (long term interest rates), no bank would do it. The banks will make more money, risk free, buying the short term bonds, and thus the mortgage market will dry up. No one could afford to buy new houses, which will send the housing market in a tailspin. Even the threat of a negative yield curve is great enough to pop the housing bubble. If the Fed increases rates by 1/4 point for the next 4 months, we will be in a negative yield curve scenario. In my opinion, this gives the housing market until November to top out at the latest. (The Fed has 3 meetings before November where I expect them to continue raising rates by 1/4 point). An interesting play on this would be to short Toll Brothers (TOL), the current king of the housing market. The cockiness and brashness of their management team is not unlike those of Enron prior to 2002. Wrap-up The world is in a very dynamic place in history. How the EU experiment will play out will be of great consequence for future models planned around it. The ability of Eastern Europe to continue making progress is now very much in doubt, although I think they will perform better than Western Europe over the next generation. Currently, in Germany, major opposition exists regarding Turkeys entrance into the EU. In fact, Schroeder's biggest political challenger for the next election is running on a platform of not welcoming Turkey into the union. Although the EU may disappear soon, I expect Turkish/German relations may become a proxy for Islamic/Christian relations over the next 10 years. I also expect an immediate economic fallout in much of Europe which will spread throughout the world over the coming months. This will only increase the chances of a pop in housing markets around the world. November may be the critical month for housing in the United States, as that is when an inverse yield curve may be expected to appear. Because of all the risk associated in the current economy, I recently purchased a mutual fund that shorts the OTC market. I highly recommend an investment in this fund: USPIX |
