Euro Markets Internal Report from Institutional MD

Did you get an email like this 20% ago? Not really no. And its easy to be bearish at the bottom. But I've had 2 very good meetings this week with our chief economist Willem Buiter and our head of Macro sales Cameron Small. As a result I wanted to get some thoughts down on paper for you. I have more detail and a few supporting charts but this is what I think plays out from here. While I've been typing, Willems latest note is out and attached.

1. Things will continue to get much worse in Europe, such as

A. effects of austerity cuts are being entirely counterbalanced by slower than expected GDP growth, meaning that debt to gdp is not actually coming down.

B. But its worse than that because the level of austerity measures needed to make the levels of debt / gdp flatten off, are already materially bigger than what has been announced

C. and we know that existing austerity measures are not being implemented properly or quickly, in many cases

D. ECB is not the Fed and wont undertake action in materially increased size or radical-ness than what they have done already (see press conf yday "we've done a great job")

E. one of the reasosns is that the ECB mgmt committee is comprised of technocrats, old school bankers, they are on 8 year non extendable contracts and they don’t generally have political ambitions. This is not like having Hank Paulson going into bat. Effectively it’s a combination of don’t care and don’t understand. Recall also that they don’t have a growth mandate. I am told that open talk of defaults is like "swearing in church". See todays news re possible departure of Stark due to conflict

C. EFSF is a red herring as wont be signed off till the end of the year and is not that big anyway AND the headline number is not the real firepower due to the "over-collateralisation"

D. we expect 1 default within 6 months in Europe and 2 more to follow

E. more of the pain will be forced onto the private sector. Special resolution regime laws are integral to this

F. political timetable such as French and German elections make honest statements of fact and radical politics less likely

G. we think France has a v high chance of losing its AAA rating within the next 9 months. This will be a major problem given their position as core europe

2. Negative feedback loop

I discussed this with Willem. He thinks it’s a very real risk. The point is that fear is exactly like greed, its like a self fulfilling prophecy. Fear breeds fear. A small change in consumer and corporate behaviour is all that’s needed to make it real. Clearly the sentiment surveys point the direction. I know that overpaid stockbrokers are not a good microcosm of the european consumer - but I can only start with me and my colleagues because that’s what I know about, list below. The fact that we have more knowledge about how bad the suituation we are in, is, just means to me this will be replicated en masse in about 6 months time….

Sky multiroom binned

Annual family ski trip downgraded from Meribel

Salesdesk encouraged to use DLR not taxis

Gym membership binned

2 planned car purchases postponed

X5 swapped (cash for cash) for a Mini Countryman with 5 years free servicing and better MPG

Senior MD's sons school shirts sourced from BHS for first time ever (the hourglass theory)

3. Markets

I've been involved in equity markets since 1994 in various low value added roles. And I'm staggered by how orderly this sell off has been. Its like we are all sleepwalking towards the exit. There has not been any panicky capitulation yet. The potential for sentiment to get materially more bearish from here I would say is huge. Hedge funds 25% NET LONG… OK cash weightings as shown by the ML survey are high, but they aren't peak. What there is at the moment is a buyers strike. There is no risk appetite (either way). Commission numbers on up days are poor. Down days we are busier. I think that the outlook for outflows and redemptions is poor and will accelerate towards year end (just the psychology of new year, fresh start etc).

I also think you will see a stream of eps cuts and downgrades continue from here. Today our strategists stopped being constructive. Equities teams are all beavering away. But are they bearish yet? Not really. A recent example is Autos…slashing numbers but still modelling 3% volume growth 2012 and steady prices. The argument from your end might be that the fund managers are ahead of the analysts, and that’s why share prices have been so weak / optically such low p/e's. And I would agree with that, BUT I just think it will be very hard for sentiment on equities to be positive against that backdrop.

Fixed income and macro people here are amazed by how sanguine the majority of equity people they meet are about the risks

Meanwhile with RoE's in investment banks under massive pressure from structural and regulatory changes, our ability as an industry to commit capital to help you get business done, is declining, which all other things being equal wont exactly help liquidity. Which might lead to thoughts on the fund management side of the fence about how much AUM can be run

Sorry to sound so downbeat but I think you have to tell it like you see it. If as is highly likely I prove a good contrary idicator, I'll put my hands up!

So i hope me posting this doesnt get me or someone else in trouble lol but.. interesting...