In our now traditional pre-Christmas convocation of former and present Morgan Stanley bankers held last Friday at the Asia Society, we applied scenario-thinking to the challenges of Europe and the world. The result wasn't pretty.
The two most important uncertainties for markets and economies reduced to two - global growth and the outcome of Europe's financial and fiscal crisis. (Middle East unrest, North Korea, Iran, US elections and social reactions are not ignored here but play into these larger uncertainties.)
Plot these two major uncertainties as axes and you have a matrix with positive growth and positive European restructuring in the upper right quadrant, and a sharply declining world (slow/small to negative growth and European de-structuring) to the lower left. The challenge is to develop these "four worlds" as plausible, then ask how they influence your intuitions about what may occur, and how to best prepare.
Throughout the afternoon's discussion, the lower left emerged as our "zone of expectation," in which global growth is flat to down, and Europe cannot get out of its own way, slipping further into recession (or worse, in some countries) while banks and sovereigns continue to weaken. The ugly realities of European banks - highly levered and full of sovereign risk - continue to come home to roost, with knock-on effects in China and US trade, and a possible meltdown in the derivatives market.
In the negative scenario, Germany continues to refuse the "print money" option through the ECB, which one analyst in the room described as "Europe's bad bank." The EFSF is revealed as a non-solution to the problem as the debts cannot be paid either by the sovereigns nor any combination of ECB-IMF or external sources. If you speak fluent banker-ese, think of the EFSF (so described by one expert), as "a two-tranche CDO with the key difference that the "guarantors" of the structure could "opt out" of the structure and become "obligors," modifying the subordination structure and adding to the credit risk."
What that means simply is that 'I was in the deal as a guarantor, then I decided to leave and now I am guaranteed by those left behind.' Huh? (Yes, it's that bad.)
Among other ideas that surfaced to consider, these from Asia experts, is that China is not interested in saving Europe from itself as China has too many challenges of its own (and has been managing all of them successfully so far.)
Clearly possible is a world in which Europe really begins to unravel in 2012, when its banks have to raise 573,613 Billion Euros (!!). Assuming Europe's sovereign debt maturities are refinanced, they need collectively to raise 1.073 TRillion Euros, with Italy and France needing just under 500 Billion of those. For those unversed in capital markets, these are giant, daunting numbers. Despite talks of "recapitalizing" European banks, the numbers there do not add up in many cases, as numerous banks are beyond help (Dexia and Monte Dei Paschi being examples.)
The darkest pronouncement on the economic scene came from one European banker who arrived late to declare, "Depression! That's where we're headed, and the Germans are leading us there."
He went on to elaborate that he believes Germany under Merkel will fight the idea of monetization (some form of extensive bond-buying and money-creation via the ECB) and urge for liquidation, a policy error in his view that could victimize much of Europe, and in the worst case spill over to the rest of the world.
As with all scenario deliberations, the insights and "aha's!" varied for participants, who would draw their own conclusions about what actions seem prudent and necessary for them in the face of these uncertainties. It was hard to see how Europe in the near or medium term could overcome the the financial realities or politics as demonstrated so far. How could Europe find an answer without further volatility and declines?
The only plausible positive scenario, one old hand suggested, was a world that will go sideways (as Europe goes down) for another 5-6 years, and then the US (somehow magically resolving its own fiscal crisis) would come out the other side advantaged (presumably by its diversity, dynamism and willingness/capability to take action.) Europe as a region would simply become less relevant in a more globalized world.
Well, that's a scenario to consider, and perhaps it smacks of local bias. In any event, a lot has to be addressed in Europe and the US between here and there, and the numbers are not forgiving.
In the near term, Merry Christmas and Happy New Year.