A couple of anniversaries last week: five years since the start of the credit crunch and one year since the US downgrade. The ramifications of both are still evident daily, of course. We all probably underestimated that day in August 2007 when BNP suspended liquidity on a money market fund in France without telling the Finance Minister. They reopened with a Gallic shrug a week or two later, but we had seen the first bite from the layered collateralized assets that were embedded throughout the financial system. The downgrade came amidst toxic debt-ceiling negotiations and so took on heightened alarm. There's no conclusion from either event. We're still living the consequences. So this is as good a time as any to take stock.

Europe, dear Europe 
Almost everything in Europe over the last months has been a band-aid. Here are a few: i) the Spanish bond buying program from last year petered out leaving rates unchanged but with numerous interim scares ii) the LTRO rally lasted only a few months before petering out iii) the Spanish bond recapitalization agreed in June has yet to happen and iv) financing the ESM remains in legal limbo. The miserable profession of forecasting has been found wanting, too. Last December, the IMF report on Greece said growth would be -3% in 2012 and unemployment 19%. The latest numbers are -7% and 22%.

One European member to watch is Finland. 
Not just because i) their bonds yield one of the lowest in the eurozone ii) have returned 7% YTD against Bunds of +5% and iii) seen their CDS tighten to become the cheapest in the eurozone. No, it's their history. This is a country with few historical or linguistic links to either the Nordics or Europe. The language is similar to Hungarian which is similar to nothing else. And the country fought off the Soviets twice in the war and the Germans once. When the Russians invaded in 1939, Finns joked "They are so many and our country is so small, where shall we find room to bury them all." They proceeded to out kill the Soviets 5 to 1.

And from there the Finnish term sisu became famous. It's best described as doggedness or stubbornness. In the euro crisis, they're the ones who demanded collateral for any bailouts and last week stated, very clearly, that the ESM must have IMF loan status. That means seniority over other creditors, a principle which the ECB is loathe to apply because it would scare off new investors from any Spanish or Italian debt deal. The foreign minister, Erkki Tuomioja, then said that it was all a "total catastrophe" and as far as the ECB, EU and Troika powers were concerned, well, that "I don't trust these people."

Now Finland is unlikely to provoke a unilateral exit. But they can simply refuse to go along with more aid and prepare for a break up. They're the only super solvent euro country with no ties and no illusion about going it alone if they must. These are the all important stats to have if you want to throw your weight around in Europe:

Public sector debt is well below the Maastricht limit of 60% of GDP and is barely moving as Europe i) heads towards a 0.2% decline in GDP and ii) increased their collective debt from 66% of GDP to 87% in three years. That's simply not sisu. If there's one lesson we have learned from 30 years of investing, it's that trouble comes from the flanks. Things like AEG (sic), Orange County, LTCM, peso devaluation in December 1994, came out of nowhere. Worth watching.

Meanwhile the rallies in Spanish and Italian stocks since the Draghi "whatever it takes" speech in late July are unlikely to stick. They're back to April levels and some 65% below 2007. We're in a torrid period of expecting a fiscal/monetary solution but with no follow through. Pity Spanish Prime Minister Rajoy who was asking for more details on how the bailouts will work and what conditions might apply. If he doesn't know...who does?

Are we too austere with the Fiscals? 
Combing through the Monthly Budget report showed some surprises. Depending on your point of view, government either spends way too much, is out of control and the debt burden is just killing free enterprise or is cutting programs with abandon and hurting the economy. Ok, so not a lot of people believe the second but way too many believe the first. So here are some fun facts. But first remember that the "Big 5" programs of Defense, Social Security, Medicare, Medicaid and interest account for 75% of spending. The other 27 agencies scramble for the rest.

Each one of the big five has decreased spending this year by between 3% and 5% in nominal terms. And interest payments are down 13% to $196bn, one of the lowest as a proportion of GDP since the early 1960s. Now that's not the number that is talked about. The scary numbers are the $440bn on the $16tr of gross debt. But $4.6tr of the debt is held by the federal government to fund retirement programs, the biggest of which, of course, is Social Security. The interest received on these assets from the Treasury goes right back to the Treasury, hence the net interest paid is far less than the gross (scary headline) interest paid. The net debt is thus more like $10.8tr. Social Security, meanwhile, pays out $680bn on hypothecated receipts of $710bn. So with its funded assets of $2.6tr and unchanged revenues from payroll taxes it would run out of money around 2038. Note the word unchanged. FICA tends to be indexed.

The reason why we have a deficit is because private sector demand plummeted following the collapse of the housing market. And that's why we advocate more spending to make up some of the demand shortfall and why we talk about the fiscal drag. And here are the all important numbers from Treasury:

And can we fund the deficit? Well, yes we can. Quite easily it turns out. Foreigners bought around $493bn of securities in the last 12 months so that's more than enough to finance the current account and keep the dollar well supported. So that's why we feel the deficit, spending and rates debate boils down to slow, aggregate demand and why it's going to be a long, slow haul with no inflationary pressure.

Other Stats 
Inflation came in at 1.4%. Even the core inflation fell to 2.1%. Here it is:

And inflationary indicators like spending and excess credit remain very sullen. Here's the revolving credit numbers which would have to start moving if there is to be any major consumer uptick.

But they probably won't because employee earnings are still under pressure. Here they are and these are the nominal rates of increase:

To put that in context, that amounts to an annual raise of about $42 for the average private sector wage earner. That's why we're sanguine on inflation and, so it seems, are more Fed members. Last week, one of the hawks, President Narayana Kocherlakota of the Minneapolis Fed, hinted that the FOMC may allow inflation to rise above its 2% target (hint, which they're missing) to tackle "elevated" unemployment (hinty, hint, which they're also missing).

Bonds 
The Fed remains active in MBS which is why that's unlikely to be a target for any QE3. Part of that is technical as the Fed's MBS portfolio is seeing high levels of prepayments so to keep the book somewhat constant, they have taken up to 60% of originations and buying $6.5bn of MBS per week, up from $3.5bn last October. We have seen a rapid back-up in rates over the last three weeks from 1.39% to 1.81%. And it has come with a bearish yield steepening (the GT2/GT10 spread) from 115bps to 152bps.

Demand for credit from mutual funds remains. We saw IG funds inflows of $1.4bn, HY $378mm (slowed from $809mm the previous week) and municipal funds inflows of $964mm. At this point we'd probably like to see some give back to the 1.70% level. Not a big move.

Equities 
Mostly repositioning as we see a slow move up to within a whisper of the March highs and 7% below the all time highs. The market is more expensive than those in Europe but that's easily explained by i) the better growth potential in the US and ii) the downright awful position of European financials.

Bottom Line: Still in profit-taking mode for equities. Spreads, equities and CDS spreads have remained mostly unchanged on the week. The relative returns of equities have stood up well but that's not the most compelling of arguments. Remain cautious.

Sources: Cepr.net; Daily Telegraph; All Hell Let Loose, Max Hastings; Suomenpankki (Bank of Finland); Bloomberg; High Frequency Economics; Capital Economics; US Treasury Department; Federal Reserve Bank of Minneapolis; Federal Reserve Bank of St. Louis; Bureau of Labor Statistics; Bureau of Economic Analysis; Sentinel Asset Management, Inc.

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