When people ask how I’m doing amidst this market and economic uncertainty, my standard answer is that, “
although I’m not feeling quite as good as the U.S. stock market, I’m doing a lot better than Europe.”
It’s been about a month since the latest grand resolution to the European crisis was unveiled and I still see little that makes me think that investors are any safer than before. Indeed, it is hard to find where any concrete decisions have been made, or any concrete actions taken. To the degree that the succession of summits achieved anything, the unintended consequences of these pronouncements are likely to cause more problems than have been solved, thus far.
First, the summit meetings have officially endorsed the fact that a Greek bailout is necessary. A year ago, EU officials were denying the need for a bailout and blaming speculators for making things appear to be worse than they were. The markets’ pessimistic view, however, proved far more prescient than the politicians public statements. And
now the markets are turning their backs on Italy, which is watching its bond yields climb toward 7%, a level which some observers say will make Italy the next domino to fall.
Second, the summit also endorsed the need for a bailout of banks all across Europe as a result of Greece’s failure to meet its sovereign debt obligations. By setting a price of 50 cents on the dollar for Greek debt, other Greek bondholders will need to write down the value of their own holdings. The “mark to market” process creates the need for many banks to reduce the market value of their own investments, and has already resulted in a U.S. investment bank (M.F. Global) going under.
The process of contagion has now officially commenced.
The
third summit achievement is that the process of forcing banks to accept “voluntary” swaps into new bonds worth half as much is that
credit default swaps were rendered ineffective as a hedge against Greece’s default. In addition to rendering Greek hedges worthless, owners of credit default swaps that protect against Italian and Spanish default swaps have to start assuming that their hedges are worthless as well. Rewriting the rules helps prevent the contagion from spreading throughout the derivatives complex, but it also renders CDS products worthless. Without a way to hedge exposure,
the yields on Spanish and Italian debt have moved significantly higher, accelerating the day when the crisis jumps well beyond the borders of the Greek isles.
Fourthly, the summit began to quantify the amount of financial damage expected ahead of us. The summiteers proudly announced the need to increase the size of the European Financial Stability Facility by more than a trillion euros (
$1.4 trillion dollars). Moreover, the EFSF funds were to be used in addition to German and French government funds. In spite of the acknowledged need for this huge new bucket of bailout money, it was quickly apparent (at least, to me) that
little progress has been made in finding a source for this funding. The press releases trumpeted an upcoming trip to China, but as of last week it didn’t appear that a check from Beijing was immediately forthcoming. A weekend meeting of G20 leaders also came up empty. A lot of dinner meetings are happening across the globe, but so far no napkins have been returned on the back of which can be found a plan for sourcing those bailout dollars.
Fifth, the summit series clearly established a
need to recapitalize the European banking system. Banks across the old world are in search of new equity capital to shore up their battered balance sheets. In August, the new IMF leader (Christine Legarde) was roundly criticized for suggesting that banks on the continent might need more than
200 billion euros to shore up their capital position. French and German leaders feared that her comment would create a panic in the markets. At the summit, after comparing notes, the leaders admitted that the real number is more like
300 billion euros, even worse than Legarde had estimated. Instead of a panic, the announcement resulted in a stock market rally.
Europe will soon find that banks in need of capital are loathe to reduce the offering price of equity listed for sale – the dilution hurts both managers and shareholders too much. The easiest way to shore up a bank’s capital position is to start calling in loans and stop lending money. Having established a need to recap the banking system,
the summit will be remembered as the start of the Great Recession in Europe, which will make it even harder for Spain and Italy to get a handle on their deficits.
Sixth, the upcoming bank write-offs will decimate bank earnings, making it even more difficult for banks to secure capital and resulting in Europe adopting the U.S. approach of using artificially low short-term interest rates to recapitalize banks in its system. As we’ve seen in the U.S., European savers will see their incomes drop to nothing, hurting consumption, and probably causing the value of the euro to continue its decline.
Seventh,
if China does become the lender of last resort, you can assume they will want the preferred collateral position that usually goes along with providing debtor-in-possession financing, leaving existing sovereign debt holders (the European banks) facing even larger write-offs than currently anticipated. Oh, and by the way,
China will have less money available to keep financing U.S. deficits, so the higher pressure on interest rates may finally begin to impact the U.S. Treasury as well.
Eighth, all of this bailout money doesn’t come without strings, of course, so big government austerity measures are being required of many of the bailout recipients. This, clearly, is leading Europe into a new recession, which threatens both the U.S. and the global recovery as well. While there have been instances where Europe has gone into a recession while the U.S. did not, those cases are the exception rather than the norm. With increased globalization, the
risk of a recession in Europe spreading throughout the developed and emerging market economies ought to make investors across the globe sit up and take notice.
Ninth, the Germans prevailed over the French at the summit, which concluded that local governments must first bail out their own institutions before they will be allowed to tap into the EFSF. If
BNP Paribas needs capital (and it does), then if the bank can’t raise it on its own, by next summer, the French government needs to provide the bailout. Say good-bye to France’s AAA bond rating. More importantly, say hello to more frightening headlines in Spain and Italy.
It is not clear whether Spain or Italy has the money to bail out its own institutions.
That, after all, is why it is so important to have the EFSF ready and funded. Between now and the day when Italy’s banks get their EFSF bailout money, there will be a lot of bad headlines about the state of sovereign debt in Rome.
In spite of the summit, it is still not clear that Greece will be able to pay its debts, still estimated to be about 120% of the nation’s economic output. When France loses its AAA-rating, the EFSF will likely lose its gold-plated AAA rating as well. If lending dries up and recession spreads through Europe, the bad loan problems will get much worse than anticipated in last month’s summit, when only sovereign debt was the topic du jour. Much more is needed to solve the problem, which has now spread beyond Greece.
It is as if the whole world knows that Italy is really the problem, so the summiteers got busy….trying to solve the issues facing
Greece. It is not so much that the summit moved in the wrong direction. Rather, the summit failed to resolve key issues. For instance,
no $1.4 trillion sugar daddy has been found. Little real progress has been achieved, although policymakers did finally acknowledge the seriousness of the issues! The crisis is moving faster than the committees and summits and bureaucrats in charge of fixing the problem.
The European crisis still feels like a slow motion car wreck, in progress. It still feels more like early 2008 when the financiers were slow to admit to the size and seriousness of the sub-prime debt debacle. In mid-2008, Freddie Mac and Fannie Mae were still being defended by their government sponsors, overpaid bank CEO’s were still claiming they were appropriately reserved while in the back office the risk managers were stumped by the challenge of pricing toxic mortgages for which it was impossible to find a bid, anywhere. Hedge funds were blowing up, banks were failing, yet many economists refused to acknowledge that the U.S. was in a recession, which had in fact started in December of 2007. The unrevised economic statistics were still unclear. By the time that the final statistical revisions were in, three years later, the depth of the economic chasm was all too easy to see.
Our U.S. economic indicator still shows strong growth. U.S. corporate earnings have been very strong. Our traditional technical indicators are giving a green light.
Yet I am reluctant to take my foot off the brakes because, in general, market volatility is still extremely high. If the market turns down, it likely won’t be a short drop. When the market burped in August, stocks fell 15 percent in about ten trading days. Asset class correlations remain high, which is typical of a market in panic mode. There are few places to hide, other than cash equivalents. Maybe it’s a “
high risk/high reward” market phase that we’ve entered. It is not clear to me if there will be a high reward to investors.
I have absolutely no doubt, however, that we’re in a “high risk” environment. Most of our recent portfolio moves have been to reduce portfolio risk. While they haven’t been well-timed, they have reduced portfolio volatility.
In addition, probably as a result of the heretofore unheard of volatility, our traditional technical indicators aren’t working very well. Our past five trades, with 20/20 hindsight, have not gone well – so the obvious next step would be to
STOP TRADING! Because our dynamic asset allocation strategies aren’t working amidst today’s volatility, I am left with the choice of either putting all of our money in the market until volatility declines and we can once again implement our dynamic strategies, or sticking with today’s lower risk portfolio until we see how things go in Europe.
For now, I would prefer to have less exposure to risk so I have thus far decided to retain our substantial investment in cash equivalents, even though a number of timing indicators have recently turned bullish. In my view, most of the timing indicators that we watch may, like our own, be miscalibrated for the high volatility environment we’re in.
While typically a skeptic of technical indicators, at the moment I have absolutely no confidence in any of them, even in indicators that have been helpful for us in the past.
There is still good news in the world,
although you may have noticed that I’ve failed to incorporate much of it into this blog post. I’m not anticipating the end of the world. I still don’t think that we’re facing another decline to the lows of March 2009. In the long run, I still believe that a decline will be the precursor of another significant market rally.
Until world markets more fully reflect the risky environment we’re in, however, I would like to have a substantial reserve on the side which can be reinvested, at much better prices, should Europe’s summiteers fail to get in front of the slow motion car wreck that is still unfolding across the pond.
Douglas B. May, CFA, is President of
May-Investments, LLC and author of
Investment Heresies .
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