The September quarter was very trying on investors’ nerves. This commentary will seek to unpack what has happened since the end of the last quarter when the outlook for stocks and the world economy was decidedly rosy.
In our last report we warned that icebergs were lurking in the form of sovereign debt issues in Europe. What has transpired is that the “captain of the ship”, or more accurately the “committee of captains” running Europe, has proved to be way behind the curve and has consequently allowed a comparatively minor crisis, namely the threat of a Greek debt default, to become a potential financial epidemic. In fact, if the captains had aimed for the Iceberg they couldn’t have done a worse job.
The feedback loop resulting from eroding confidence, reflected in reduced spending and investment will in itself create recessionary conditions if these conditions are allowed to escalate.
How the Crisis Developed
As our clients are aware, the Euro sovereign debt crisis, particularly the impact on Greece, has been brewing for some time. An analysis of the data shows that yields on Greek government debt began ballooning around the middle of last year, with influential European officials suggesting that investors would have to take losses on their holdings of Greek debt. A significant and sustained increase in borrowing costs can be potentially ruinous for many economies. Budgets are based on expectations of interest rates. A doubling of Interest rates can cause budget deficits to soar and lead to the solvency of the state being questioned.
The dual themes of solvency and liquidity crisis cascaded through the rest of the group quaintly described by the acronym PIG Portugal, Ireland and Greece. Markets managed to price these factors in without too much dislocation. However, what really caused major risk aversion in August was when Italy and Spain were added to the list. Yields began soaring on Italian and Spanish government bonds and the interbank funding markets started showing signs of stress. Stock markets weakened in unison around the world as they attempted to price in the new developments.
Finding Solutions to the Crisis
A run on any bank or country risks becoming a self-fulfilling prophesy, threatening the survival of that entity. That is true unless a supplier of significant liquidity emerges. At Rezco, we believe that there are two central factors that have triggered the escalation of the Euro crisis. Firstly, during the initial stages, the terminology “Periphery Countries” was used to describe and effectively isolate the developing crisis. This lulled the core of Europe, led by the Germans, into an ambivalent attitude regarding the troubles of their fellow Euro members. However, once the malaise spread to Italy, Spain and even France, all the major countries with the exception of the Germans, were put in the same boat.
The second factor aggravating the crisis was the anticipation that a group of 17 separate and independent governments could produce a viable and timeous solution and stay ahead of the curve in terms of implementation. If one remembers the wrangling that occurred to get TARP (Troubled Asset Relief Program) passed by the US Congress, hopes of getting 17 Euro zone governments to do something in time and effectively, was always going to lead to disappointment.
The solution, we believe, stems from the fact that the crisis has now become core to Europe rather than peripheral and there is appreciation that the example of the US will have to be followed. Extracting the United States from the crisis of 2008 was mostly the work of the Fed. Whilst Congress dithered over a $700 billion rescue package, the Fed quietly lent banks $2 trillion and pumped a further $ 1.8 trillion into the US and world economies, thus solving the liquidity crisis at the root of the panic
In the case of Europe, the European Central Bank (ECB) has the same ability to act as the Fed did. What has changed since the crisis has become core rather than peripheral is that the ECB now also has the desire to act. Where Euro government action requires unanimity, the ECB requires only a simple majority vote, and there is not a lot the Germans can do about it. Note the recent resignation of German members.
In the final analysis, the ECB has unlimited supply of Euro’s to solve any developing liquidity crisis and they don’t have to ask anyone’s permission to supply it. The current crisis has two dimensions, namely liquidity and solvency. We believe that ECB action can solve the liquidity problem while the solvency issues have been overblown for most of Europe. Currently, Italy has a primary budget surplus of 2% of GDP (budget excluding interest payments) which is better than even Germany and shines when compared to the USA’s primary budget deficit of 5% of GDP. Greece’s solvency is clearly questionable, but it is small enough not to sink the ship.
Markets Looking Forward
Over the next couple of months, markets are likely to continue the volatility seen over the past quarter, with a potential of weakening another 5-10% below the levels seen at the end of the September. Risks remain elevated but we believe that the crisis will ultimately be resolved without excessive dislocation.
The ECB will extract its’ price for support and that price will be fiscal discipline – expect some brinkmanship as unruly national parliaments are brought into line. The Euro Governments should eventually support their bail out fund. However, having said this, we are holding some cash to make use of buying opportunities lower down. In short, we do not see the current crisis degenerating into a repeat of 2008. International stocks are well priced at current levels and have discounted much of the negative scenarios currently playing out.
Bonds have been severely impacted by investors fleeing any sort of risky assets – US 10 year treasury yields have fallen to their lowest levels ever. Currently the risk free 10 year interest rate, adjusted for inflation, is close to zero and even negative on occasion. In both the medium and long term, this will not increase wealth but rather erode it. Bond markets should return to more normal levels as the fear psychosis lifts.