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Raul Elizalde - Thursday, June 21 2011
Hurricanes, earthquakes and avalanches can be devastating but they end quickly. That’s not so with the financial crisis of 2008. It doesn’t seem we can ever shake it off.
The latest flare-up is in Greece. This long-festering problem finally hit a point where the market is demanding resolution. Remarkably, European policymakers appear willing to kick the can down the road a lot further instead. This, as it turns out, might be the only option left for dealing with Greece.
Troubles with Greece date back to the days when the country falsified its national numbers in order to gain admission into the eurozone. Having been unprepared for entry was actually not as bad as the very curse of membership: access to cheap financing and generous transfer payments, which made it far too easy for the country to borrow and spend.
The country’s finances have now deteriorated beyond what it can handle and what markets are willing to tolerate. Investors providing new money to roll over maturing bonds cannot be found, so default is looming.
2-yr Greek Government Bond Rate
And who would be affected? The short answer is that nobody really knows; analysts estimate that French institutions may be the largest owners of Greek bonds, but hard data is old and does not reflect the fact that a large chunk of the $350 billion outstanding bonds have gradually moved from private hands – mostly banks and other financial institutions – to supra-governmental organizations such as the European Central Bank. A default by Greece, therefore, wouldn’t hit European banks hard as long as other countries’ bonds are not affected by contagion.
This contagion effect is the real reason why the ECB has been steadfast in its refusal to allow bondholder participation in bailing out Greece. A bond “haircut” to lighten Greece’s debt load would set a serious precedent that could cause borrowing rates to soar for Spain and other peripheral countries, making it more difficult for them to finance maturing debt and creating a far more serious problem for heavily exposed European banks.
Until recently this demand from the ECB was met by strong resistance from Germany, who insisted that bondholders had to participate in a Greek bailout. Germany’s position was that a rescue package that did not ask anything from private holders of debt and everything from public bodies was unreasonably burdensome for Germany, which is the largest funder of European institutions.
But Greece’s largest creditors now are those very public institutions that Germany is funding, so in the end it made little sense for Germany to be the biggest hurdle to a rescue package. It nevertheless demanded that the Greek government passed a new set of austerity measures before receiving the lifeline, needed by June 28 to pay off maturing debt.
But Greece had indeed passed an austerity package which caused major disturbances around the country. A new round of belt-tightening will further agitate a population that has already taken to the streets. And even if this is agreed - as last night's confidence vote for the Greek government suggests - fiscally contractionary policies will only aggravate the long-term insolvency problem that the country faces. The sad truth is that austerity will make it even more likely that Greece will eventually default, or that will end up needing a lot more bailout money to keep it afloat.
What does this mean for markets? There seem to be three possible scenarios: default now, fiscal integration, or containment.
The time for letting Greece default has passed. Unlike a year ago, all peripheral European countries would be hit hard, thus unleashing a systemic impact of unknown proportions. It is estimated, for example, that 50% of US money market funds are invested in instruments of European financial institutions. That’s why a significant deterioration of European banks will have global repercussions, and authorities know this. This means that letting Greece default is off the table for the time being.
Another European solution would be fiscal integration. The fact that eurozone countries are only united by monetary policy is perceived as a serious structural weakness. But the political environment in Europe is today much different from the one that launched the eurozone in 1999. While back then politics brought countries together, today politics gets in the way of unity as taxpayers in Germany resent the bailouts to the periphery, people in the periphery resent the imposed austerity, and nationalism takes hold virtually everywhere. Fiscal integration is a long way off.
Containing the crisis long enough until Greece can default without systemic consequences seems to be the likeliest course of action. Indeed this seems to be the strategy so far, and it may well work providing that no other crisis arises anywhere else in the world.
Betting on this is risky since US and European banks are vulnerable, the rise of core inflation is starting to be noticeable all around, emerging markets such as China and Brazil are tightening policy, and US politicians are veering dangerously close to a showdown over the debt ceiling.
Containment will also demand a steady stream of public funds, which will only harden fiscally conservative positions of politicians around Europe. It seems likely, therefore, that European growth will be weaker than currently predicted, which would not be supportive of higher equity prices.
But this is what we are most likely to see in the months to come, and it may have the best chance of preventing a systemic event even if it’s not what markets want to see. From that point of view, it supports our view that markets will remain in a range in the months to come, as we proposed in our previous letter.
If we are right, then tactical investors may be well advised to reduce risk exposure for the coming quarter. On the bright side, the risk of a severe market disruption seems to have been averted. Sometimes, kicking the can down the road a little longer may just be the right thing to do.
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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