June 3rd, 2011
Guest Author: MacroTides. See About the Author at end of the article.
Coming into 2011 we suggested there were three major themes that would play out in the course of this year. We have already discussed U.S. macroeconomic issues and investment outlook in two previous articles and our concerns about the BIC part of the BRICs in a third. In this discussion we will address our continuing (for more than a year) concern about the long-term drag of the unresolved sovereign debt problems in Europe. Follow up:
Follow up:In a letter 50 years ago to President John Kennedy, economist John Galbreath wrote,
"Politics is not the art of the possible. It consists in choosing between the disastrous and the unpalatable".
This certainly applies to the sovereign debt problems plaguing the European Union. The fundamental problem is that Greece, Ireland, Portugal, and Spain have too much debt, and too little economic growth to service their debt loads. The European banking system could collapse if their banks were forced to acknowledge this reality. German and French banks have $541 billion of exposure to these weak countries. If the ECB allows any restructuring of Greece's debt, banks in Portugal and Spain will wobble. This event will spill over into Italy, and from there move on to Paris and Berlin.
We are witnessing an example of the classic paradox, "What happens when an unstoppable force meets an immovable object?" The ECB would like to think of itself as an immovable object. Unfortunately, the real world is far less malleable than the ECB needs it to be. In 2010, Greece's economy shrank 6.6%, so its ratio of debt to GDP rose, and is expected to reach the unsustainable level of 159% of GDP in 2012. Last spring, Greece received a $158 billion bailout package from the EU and IMF. In March, the IMF estimated that Greece would be able to roll over $20 billion in debt coming due on March 20, 2012 at 5.6%. On Monday, May 23rd, Greece's 10-year bond was yielding 17.23%. This represents the unstoppable force of a Greek debt restructuring which is unpalatable, or worse, a default that would be disastrous.
The rippling effect since the end of 2010 is plainly evident, as the yield on 10-year Italian bonds has jumped from 3.75% to 4.81%, and Spain's 10-year yield has soared from 4.0% to 5.54%.
Greece announced on May 23rd that it would accelerate plans to sell state-owned assets over the next five years it says are worth $70 billion. This is not going to be easy. First, it assumes the credit market will exhibit a level of patience that will be sorely tested by Greek labor unions. The largest Greek union represents 1.5 million private sector workers and strongly opposes privatization of state companies of strategic significance. It says privatization will lead to higher prices for power and water, and lost jobs. We expect there will be work stoppages that will bring the Greek economy to its knees. A poll last week found that 62% of Greeks believe the austerity program, imposed by the EU and IMF as conditions for the bailout last year, were hurting the Greek economy, rather than helping. This suggests union strikers may receive broader public support, even if strikes prove inconvenient.
Greek banks are not able to borrow money in the credit market, so in March they borrowed $125 billion from the ECB. The ECB accepts Greek government debt as collateral, even though all three rating agencies rate it as junk. The ECB has threatened to stop accepting this junk, which would precipitate an immediate collapse of the Greek banking system. Since this would tip the first domino of a broader crisis, we expect the immovable object the ECB fancies itself to be, to move however reluctantly.
However, even if the ECB displays a measure of flexibility, it does not change the magnitude of the underlying problem. European banks are under-capitalized, and the sovereign debt problem is only going to get worse. The ECB and the IMF will do everything possible to postpone the day of reckoning. We doubt they will be able to hold it together until March 20, 2012 when Greece needs to roll $20 billion of its debt. And we haven't even mentioned Spain!
In light of these problems we recommend being very careful with investments in Europe for the foreseeable future.
U.S. Macroeconomic Overview by MacroTides
Overview of the Markets by MacroTides
Investor Caution Advised for the BICs by MacroTides
Eurozone Banking Crisis Is Both Global and National by Clive Corcoran
Eurozone Crisis left to Fester by Daniel Gros
The Rough politics of European Adjustment by Michael Pettis
Will Europe Face Defaults? by Michael Pettis
Macro Eurozone Risk – we’re all in this together, aren’t we? by Clive Corcoran
Global Stock Markets Send Mixed Signals by Erik McCurdy
About the Author
Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at MacroTides@email@example.com