Guest Author: Macrotides (See info at end of article.)
In some respects, the global economy is in a more precarious position than it was in early 2009. Two years ago, governments around the world were still capable of unleashing trillions of dollars in fiscal stimulus. Central banks were able to slash interest rates, and in the case of the European Central Bank and Federal Reserve, force feed additional trillions of dollars of liquidity into their respective banking systems. The initial goal was to stabilize the global financial system, and subsequently engineer a self-sustaining economic recovery in each country’s economy.The results have been uneven. In the United States, GDP growth has been roughly half the average of post-World War II recoveries, so the question of whether a self-sustaining recovery has taken hold is debatable. Although Germany and France have fared relatively well, the same cannot be said for Greece and Ireland, whose economies are still contracting. Spain, Portugal, and Italy are barely growing, with Spain sporting an unemployment rate of 21%. In order to right its fiscal house, Britain has adopted a stiff austerity program that proposes to cut government spending by more than 20%. In the short run, the decline in government spending will weigh on growth. Japan will rebound from the earthquake/tsunami plunge in GDP, but the rebound will fade into the moribund growth that has plagued the Japanese economy for two decades.
The United States, European Union, Japan, and Great Britain account for 62% of global GDP. To varying degrees, these developed economies share a number of common traits that will retard growth for the foreseeable future. Demographically, they have aging populations, which will increasingly stress the social safety nets in each country. Most have a relatively to high debt to GDP ratio, that will slow economic growth in coming years. Slower growth means weaker income growth, so interest payments on their debt will absorb a greater share of total income and leave less for spending and saving. Not the best prescription for long term economic growth.
Focus on Europe
In the 1972 movie “The Godfather”, Don Corleone tells his godson that he will get a part in a movie his godson wants to act in, even though he has already been rejected for the part by the head of the studio. When asked by the godson how Don Corleone can be so sure, the Don tells him “I’m gonna make him an offer he can’t refuse.” In the tragicomedy the Greek debt crisis has become, this famous line seems appropriate. The rating agencies have determined that any extension of maturities of Greek debt or involuntary rollover of current holdings of Greek debt would constitute a default. In recent days, discussions have suggested that current debt holders would be able to roll existing Greek debt as it matures on a “voluntary” basis. With existing Greek debt selling at a very deep discount (10 year yields are above 18% and 2 year yields above 28%), no institution would roll over a bond at par, when it could be purchased in the open market for $.50 on the dollar. But these are desperate times and everyone involved wants Greece to receive more funding in a manner that avoids triggering a default now, even though everyone knows Greece will never repay the loans they have already received. Our suspicion is that behind closed doors current holders of Greek debt will be made an offer they can’t refuse. We doubt the financial markets will be so willing.
As we have noted previously, Greece is merely the tip of the debt iceberg the European banking system is on course to collide with, irrespective of any last ditch maneuverings. The fundamental problem is that Greece, Ireland, Portugal and Spain have too much debt, and too little economic growth to service their debt loads.
Germany and France have $541 billion of exposure to these weak countries.
We continue to believe it is merely a question of when Greece defaults, not if. And when that happens, banks in Portugal and Spain will be severely impacted. According to the Bank of International Settlements, French banks own $57 billion of Greek debt. One June 15, Moody’s warned it may downgrade three French banks, due to their exposure to Greece. In an example of how interconnected the global financial system is, Fitch ratings reported that as of May, almost 50% of the assets in the ten largest prime money market funds were invested in short-term loans to European banks. Fitch noted these funds have sold much of their holding of Spanish, Portuguese, and Irish debt, and have never held Greek bank debt. In another example of how interconnected the global financial system is today, U.S. banks and insurance companies have issued default insurance on Greece, Ireland, and Portugal debt through credit default swaps purchased by German and French institutions. The French and German institutions will receive payments from the U.S. banks and insurance companies issuing the credit default swaps, for the amount of the insurance coverage upon a default by Greece.
Even though U.S. institutions hold only 5% of Greek debt, their exposure to a Greek default will likely be larger than their actual holdings of Greek debt, since they will have to pay for the amount of debt they insured to the German and French institutions. Since credit default swaps are not traded on an exchange or through a clearing house, no one knows precisely the total value of credit default swaps on Greek debt, and more importantly, the exposure for U.S. banks and insurance companies. And, if one of these institutions just happens to be too big to fail, the exposure of the American taxpayer.
One of the contributing factors that fed the financial crisis in 2008 is that no institution will blindly trust every counter party, as long as no one knows what each institution’s exposure really is with certainty. When Greece defaults, confidence and trust will plunge right along with the value of Greek bonds, and it will spread globally within 24 hours, even though a Greek debt default is widely expected. It will be the uncertainty created by the default that will cause liquidity to dry up. Sadly, this lesson from the 2008 crisis has not been addressed, so the murky world of derivatives remains a financial black hole.
What cannot be overlooked is the social displacement and resulting anger the necessary austerity programs will continue to have within many countries. We have seen the riots in Greece, which are likely to become larger and more violent as Greece makes further budget cuts. With unemployment over 20%, the problem of unemployment for those under 25 is an epidemic within the European Union. Millions of young people out of work and losing faith in the current political system and hope for the future are a combustible mix for revolution.
Historically, it is rare for revolutions to start at the top of any society, since the “establishment” is more interested in maintaining the status quo. In Spain, the unemployment rate for those with a college degree is over 30%, and without a college degree exceeds 40%. On June 30, hundreds of thousands of British public sector workers are set to strike over jobs, pensions and pay cuts. Britain has instituted a four year plan that is expected to lead the elimination of 300,000 public sector jobs. The imbalances that are now being addressed throughout Europe took decades to build up. What must be appreciated is that we are only at the beginning of this process, which will last several more years. Sooner or later, the anger and frustration will reach a boiling point. Greece or Ireland will choose to leave the European Union, while other governments topple.
Our current investment tactics will be posted in a few days on this blog. In summary, we will discuss why we think the S&P 500 may be within 1% to 2% of a short-term low, why we think investing in the dollar and U.S. Treasuries may be a good short-term tactic and why gold could be primed for a pullback.
Comparing World Markets by Doug Short
Call-Put Ratio Approaches an Extreme Low by MacroTides
Weighing the Week Ahead: Has Stock Selling Gone too Far? by Jeff Miller
Weighing the Week Ahead: An Economic Tipping Point? by Jeff Miller
Stock market Cycle Analysis by Erik McCurdy
Consensus: Groundhog Decade for Stocks by Ed Easterling
Margin Debt and the S&P 500 by Doug Short
Investor Sentiment Leads Price by Guy Lerner
The Double/Triple Doji: Have We Been Warned? by William Kurtz
Overview of the Markets by MacroTides
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 [email protected].