Europe Again & Again & Again – Part III, Some DIY Tips

Given all the news that comes out of Europe, I figured it would be a good idea to provide readers with a quick way to find easy to read news stories and then see how markets react. 

First, here is some good source material from the NYT.  I choose Spain and Italy given they are the rage right now. The pages are set up rather nicely, with a summary of all relevant information at the top, followed by the newest NYT articles on the bottom:

• Greece
• Spain

Next, when a new piece of information comes out how will the markets react?   I like to follow the yield on government bonds.  Bloomberg provide 10-Year yields and I picked three of the riskier Euro nations and then Germany as a way to compare:

• Greece
• Spain
• Italy
• Germany

Basically if things in Europe are worsening riskier Euro nations will have their yields rising and Germany should have its yield falling (note: this might not hold in the remote worst care scenario). 

There is also Intrade to see a market prediction on a county leaving the Euro.  Without getting into detail, essentially just look at the % chance.

There are obviously many more places to mine for data.  I think these are the most basic and direct. 

One thing to note, it appears the trend is that markets are reacting less and less favorably after every “positive” announcement.  To me this indicates markets aren’t buying what Europe is selling.  Again, as I mentioned in my previous post, I don’t think this will happen until Germany backs substantial systemic change. 

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development – basically banks will now be able to borrow directly from the ECB, not their own Central Bank.

This is bigger than any news out of the EU in awhile.  While the restructuring I think is needed, it is certainly a step in the right direction:

1. A step toward UNITY.  This is key, all countries need to start moving together, not apart.
2. By recapitalizing the banks directly through the ECB, the risk of the worst case scenario credit crisis scenario (bank runs) appears to be reduced, although not eliminated.  

Europe Again & Again – Part II, Too Much of Nothing New: What to Expect

When I say “nothing new” I mean anything that isn’t a total restructuring of the Euro.  This should be approached with either new rules/institutions (e.g. Eurobonds, EU backstop, etc.) or with a change in members (e.g. weaker members leave, Euro disbands, etc.).   Status quo will not do - something new, something systematic is required if some semblance of the Eurozone is to survive.

What does not constitute something new is what I outlined in my last post – Spanish bank bailout, and  a Greek coalition to stay in the Euro.  These are stop gap measures that will only kick the can down the road.  The market apparently agrees.

So if Europe continues to kick the can down the road what should we expect?  More of the same from late last summer to now:

• Downward pressure on the Euro vs. Dollar (i.e. the Dollar continues to strengthen versus the Euro, making your European vacations cheaper and our exports more expensive)
• Steep VIX futures curve
• The VIX is a forward looking volatility measure.  The steep curve implies the market expects volatility to be greater in the future than it is now.
• Upward trend in yields of weaker EU countries (Greece,  Spain,  Italy)
• Downward trend in German yields
• Low Treasury yields
• Choppy equity market, perhaps range bound

How long with this continue? I am not quite sure, but I would think the above trends will probably hold until there is a resolution one way or another.   That isn’t to say there won’t be movements against the trends whenever some news comes out, just that over the course of “kicking the can down the road” they will persist. 

The ball is in Germany’s court.

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development – basically banks will now be able to borrow directly from the ECB, not their own Central Bank.

I will comment more on this in my last post of this 3 part series.

Europe Again – Part I, Too Much of Nothing New

While I would like to stop writing about Europe, unfortunately it doesn’t appear that I can.  I gave my most recent breakdown here, here, and here.  Since then, Spain announced a bank bailout and Greece had new elections.  Here is what has happened since my last blog:

Spain – “Euro zone finance ministers agreed… to lend Spain up to 100 billion euros ($125 billion)”

Greece – “Greece’s two traditional political rivals are in a race to forge a coalition as the state’s cash dwindles, bank deposits flee and Europe demands renewed austerity pledges before releasing more emergency aid… New Democracy won 129 seats in the 300-seat parliament, according to Interior Ministry projections with 99 percent of the vote counted. Pasok, which has alternated in power with New Democracy over the past four decades, won 33 seats, enough for the two of them to forge a coalition that backs the creditors’ austerity demands.”

So what do these two events mean?  It appears not a whole lot.  Markets were unmoved by either.  The Spanish bailout at first created some optimism but that quickly dwindled.  Why?

I can’t answer with certainly, but it would seem both of these are stop gap measures that do nothing to address the major concern of the Euro – disconnected monetary and political/fiscal policy (via Pragmatic Capitalist, Goldman Sachs).  So where is the game changer?

There is a lot of noise, so it’s difficult to tell when something substantial (like our TARP program) will change the dynamic; however, one thing is very clear: Merkel will be the key.  Whenever Germany starts talking and acting on the inevitable wholesale change that must develop is when there will be some resolution.  

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development:

“Euro-area leaders asked for proposals this year to unify banking supervision and soup up the ECB’s powers. They referred to a clause in the EU treaty that allows them to give the ECB prudential oversight of banks and other non-insurance financial companies.

The move paves the way for the European Commission, the EU’s regulatory arm, to augment its proposals on deposit insurance, capital requirements and how to handle failing banks…

Once Europe establishes a single banking supervisor, leaders said they may allow cash-strapped lenders to be recapitalized directly instead of through their home governments. ”

I will comment more on this in my last post of this 3 part series. 

Europe – Now What

In my last two posts I covered what happened in the Greek elections and the potential repercussions of those elections.  Now it’s time to look at what will happen to the EU.  Aside from the previously referenced NYT and Spiegel articles, I used a couple different sources (Krugman, The Big Picture, The Reformed Broker, Kotok) for this post.  My key takeaways are as follows:

• Unless the EU renegotiates its rescue package with Greece, it’s highly likely they will leave the Euro.

• The chances of a renegotiation increased as elections in France and Germany indicate there is a growing backlash against austerity.  Still, Germany seems dead set against a renegotiation and they are the key player.

• Even if the rescue package with Greece is renegotiated, given all the previous aid these appear to be stop gaps that just kick the can down the road

• Thus, unless there is a complete overhaul to the system (e.g. Eurobonds, ECB backstopping banks, etc.) it seems likely Greece will eventually leave even if another new stop gap measure is added.

• Despite the anti-austerity elections there just doesn’t appear to be enough support (e.g. Germany) for an overhaul and the support probably won’t come until Greece leaves and the rest of the EU has to deal with the fallout, which would be…

• Anybody’s guess.  EU leaders appear to have enough resources to weather a Greek exit; however, no country has left the Euro before so it’s really an unknown.

• The real concern is a country like Spain or Italy having massive withdrawals from their banks as markets panic.

• If that happens the ECB will need to backstop the withdrawals and/or institute capital controls, then subsequently guarantee their sovereign bonds and put together some sort of fiscal policy (e.g. Eurobonds).

• Or let the Euro collapse, bringing on an even greater recession to all EU economies simultaneously. 

• Again, the big risk here is not Greece leaving but the potential domino effect that it could create with other EU countries.

• However, the best case scenario is that the elections and a Greek exit are a wakeup call to overhaul the Euro and make it a workable currency.

Greek Elections – The Fallout

In my last post I provided an overview of the Greek elections; now it’s time to look at the Greece faces.  Aside from the previously referenced NYT articles, I used this Spiegel article.  My key takeaways are as follows:

• The parties that initially negotiated the bailout terms are willing to renegotiate some of the bailout terms, but that won’t be enough for Syriza, which is needed for the coalition to have legitimacy.
• As a result new elections will most likely be called with anti-bailout parties primed to pick up more votes.  The new election will basically be a referendum on whether Greece will remain in the Euro.
• Presuming the EU will not finance Greece without the bailout terms, if Greece officially refuses the provisions of the bailout package they will default and leave the Euro, unless the EU relents.  
•  At this point Greece leaving seems likely.  Intrade probability has it around 60% by then end of 2013 for one country to leave the Euro.  That one country would be Greece.
• Assuming that happens, Greece will return to the Drachma.  This will be significantly devalued relative to the Euro, in turn making imports expensive and exports cheaper; thus, making Greece more competitive.  Currency devaluation could be between 50% and 80%.
• It also becomes cheaper to invest in Greece, which would attract FDI (foreign direct investment).
• Private companies with debts denominated in Euros would no longer be able to pay those debts and bankruptcy would then follow.
• Given all that, the IMF estimates a decline in Greece GDP by more than 10% is possible in the first year, but then after that the recovery should be quicker given the devaluation.  
• Such a plan has worked before; however, there is still a risk of a government collapse.  Further, savers essentially have their savings inflated away.
• Note:   Greece is currently in year 5 of their recession.  Unemployment is 22% with youth unemployment at 53%.  In the 3 years unemployment rose by nearly 100%.

 In my final piece on this subject, I will take a prospective look at the fallout in the EU.

Greek Elections – What Happened

Elections were just held in Greece and probably will be held again in June.  Being that I am new to how the Greece Parliamentary system works, I decided to do some digging.  I used some NYT articles (here and here and here) to try and figure out exactly what happened.  My summary is below:

• The two main parties in Greece – New Democracy (center-right) and Socialists – lost seats in Parliamentary elections.
• Syriza (Coalition of Radical Left) and Golden Dawn (far-right) both picked up seats.
• There are now 7 parties in Parliament, which means that a coalition government is going to be very hard to get, and will probably lead to new elections.
• The vote seems to be a clear rejection of the bailout terms; thus, the parties gaining seats are refusing to accept the previous ruling parties negotiated austerity package. 
• Polls indicate that with new elections, parties opposed to the bailout will pick up more seats.
• Further, since Syriza has the second most seats now (16% compared with New Democracy – 20%, and Socialists – 14%) any coalition government formed without them could stoke even more civil unrest.
• The EU’s financial support is dependent on those negotiated austerity measures.  Without those spending cuts, in the absence of a change in policy, the EU will stop financing Greece.
• If the EU pulls the plug Greece will default and be out of the Euro.
• Note:  the EU + international community has pumped in roughly $312B, still debt to GDP is at a peak and the recession worsens.

Next, I will cover what the fallout will be to Greece.

Europe Summarized

As the Euro crisis deepens and the leaders of Italy and Greece resign, I figured it would be a good time to summarize what is going on.  Luckily, I found this great SNL video that does so nicely (via Big Picture):

Aside from being funny, I think you would be hard pressed to find another three minute video that better captures what is going on overseas:

• It’s hard to convince the masses to cut government spending and lower their standard of living.
• Why were countries like Germany and France lending lots and lots of money to countries like Greece and Italy when the former should have known paying off all that debt would be difficult, if not impossible?
• As such, creditors need to work with debtors to figure out a solution.  The burden isn’t only on the debtor. 
• Leadership from France and Germany has been weak.
• Given the cultural, social, and language barriers, pulling the Eurozone together was an uphill battle from the start.  In times of crisis this will probably prove to be more difficult.  Plus they have been fighting each other since Europe was inhabited and were at it as recently as 60 or so years ago. 

Europe – It’s a Start

Some of my past posts highlight just how important a solution is to the European crisis.  A solution might be on the way.  Recently, French President Sarkozy said “We will recapitalize the banks… in complete agreement with our German friends.” 

A key to such a step appears to be the holders of Greek debt taking a haircut (e.g. a bond has a face value of $100 and the investor accepts $80).  Further, there also seems to be less certainty that Greece will stay in the Euro.  Ultimately, there should be a plan delivered by early November at the latest.  

Just how good last week’s news is will ultimately depend on the goal, strength, and the execution of that plan.  I am unsure how much money is needed for recapitalization, how much Greece leaving the Euro will impact the global economy and markets as a whole, and what the implications of taking these haircuts will be.

However, the success of such a plan will depend on whether or not a PIIGS (Portugal, Ireland, Italy, Greece, Spain) fallout can be contained, if this is a systemic solution (i.e. not the banks), and if the plan can be applied  a timely and effective manner. 

“Contained”  in this instance means preventing the credit markets from freezing up.  As I have outlined before, if such a freeze up happens, it will likely spread to our markets.

In my opinion, this is the central overriding issue facing our markets through at least the end of the year.   Let’s hope the plan is enough to prevent liquidity from drying up and punishes the imprudent while protecting the system.  

Greece – Who is at Fault & Now What?

I used this example with a client earlier this week:

Suppose I have 5 children.  From a responsibility point of view, two of them are great, two are about average, and one is awful.  While the irresponsible kid can’t generally be counted on to make rational responsible decisions, I continue to subsidize his lifestyle.  After years of handing over funds that are no doubt going to unproductive resources, the irresponsible kid finally hits the financial wall and flames out. 

In the example above Germany is the parent and Greece is the irresponsible kid.   So who is to blame?  Certainly it could be argued both sides are culpable.  While the irresponsible kid did not spend money wisely, the parent still could be considered just as irresponsible.

Admittedly who is at fault is of minor importance; however, as I hinted at before the above example illustrates just how Germany’s stance is misguided. 

While the rest of the Eurozone and the world should help, it just seems clear Germany needs to take the lead.  Saying “it’s not our problem or our fault” not only hinders any sort of solution, but is categorically untrue.

With default nearly certain, some sort of action is needed to assure “breakdowns that seemed inconceivable at one moment can seem inevitable at the next.”

Greek Follow Up

So Greece passed an austerity package and it appears that they will get a bailout from Germany and France.  I expressed my concern in the past about the perils of a Greek default and now that it is “resolved”, I feel a quick follow-up is necessary.

I get the sense from my readings that this won’t solve anything long-term.  The problem still exists (Greece can’t pay back their debt) and has probably been pushed down the road. 

At the same time, the situation in Greece seems to be getting more combustible.  I do wonder if (maybe when?) more cuts are needed down the road how the people will react.  Will the government be thrown out, making default inevitable?

That said, the delay does give holders of Greek debt more time to adjust their positions, strengthen their capital base, and hedge accordingly.  Basically, a slow moving train wreck is better than a quick one in this instance (e.g. 2008).  It should contain the damage I outlined in my previous posts (linked above); “should” being the key word in that sentence.   Maybe I am being too optimistic. 

Time will tell on this.  For now, this is a positive. 

Managers Focused On Risk

A recent poll by the Economist Intelligence Unit and BNY Mellon (via FT) gave 800 institutional investors and executives various economic/geopolitical themes.  They were then asked how likely they thought each theme was and what impact that theme would have on their portfolio.   Below are some of my key takeaways:

• Many of the themes were rated as “Highly Negative” in terms of the impact on their portfolio.  To me this signifies the heightened risk aversion given the global financial crisis of 2008.
• The only “Likely” positive impact theme was that the internet and social media will be a catalyst for economic change around the world.  This always appears to be the case – a technological advancement stimulates global growth.
• The only “Highly Likely” and “Highly Negative” theme was unrest in the Middle East.  When is this never likely or negative? 
• A sovereign default is toeing the “Unlikely” and “Likely” line while being highlighted as negative.  You can read in my Greek posts here and here why that might be bad.
• Any theme involving Emerging Markets is either in the “Highly Positive” or “Highly Negative” categories or close to it, which shows the growing interconnectedness of the global economy/markets, the rising dependence on those markets for growth, and/or the increasing stakes portfolio managers have in those markets.
• There was one theme that highlighted the risk of monetary or fiscal tightening.  That is one of my concerns. 

You may have noticed, I like lists and graphs as they are not only fun to look at, but also can provide some good data that would have slipped through the cracks.  This one in particular was good because it highlights many themes and risks that are often overlooked, but need to be considered when constructing a portfolio. 

The Perils of Contagion

In my last post I highlighted why Greece is so important to global markets and the global economy.  I mentioned why contagion, especially in the financial markets, is so dangerous.  In a recent article, Ed Harrison does a good job of explaining the ripple effect of the Greek default.  Below I try to summarize the general idea:

European banks own Greek debt.  To insure this debt they purchase a CDS contract.  In this contract banks (i.e. the buyer) pay the writer of the contract every year.  The writer of the contract promises to pay the buyer the face value of the contract in the event of default.  A CDS is essentially insurance on the Greek bonds.

Thus, if Greece defaults the writers of these contracts will have to pay out.  These contracts may have been written by US financial institutions.  Therefore, a default by Greece could trigger large cash payments from US institutions, putting them at risk.

These payments may or may not be manageable.  A greater issue would probably be if Ireland or Portugal or a larger European country is forced to default as credit markets cease up.  This would in turn force US institutions to pay out CDS contracts on those countries debt instruments.

Going even further, a default in Greece could put European financial institutions at risk even with CDS contracts insuring the debt.  If those banks take large hits to their balance sheets or even fail, any US financial institutions with direct exposure (e.g. loans) or who wrote CDS contracts would be under pressure.

Essentially, the above excerpt illustrates how global financial markets have become interconnected and interdependent upon one another.  How exposed is the US to European sovereign bonds and bank debt?  I don’t believe anyone is quite sure, especially given the lack of transparency in the CDS market.

The point of concern is that one relatively small event can cause a systemic disruption across global financial markets given how interconnected and opaque they are.  This is why the prospect of a Greek default is negatively impacting our markets.   

Why Greece Matters

When looking at world, GDP Greece is ranked 39^th, roughly .50% of World GDP.  The logical question is: why is Greece having such an impact on our domestic market?  Here are some reasons off the top of my head:

1. Uncertainty – It seems nobody is sure how Greece restructuring or a bailout will work.  The longer it takes to find an actual solution (as opposed to kicking the can down the road) the more uncertainty for global markets and the more default issues will keep creeping up.
2. Contagion:

• Debt:  If Greece defaults does that create a run (i.e. institutions no longer will roll over purchases of short-term debt) on Ireland, Portugal, Spain, etc., and thus lead to their subsequent default? 
• Unrest: There has already been rioting in Greece.  Social unrest spreading through Europe would have economic consequences.
• Financial Markets: A default in Greece has vast ripples all over the financial system making a small country paramount in how capital flows.

It is contagion that I want to focus on.  There has already been talk of a U.S. bailout of Greece.  This is mostly likely because U.S. officials fear contagion spreading into the financial markets.  Think about what happened with AIG after Lehman (although now it would appear banks are in a better capital position). 

In my next post I will delve into the particulars of why contagion, especially in the financial markets, could be extremely harmful.