A perfect storm? In recent commentaries we have touched on various themes currently affecting world markets. Certainly, Greece is in the news – again! With one year Greek government bonds yielding more than 130%, the bond market gets it – even if European leaders do not. Yields that high not only imply a 100% chance of default, they are pricing in a recovery of well below 50%. You do not hear of a default from the responsible parties because of all the unknown ramifications. We wrote about Greece in June 2010 and again in June of this year. Stop gap measures have allowed the major European banks to unload a good portion of their Greek debt onto government entities, which is the good news. However, the banks still need more capital – estimates vary, some are north of 200 billion euros, definitely more than the 3 billion euros that the European Banking Authority (EBA) states they need. Because the major European banks are disproportionately large compared to their retail deposit bases, they depend upon purchased money for their funding. In the meantime, US money markets are dwindling as a source of funds.
Because leverage is so high in the European banking system, the markets become very concerned when they look at the potential risks of defaults moving across the peripheral European countries (“Club Med”). Likewise, the markets rejoice when they sense something reasonable is about to happen to resolve the issue. The latest proposal to convert the European Financial Stability Fund (EFSF) into a bank does not appear reasonable to us. The idea is to empower the bank to post its capital and sovereign debt as collateral with the European Central Bank (ECB), allowing it to borrow more money from the ECB to buy more sovereign debt and posting it as collateral, starting the cycle all over again. It is worth noting that banks have never had to reserve against loan losses for sovereign debt held on their balance sheets, much like US banks do not have to have reserves for US treasuries on their balance sheets.
While Greece can do many things to improve its fiscal situation, no amount of austerity will enable Greece to repay its existing loans (now in excess of 130% of GDP) – ever. And providing more money, even at lower interest rates, will not change that fundamental truth. The sooner the European authorities can orchestrate an orderly default, the better – for Greece and world markets. Even though the stock market can have a short attention span, it is concerned by more than just Greece. China is showing signs of slowing down as the government tries to rein in inflation, affecting industrial commodities and countries exporting to China. Should the US slip into a recession, China’s economy would slow even more since consumer spending would drop below current low levels. It is apparent that emerging economies, though healthy, have not decoupled. In fact, the global economy is as entwined as ever. Although US corporations are very healthy and well positioned for bad weather, revenue and earnings will likely come under some pressure next year. Nonetheless, analysts have not taken down S&P estimates, yet. However, market action implies lower earnings. Productivity growth will be hard to sustain, leading to potential additional layoffs. The value of the dollar also plays a role in reported earnings. The yen has probably peaked and problems in euro-land will contribute to a strengthening dollar (finally!). Since profits from overseas sales were enhanced by a weak dollar, that contribution to record earnings will no longer be there.
A recession in Europe is probable. It remains to be seen if it comes to the US. Nouriel Roubini, the economist who forewarned the 2007 financial crisis, says that the next downturn could be even worse because the US’s problems have shifted to the public sector. A perfect storm? We hope not, but have prepared portfolios for rough sailing.