Market Comment Q3 2011

Beware of Greeks Bearing Bonds1

Once upon a time, Greece was simply a beautiful and quaint sun-drenched country jutting into the Mediterranean. It seemed a little backward, but that was part of its charm. The conversion rate of the local currency – the drachma – was such that prices were very attractive to visiting Americans and other Europeans.

That began to change when Greece was accepted into the group of countries using the euro as a common currency – the eurozone. With the benefit of hindsight, we now know that this should never have happened. The then-existing Greek government cooked the books to demonstrate that their fiscal situation met the necessary qualifications, and the European Central bank (ECB) turned a blind eye rather than ask too many questions. Once inside the eurozone, Greece was able to issue debt at much lower interest rates than earlier, and the debt was readily acceptable by banks and other institutions throughout Europe. This essentially gave the Greeks carte blanche to spend whatever they wanted, and they did. even in 2007 – before the global financial crisis – Greece was well beyond the levels of both government deficit and debt required by the ECB. Now Greece’s central government debt is 143% of GDP, the government deficit is nearly 14% of GDP, and these numbers are still worsening as the country pays its bills with advances from the rest of the eurozone.

Rules are made to be broken. The euro came into existence as a currency in 1999 with strict rules about required financial behavior that still appear prominently on the website of the European Central bank (ECB). The two most important rules hold that no country in the eurozone may have a government deficit greater than 3% of GDP, and no country may have debt greater than 60% of GDP. The first two nations to break these rules were Germany and France – the largest economies in the group. By 2009, the seventeen eurozone nations collectively had deficit spending greater than 6% of GDP, and twelve nations had debt outstanding that was more than 60% of GDP. The ‘required’ financial discipline did not last long, casting doubt on whether these nations collectively can rediscover enough discipline to work their way through these problems.

Why is this such a crisis? The rest of the world – including European banks that own most of the outstanding Greek bonds – grasped the situation only in hindsight. The nature of the story is now all too familiar to all of us who have lived through the U.S. chapter that was based on overrated subprime mortgage debt securities. All around the western world, too much economic activity was being supported by ever-increasing debt. In Greece and potentially other countries the load finally has become too much to bear.

If Greece were the only problem child, the situation could no doubt be contained. The GDP of Greece is only 2% of the European Union total; the other members of the eurozone could pass the hat and cover the Greek debt if their citizens were so inclined. Most are not so inclined, and, unfortunately, some other members of the eurozone also have been less than prudent in their financial affairs. Portugal, Ireland, Italy, and Spain have all at various times been in the spotlight as countries that may not be able to repay or refinance their debts. Markets and central bankers fear that a Greek default may be contagious, calling the euro itself into question and potentially destroying European banks. The biggest reason this crisis is growing is the simple fact that it has been playing out for a long time and remains unresolved.

In recent issues we have been keeping score on market perception of the various countries through the yields at which their bonds are selling. There have been some noticeable changes in relative yields since our last report:


Since July, yields for Germany, France, and the U.K. have declined as they have in the U.S. Spain’s yields have declined a little while Italy’s have risen a small amount. Ireland has improved dramatically from double-digit levels. Markets are clearly pricing in a Greek default or debt rescheduling while showing less concern for all others except Portugal.

Why do Europe’s problems make such waves in U.S. stock markets? There are several facets of this complex puzzle. First, U.S. markets are not alone. Stock markets in most major countries have reacted in substantially the same way, gaining nicely this year into July before giving back those gains and more. Over the past twelve months, the S&P 500 does show modestly positive return while the German equivalent is down about 10%. In some respects these negative reactions are occurring simply because the liquidity of stock markets makes them an easy place to register changes in mood. Are you fearful of the incompetence of European leaders? Sell stocks.

Second, we have seen more frequently than we would like that rapid price change can feed on itself. Once a market begins moving in one direction, momentum can accelerate in that same direction. This is largely caused by automated trading where responses to specific change are pre-programmed. A positive comment on the eurozone salvation plan from someone like German Chancellor Merkel can immediately lead to upward stock market movement, a negative comment the opposite.

More rationally, the dithering in Europe is further reducing an already sluggish growth outlook on that continent and lessening the near-term prospects for corporations doing business there. Eurozone GDP change could very easily be negative in the third quarter.

The rest of the world is not easy either. In the U.S., first half economic growth was too anemic to have any meaningful effect on employment. It is worth repeating that some of the weakness came from supply issues caused by natural disasters like the Japanese earthquake and domestic flooding. These problems are healing. but it is also very likely that consumer confidence – and thus consumer spending – are being held back by continuing uncertainty about the federal deficit and debt situations in this country plus the difficult employment picture. These conditions in both the U.S. and Europe could lead to reduced corporate profit expectations.

China has a different problem. Rapid growth has brought inflation that is sowing unrest in the population – particularly with regard to food prices. Food is 30% of China’s consumer price index, and that component has helped push overall inflation beyond 6%. Thus China is trying to tighten money supply growth and lending, leading to a risk of slower orders at suppliers like BHP Billiton and Vale.

Amidst all this, stock market unrest is understandable. The major eurozone issues and the concern over the deficit and debt in the U.S. have been hanging over the world for quite some time now, and there is no discernable improvement in either situation. There seemed to be an increased willingness to take more investment risk earlier in 2011, but that has been waning as the same difficulties go on and on. So far there has been little if any reduction in earnings expectations at the corporate level, but economists are beginning to trim their expectations for overall corporate profits. This is contributing to a reduction in the price investors are willing to pay for each dollar of estimated earnings.

To calm the nerves of both investors and traders will require a solidly workable conclusion to the eurozone crisis. If that can be accompanied by similarly better news on the home front, markets can improve quickly.

1 With thanks to Vanity Fair and Michael Lewis, from whom we have lifted our title verbatim from his article in that magazine’s October, 2010, issue.

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