What’s Happening?

 “We look forward to a fascinating year ahead, where one of many misunderstood risks in the market is that of sovereign debt defaults which remain at a generationally low level. That can change, especially when one considers the record amount of sovereign debt issuance by governments in mature economies.”  

The above quote is from our year-end letter to investors.  Since then, sovereign debt issuance continues to surprise to the upside (along with Greek budget deficits and funding requirements) while equity markets continue their steady march higher in the face of systemic risks in the aftermath of crisis . . . well, at least until recently.  In the past few weeks, it would appear that equity investors have woken up to the familiar aroma of contagion and those “misunderstood risks” are quickly becoming more understood.  To help our friends understand the gravity of the current situation in Europe, we offer up the following links from other astute investors that understand.  So, without further ado, here’s What’s Happening Now. 

 

Carmen Reinhart and Kenneth Rogoff explain, Why we should expect low growth amid debt: 

“In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. The dynamic is hardly surprising, since public debt soars after a financial crisis, rising by an average of over 80 per cent within three years. Public debt burdens soar owing to bail-outs, fiscal stimulus and the collapse in tax revenues. Not every banking crisis ends in default, but whenever there is a huge international wave of crises as we have just seen, some governments choose this route.” 

Following the influential work done by Reinhart and Rogoff, the BIS recently released their own report on The future of public debt.  The paper is worth the time it takes to read, but for those looking for a summary, John Mauldin outlines the key points in Thoughts from the Frontline: 

“Since the start of the financial crisis, industrial country public debt levels have increased dramatically. And they are set to continue rising for the foreseeable future. A number of countries face the prospect of large and rising future costs related to the ageing of their populations. Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability.” 

 

The Economist demonstrates, Which countries have the biggest problems: 

If the interest rate paid on public debt is higher than the economy’s growth rate, the stock of government debt will rise as a share of GDP unless governments run a primary budget surplus. The bigger the stock of debt, the bigger that surplus needs to be. This arithmetic suggests that countries with big primary deficits, big debt stocks and a big gap between interest rates and growth are most vulnerable. 

 

Perhaps no one has forecasted the repeated miscalculations and political obstacles throughout the crisis then PIMCO CEO Mohamed El-Erian.  In January, El-Erian warned that Waiting for Better Times is No Substitute for Action: 

“The immediate aftermath of a financial crisis can involve a period of deceptive calmness when it comes to financing the public sector. As a result, some have fallen victim to the notion that large post-crisis deficits and debt burdens can be repeatedly financed without meaningful consequences for the cost and availability of credit. But if higher budgetary financing needs are not accompanied by credible medium-term fiscal consolidation, history suggests that the impact on financing costs can often become exponentially challenging. The longer it takes for such commitments to materialize, the harder it becomes to arrest disruptive debt dynamics. And, once they get going, serial credit rating downgrades can aggravate already fragile financing dynamics. At that stage, playing catch-up on the fiscal adjustment front becomes even more difficult.” 

And more recently, he promised Many More Chapters Left in the Greece Drama: 

“Sunday’s announcements will not mark the end of the Greek debt crisis, nor will they constitute a much-needed turning point that can be sustained for many months. Instead, they will be part of the multi-stage process that still has a few rounds left. If the design and implementation issues detailed above are valid, these future rounds would involve a reopening of negotiations and a recasting of the approach in some areas.” 

While Greece’s problems are front and center today, we have always been more concerned with the structural weakness across the periphery as the total size of a liquidity backstop for Greece, Portugal, Spain, Ireland and Italy could add up to somewhere between EUR 500 Billion EUR 1000 Billion.  The Wall Street Journal has chronicled The Euro’s Next Battleground: 

“The euro zone’s No. 4 economy, Spain has an unemployment rate of 19%, a deflating housing bubble, big debts and a gaping budget deficit. Its gross domestic product contracted 3.6% in 2009 and is expected to shrink again this year, leaving Spain in its deepest and longest recession in a half-century.” 

 

The Journal has also highlighted that Spain’s Woes Start to Sting Big Banks: 

“The problem now is that the Spanish economy is continuing to deteriorate, making the dynamics of the property market even worse. Unemployment is expected to hit 20% this year, by some estimates, and Spain’s gross domestic product contracted 3.6% in 2009 and is expected to shrink again this year. Property prices have fallen an estimated 15% from their highs and are expected to keep declining.” 

 

And the New York Times cautions that Spain Seen as Moving Slowly on Financial Reforms:  

“Spain joined Greece and Portugal last week in being downgraded by Standard & Poor’s, the rating agency. Among the reasons for its decision, S.& P. highlighted Spain’s private sector indebtedness of 178 percent of G.D.P. and an inflexible labor market that was likely to leave Spain with a jobless rate of 21 percent this year. To date, Mr. Zapatero’s policies have rested on the hope that the economy would begin to recover soon and that the jobless rate would average no more than 19 percent this year.  Yet the jobless rate has already reached 20 percent, according to government statistics for the first quarter released Friday, almost double the level when Spain’s recession began in 2008.  The bleak outlook makes it difficult to come up with a coherent policy. Mr. Zapatero is now boxed in, experts say, because he failed to adopt changes that challenged existing political interests when he enjoyed greater popularity after his re-election in 2008.” 

 

Recent Viewpoints review PIMCO’s Inflation Outlook and Its Investment Implications amid the developing crisis: 

 “Countries such as the UK and the US, which have their own fiscal issues, clearly aren’t going to default on their debt. They issue debt in their own currency and control their own monetary policy. Hence, in the longer term, inflation is a likely solution to deal with their inability to grow their way out of persistent deficits. However, in the eurozone, you’re faced with a very different situation where countries like Greece cannot issue debt in their own currency. They cannot debase their currency, which makes their economy more competitive, and so it is unlikely that they can grow their way out of it. So the only possible outcome (other than an outright default) is fiscal belt-tightening and reduction of input (labour costs) in order to make the goods and services they produce more competitive – and this is deflationary. We are already seeing signs of this. Countries in Europe with the worst fiscal situations that have started the tightening process, like Ireland and Spain, are already showing strong signs of deflation and we expect to see deflation in Greece as well.” 

In addition to Post-Crisis Risks, Opportunities: 

“Much of the rest of peripheral Europe entered the crisis with a very high and unstable debt load. Coupled with weak growth and disinflationary biases, peripheral Europe is at risk of entering the debt death spiral in Greek fashion. Once interest costs on the accumulated stock of debt begin to grow faster than the economy, debt builds exponentially as interest must be paid back with new borrowings. The rising risk of entering this vicious cycle dictates that much of Europe dramatically curtail spending plans over the coming quarters. This dramatic contraction in spending will prolong recession and disinflation for much of Europe. But as the situation unfolding in Greece shows, the alternatives are not necessarily better. 

 

“The supportive environment for growth created by fiscal spending is about to reverse; in some cases, it is increasingly demanded by markets concerned with sovereign debt sustainability. In other cases, the change is self-imposed due to a slowdown in the pace of fiscal spending from record levels. This effect is especially pronounced in the U.S. and U.K. Both countries used generous helpings of fiscal spending to brake the recession and stimulate growth. But as the year progresses, the fiscal impulse turns from being a massive positive to a meaningful negative in terms of implications for growth. In contrast to Germany, the rapid change in fiscal stance has less to do with prudent forward-looking policy and a sober look at debt dynamics. Instead, it has much more to do with expiration of the record spending spree that was responsible for so much of the growth we have seen in the last year. This should make for a very tepid economic environment in both countries as the year progresses. Both of the key drivers of recent economic activity, fiscal spending and the inventory cycle, will likely cease contributing positively to growth and may in fact become negative contributors to growth as we move into 2011.” 

We’ll have more to say on investment implications, etc. in the days and weeks ahead.  Even after the Crisis of 2008, we are shocked at how fast markets can turn south.  We began writing this piece a  couple days ago with the S&P trading near 1170.  We looked up briefly in the afternoon and it had dropped to 1065 intraday.  While a short term relief rally is likely, it is equally probable that those intraday lows are broken.  Be careful out there!  We are hearing that markets are beginning to freeze up again as banks are afraid to lend to other banks because they question their exposure to the PIIGS.  Both BNP and Soc Gen mentioned this on recent earnings calls.  As did the FT in an article, Counterparty risk returns to haunt financials.  Lehman 2.0 anyone?