David Rosenberg is out with some very fitting analogies of the current sovereign crisis. If he is proven prescient, which we have no doubt he will, the Greek near-default will have massive repercussions to the entire developed world when all is said and done."In my opinion, Greece is the same canary in the coal mine that Thailand was for emerging Asia in 1997, which ultimately led to the Russian debt default and demise of LTCM; the same canary in the coal mine that New Century Financial in early 2007 proved to be in terms of being a leading indicator for the likes of Bear Stearns and Lehman. So, the most dangerous thing to do now is to view Greece as a one-off crisis that will be contained." Furthermore, as he makes all too clear, if a $1 trillion bailout can only buy 400 points in teh Dow, Europe, aside from all the other fundamentals which confirm the same, is doomed, and even the ever-optimistic market now realizes it. Lastly, should Europe pursue the required austerity measures, the hit to European GDP will be massive, and is certainly not being priced in European stocks, but certainly not in US stocks, whose primary export market is about to disappear.
From today's Breakfast with Dave.
Well, I think the turbulent global events of the past few weeks underscore the reason why I have maintained a cautious investment approach for the past year, notwithstanding the massive recovery in risk assets we saw from the March 2009 lows, which from my lens bore a huge resemblance to the bungee jump in the market back in 1930. In fact, at one point two weeks ago, at the highs, the stock market had already achieved, in barely more than a year, what took five years to accomplish in the 2002 to 2007 bull market, and at least that market wasn’t being fuelled by unprecedented government intervention in the economy and incursion into the capital markets.
The dramatic government stimulus was global in nature, and this was the primary prop behind the rally in equities over the past year and change, and the message coming out of Greece, and not just Greece but many other governments in the European Union and across the globe, is that governments are probing the outer limits of their deficit finance capacities. History does indeed show that it is quite common to see sovereign default risks follow on the heels of a global banking crisis, which was the story for 2007 and 2008; it took a respite in 2009 and we are now in a new chapter of this prolonged debt deleveraging story. These cycles of balance sheet repair, alternating between the private and public sector, typically lasts 6 to 7 years. We are barely into year three, and what is extremely important in this roller coaster ride is to focus on capital preservation strategies that minimize the volatility in the portfolio, which is one reason why I have favoured long-short income and equity strategies.
In my opinion, Greece is the same canary in the coal mine that Thailand was for emerging Asia in 1997, which ultimately led to the Russian debt default and demise of LTCM; the same canary in the coal mine that New Century Financial in early 2007 proved to be in terms of being a leading indicator for the likes of Bear Stearns and Lehman. So, the most dangerous thing to do now is to view Greece as a one-off crisis that will be contained. Even with this new and aggressive EU-IMF financing arrangement that has managed to trigger a wild short covering rally yesterday, the risks are still high that the contagion spreads to countries like Portugal, Spain, Italy and even the U.K., which has already received some warnings from the major rating agencies and is gripped with political gridlock in the aftermath of last week’s uncertain election results.
The problem of there being far too much debt on balance sheets globally has not gone away and in many cases has become worse, and the ability to service these debts especially in countries that have weak economic structures like Greece, Portugal and Spain has become seriously impaired. It remains to be seen how Greece and the other problem countries in the euro area will manage to cut their deficits without, at the same time, controlling their monetary policy and their currency, which of course we were able to do here in Canada during the 1990s but with the help of a 30% currency devaluation.
Speaking of Canada, the downdraft in our market and our dollar shows once again that we can be doing everything right, and in terms of fiscal policy we still look good on a relative basis. However, being a small open economy sensitive to commodity prices, this is one of those times where sudden shifts in global economic sentiment can hit us disproportionately.
Even before this latest leg in the European financial crisis, China was already tightening monetary policy aggressively to lean against what appears to be a property bubble in various urban centers. One has to consider what the outlook is for the global economy in general, and near-term prospects for the resource sector in particular, when the Shanghai equity index is down more than 20% from the nearby highs; yet something else to add to the concern list.
Recall that we headed into this latest round of turmoil with the equity markets priced for a return to peak earnings as early as next year, bullish sentiment on the stock market and institutional investor cash ratios at levels we last saw in late 2007 when the market was just rolling off its highs, and measures of volatility at extremely low levels, the VIX index was a mere 15 as an example, a sign of widespread complacency. It is at times like that, when all the good news is priced in and then some, and the exact opposite of what was happening at the lows just over a year ago, that the markets are most susceptible to a pullback.
With the benefit of hindsight, it is clear that the time to start to wade into the risk asset pool was a year ago after a 60% plunge in equities. However, 80% later on the upside, it’s time to get more defensive and less cyclical with a keen eye towards taking advantage of this crisis if it presents opportunities in the equity market as the panic in the corporate bond market presented to us back in early 2009. I, for one, am looking forward to having my temptation level tested if this market heads back into undervalued or even fair-value terrain, which it only managed to achieve for a few months early last year.
While the coincident economic indicators, such as employment, have improved in recent months, many of the leading indicators have begun to roll over. In fact, these indicators are pointing towards a discernible slowing in economic and earnings growth in the second half of the year and into 2011 when we will see the stimulus shift to significant fiscal restraint in both Canada and the U.S., and the lagged impact of the Chinese policy tightening.
In addition, while the periphery of Europe received a financial lifeline package, the conditions for accessing the funds will require massive fiscal tightening and it will be interesting to see how countries like Spain, let alone Greece, can cut spending and raise taxes at a time when the unemployment rate is at a sky-high 20%. Remember, 20% of the global economy is going to be slowing down going forward, the question is by how much and this in turn will impact North American exports. On top of that, the equity and debt cost of capital, which had been on a declining path for much of the past year and has very supportive of risk appetite, is now going on the opposite path. This is not necessarily a double-dip recession scenario, but I would not rule it out.
What’s important from an investor standpoint is that the uncertainty surrounding the macro outlook is much wider now than it was before. Over the near term, there is still more downside but the main message is that one should be prepared to take advantage of the springtime selling by using cash and near-cash as part of a tactical asset allocation strategy because one of the best way to make money in this tumultuous environment is not to lose it, but to have it ready to put to use once things get really cheap.
At the same time, we are confronting a deflationary shock at a time when most measured rates of underlying inflation in most parts of the world, especially the U.S. are already extremely low, barely 1%, and in such an environment, having an income theme as a core component of the portfolio makes a whole lot of sense.
As for the GDP impact on Europe now that all the dirty laundry is out int he open, here is why it will get very ugly:
We did some in-depth analysis on how the economies of the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) countries (and the rest of Europe) would fare if deficit-to-GDP ratios were to revert back to the Maastricht criteria of 3%. The adjustment will be painful for Europe in general, slicing off about 1% GDP growth annually over the next three years, and very painful for the PIIGS specifically. If these countries’ fiscal ratios were return to 3%, Ireland would see four percentage points (ppts) shaved off nominal GDP annually over the next three years, Greece 3.5ppts, Spain 2.8ppts, Portugal 2.2ppts and 0.8ppt for Italy.
It would not be a picnic for the rest of Europe, where many countries were running deficits greater than 3% of GDP in 2009. We estimate that fiscal cuts will shave about 1.5ppts off France’s nominal growth, 1.0ppt for Belgium, and 0.8ppt for the Netherlands. Austria and Germany would only have to endure 0.2ppt and 0.1ppt lower GDP growth, respectively, to bring their ratios back in line with targets. Finland is the only country with a GDP deficit under 3% (using 2009 data). Note that the starting point for our analysis was 2009 — the adjustment could be more painful as deficit-to-GDP ratios look to have deteriorated further in 2010.
Lastly, it appears that even Rosie has had it with the unbearable hypocrisy of our "leaders."
Maybe it’s all about false pride. The need to counter-attack those who would dare to attack the Euro. How interesting was it to see the sharpness of the political rhetoric over the weekend from the European political elite. Please, fund our lifestyle, Mr. Market, but don’t hold us to our commitments:
“ ... a battle of the politicians against the markets. I am determined to win” (German Chancellor Angela Merkel).
“... unfounded off-the-wall suggestions and speculation” (EC President Jose Manuel Barroso).
“... confront speculators mercilessly ... know once and for all what lies in store for them” (French Present Nicolas Zarkozy).
It is a sad deflationary reality when a trillion dollars can only buy you 400 points on the Dow. What can the politicos do for an encore?