Europe is Running out of Time
04/30/10
One of the lessons to be learned from the unfolding Greek tragedy is that corporations can be bailed out if there is enough money willing and able to step in. Negotiations take place between debtors, shareholders, employees, vendors and other claimants. The process may take weeks months or years depending on the complexity of the situation - until a settlement is reached. While this is a complicated process, it is in the end possible. Bailouts of entire nations on the other hand may not even be achievable if there is enough money willing and able to step in. That is the current situation in Europe. Even though today, Greece accepted a harsh three-year austerity program in return for a multi-billion euro loan from the European Union and International Monetary Fund, a "Bailout" it is not. On the contrary, the loan aimed at averting a sovereign default, is highly deflationary and may still not save Greece from itself. The markets had forced the issue all year long. Just on Tuesday, Credit Rating Agency Standard & Poors had downgraded Greece by three notches (and Portugal by two) - a significant vote of no confidence by the financial world - bringing Greece's bonds to "junk status" and thereby preventing many institutions to participate in future Greek bond offerings. As a sign of markets' lack of confidence in Athens' ability to pull out of the crisis, Greek credit default swaps - essentially tradable insurance policies that protect the buyer against default on government debt - catapulted to new highs, with only the financial basket-cases of Venezuela and Argentina trading higher (and not by much). Stratfor described it best when they said: "In other words, insuring oneself against a Greek default is kind of like buying car insurance for a blind, alcoholic, 19-year-old male who drives a red sports car." The financial markets have already figured out that bailing out Greece is impossible and that loan packages are just not sufficient to address the structural imbalances of the Greek economy. Throwing money at the problem might have worked at one point earlier in this crisis. But now, after months of hesitation and empty promises, it has instead morphed into justifiable doubts with regard to the institutional framework behind the entire euro zone. If European officials cannot get their act together to aid a small member country such as Greece, what happens if Spain or Italy gets into trouble?
The above two charts show the yield difference between Greek, Portuguese, Italian and Spanish bonds to German bonds, which currently yield around 3%. Interestingly, 5-year Greek bonds yield about 13% versus 10-year bonds which yield about 10%. The chart below will show you that 2-year Greek notes yielded on Friday about 16%, which means that the shorter maturities pay more than the longer dated maturities. This "Yield curve inversion" is a clear sign that markets expect the inevitable default to come sooner rather than later. The real danger in the Greek sovereign debt crisis is that the eurozone's continued lack of urgency could precipitate a lack of investor confidence in other eurozone countries - especially "Club Med" countries like Portugal, Spain and Italy. The downgrade of Portugal in conjunction with Greece on Tuesday is an obvious sign of this scenario. At this point, it is no longer clear that even the joint eurozone-IMF "bailout" package will sufficiently reassure investors. Given the noise, uncertainty, domestic political concerns and eurozone constitutional issues, many investors may already have made up their minds as to where this debacle is ultimately headed. The current government is unlikely to survive this crisis and if the Europeans are not careful, the European Union may not survive this either. A bailout, you see, is usually done by governments to save private firms - as the U.S. government did in the wake of the Lehman Brothers collapse in September 2008. Similarly, when the public sector is faltering, private sector activity can support the public sector. However, as the brewing sovereign debt issues in Greece and Europe were preceded by a substantial European banking crisis (a private sector failure), it's unclear whether the private sector can pull the public sector through this difficult period. Who then is going to bail out the governments in Europe? We will find out this week. While the markets have already reacted to the Greek situation, they have yet to fully express their view about the next weakest links in the European chain. Portugal, Spain and Italy are next. The markets are already discounting the likelihood of future defaults of those government bonds, also. Take a look at the 2 year bonds and of the credit default swaps in the following charts.
Europe's banking problems preceded the U.S. subprime mortgage crisis. We highlighted the property bubbles throughout Europe in our Newsletter dated December 31, 2008. Read it. In hindsight, it looks more prophetic than I ever could have intended. I said then:
"What I am trying to say is that the Euro currency is in greater danger to disappear by 2014 than the US Dollar is to be overtaken by the Euro. Don't kid yourself. Europe is the one with the structural problems. The Euro was good for investment purposes while the going was easy. Now that times are getting tough it will become more and more difficult to keep the weak countries from financing their bailout and stimulus packages on the back of other EU members. The Euro is only as strong as the political will and financial stability of the sum of its member countries. Italy and Greece will be tested severely soon. All countries with overvalued real estate markets will come next. Their banking systems are in grave danger of collapsing. I hope that Europe will be able to manage the coming crisis. I wish to see the 20th anniversary of the Euro, too. The greatest peaceful experiment among nations deserves to last longer than 10 years. Unfortunately, there are not many reasons to be optimistic."
Let me finish my newsletter by quoting Stratfor one more time:
"For Europe the fundamental issue is that the financial and non-financial sectors are even more intertwined than in the United States. Unlike the United States, where firms raise a substantial amount of their capital through the stock and bond markets, European economies are heavily reliant on financing by banks; Banks in many countries, including Greece, supply up to 90 percent of corporate financing. The fact that European banks take such a leading role in financing their respective economies reflects the tight political ties in the financial industry, which is a consequence of the European tendency to view the economy as a state-building enterprise rather than a free-market one."
The Greek "rescue package" is not going to fool the markets. US stocks and bonds will continue to be the safe haven for many European investors. Let us continue to buy on any significant weakness.
Hermann Vohs
"Love thy neighbor as thyself, but choose your neighborhood."
Louise Beal
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
