The End of the Line: Eurozone Crisis Hits Tipping Point
By Liz Ann Sonders & Michelle Gibley
September 12, 2011
The inevitability of the eurozone crisis was foreshadowed by the late, great economist Milton Friedman. At the time of the euro’s debut in early 1999, Friedman expressed concern that it would not survive the first major European economic recession or crisis. Prescient thinking.
The primary motivation for the creation of the euro was less economic than political. The goal was an integrated Europe that could more effectively compete with (and/or rival) the United States. The hope was that a single currency would also force economic restructuring in the more-wayward peripheral countries, requiring them to abide by the Maastricht Treaty rules that govern member countries’ budget policies.
Things didn’t work out as planned. Blatant disregard for budget policies among the “PIIGS” nations (Portugal, Ireland, Italy, Greece and Spain) brought on wage and price inflation greatly exceeding the eurozone average. In addition to the resultant diminished competitiveness of these peripheral members was the effect of burgeoning budget deficits as a percentage of their gross domestic products (GDP).
Fast-forward to today, and there’s legitimate risk that these countries don’t have the wherewithal to honor their debt obligations. The major problem is that European leaders don’t appear (at least publicly) to understand either the gravity of the crisis or the impact that confidence has on the financial system. The very recent decision by Germany to begin contingency planning and shore up its banking system suggests perhaps they are just getting to this point of awareness.
Not contained to Europe …
The pressures emanating from the overhang of government debt in the eurozone continue to negatively impact trading in Europe, but why have US stocks also been taking their cues from the eurozone? Why does Greece matter so much?
Because the crisis is about more than just Greece. The problems in the eurozone are more about the health of the banking system in Europe, the long-term viability of the euro, Europe’s contribution to global growth and the indirect impact on the US dollar.
… but Greece is unique in severity
Greece’s deficit and debt levels (15% and 140% of GDP, respectively), lack of economic growth and commitment to austerity put it in a class of its own, and Greece is the most likely member to default on its debt. Greece’s quarterly review for funding conducted by the troika of the International Monetary Fund, European Commission and the European Central Bank (ECB) broke down in early September. The breakdown was due to lack of progress on achieving fiscal targets, implementing structural reforms, selling off public assets (privatization) and a public debt-swap plan rumored to be short of the 90% participation goal.
In an illustration of Greece’s struggle, the ability for Greece to generate the revenues targeted under the bailout is severely hampered: the economy contracted 7.3% in the second quarter and Greek officials have confirmed that they have cash for only a few more weeks. If this sounds familiar, it is: Greece was in the same position in mid-July of this year when cash was running low because the deficit was higher than expected.
This was partly due to lack of progress on austerity and reforms, leading to the second Greek bailout to cover higher-than-expected cash needs. Since then, yields on Greek two-year debt have skyrocketed relative to the other peripheral nations.
Greek Two-Year Bond Yields Go Parabolic
Source: FactSet, as of September 9, 2011.
So is forcing more austerity on a country already suffering from a lack of economic growth the solution, or will this just exacerbate the problem? It’s clear to most observers that this is an unsustainable situation, with a restructuring of debt obligations ultimately needed.
Contagion from Greece is infecting the European banking system
Policymakers have been hoping to postpone a Greek debt restructuring until growth recovers, reforms have been put in place and banks have had a chance to better capitalize to cover potential losses. However, the lack of agreement and ability to act in a coordinated way by eurozone policymakers has allowed a crisis of confidence to develop, resulting in contagion to other countries and a banking-system infection. As a result, banks are less willing to lend to each other, as highlighted in the chart below by the widening in the three-month Euribor/EONIA spread, indicating a growing credit crunch.
European Bank Stress Up, But Below 2008
Source: FactSet, as of September 9, 2011. Europe Bank Stress=three-month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate.
There’s a question of which came first, the chicken or the egg here, but the interaction between banks and governments appears to be reinforcing this negative feedback loop. Reasons include:
- Banks have large holdings of sovereign debt which they may need to write down.
- Governments tend to be the backstop for banks.
- Yields on government debt are often the basis for loan rates.
- Banks themselves can have funding issues if they’re using government debt as collateral for loans.
As a result, we believe European banks need more capital. Reasons include:
- Eurozone banks have low levels of capital. European banks remain highly leveraged, not having recapitalized or deleveraged to the same degree as those in the United States. According to Michael Cembalest, head of JP Morgan’s private bank, European banking-sector liabilities are three-to-four times the size of European GDP, versus the one-to-one ratio in the United States.
- It’s likely that sovereign debt (Greek in particular) will have to be written down further at many banks. While the proposed second bailout for Greece forced a 21% write-down of some Greek debt, markets are pricing in more than a 50% discount, in line with the haircut many believe is sustainable for Greece to support.
- There’s a need to bolster confidence that banks can absorb losses. Banks’ overreliance on short-term funding has exacerbated uncertainty and volatility, and investors need comfort before providing capital.
- Banks must have the strength to lend—the lifeblood of economic growth.
Why not let Greece default and stop the contagion?
Some believe that separating Greece’s solvency issues from liquidity issues elsewhere by drawing a line in the sand and recognizing that Greece needs restructuring may ultimately be a positive action. While this could be destabilizing in the near term, it’s possible that by sizing asset values and removing uncertainty, markets could form a base from which to build.
The problem for markets is that we just don’t know the broader implications of a Greek default on European banks or contagion to the other PIIGS. Banks across the eurozone own Greek debt, and Greece is only one of the three countries currently under bailout (Portugal and Ireland being the others), while the debt of the other two PIIGS (Spain and Italy) is currently being propped up by ECB purchases. An immediate default without a longer-term plan to “ringfence” banks and other sovereigns (like Italy) would be quite risky.
The question is whether the value of the debt of these other countries will also be marked down and whether Portugal and Ireland will decide to either default or ask for new conditions. Lastly, the lack of transparency in the credit default swaps (CDS) market means we don’t know where all the liabilities exist.
Ultimately, it’s unknown how much additional capital eurozone banks would require if contagion spreads, but it’s believed that even including CDS exposures, US banks would feel little impact. The chart below shows the direct exposure of US banks to PIIGS’ sovereign debt, relative to the European banks.
US Exposure to PIIGS Limited
Source: BCA Research and Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.). Debt as of December 31, 2010, and includes public and private. GDP as of June 30, 2011, and expressed in nominal terms.
US banks’ capital ratios are about double those of the average European bank. In addition, many banks claim that their “net” (including CDS) exposure is limited. But as we learned through the Lehman Brothers debacle in 2008, if you have “insurance” via CDS, but the party on the other side (AIG at the time of the Lehman failure) can’t pay the claim, a can of worms is opened. (You can see a chart of Greece’s CDS further below.)
Meanwhile, the ECB’s ability to purchase debt, which has helped ease pressure in Spain and Italy, is limited by its need to sterilize (offset) injections of money into the financial system with withdrawals of liquidity elsewhere. Discouragingly, even the ability of the ECB to stabilize the situation has been hampered.
Greek default may force decision between euro breakup or fiscal union
A potentially bigger-picture implication of a Greek default is whether it would come in conjunction with a decision to leave the euro, either voluntarily or involuntary. In the near term, Greece leaving the euro and returning to the drachma could result in debt defaults for businesses and households, require banking system recapitalization and disrupt international trade. There would need to be strong coordinated action in the eurozone to stabilize the situation and keep things orderly—something that’s been lacking thus far in the crisis. This may ultimately require coordinated global central-bank intervention.
Any country opting (or forced) to leave the euro would find the process a lengthy one. An exiting country would have to negotiate with the entire European Union (EU), not just the eurozone authorities. All treaties and legislation governing the euro are EU treaties. In fact, several of the 27 countries encompassing the EU require referenda to be held on changes to treaties.
On the other side, a full eurozone fiscal union may be desired but politicians must convince their citizens of the advantages. Additionally, many new laws and treaties would be required—which would not be an easy or quick process. To date, more-austere nations have been unwilling to consider measures toward fiscal union (such as issuing common eurobond debt) until bailout nations make more progress on austerity and reform.
One outcome of the German court decision this week (that ruled the European Financial Stability Facility constitutional) is that it rules out open-ended, longer-term fiscal responsibility for other nations, thwarting the possibility of eurobonds. The flaw exposed during this crisis is that a currency and monetary union without fiscal union may not be sustainable.
Greek CDS surge
The choice will be between kicking the can down the road again or removing the band-aids and taking the short-term pain. Over the weekend, Greek officials indicated further measures to close the deficit gap for this year and renewed their commitment to meeting obligations rather than default. Additionally, despite continued resistance to assist in bailouts and strong language that austerity and reforms agreed to must be adhered to, the German finance minster has rejected speculation of a Greek default. Markets remain unconvinced, as the CDS market is indicating a 92% probability of a Greek default.
Greek CDS Go Parabolic
Source: Bloomberg and FactSet, as of September 9, 2011.
It’s also important to note that both Italy and France five-year CDS have increased sharply, indicating that contagion has begun. We don’t know when a Greek default will happen, and it is possible the can will be kicked down the road again before a restructuring ultimately occurs. Additionally, while the current negative sentiment may end up presenting the possibility of a short-term bounce for stocks, we await better visibility on a resolution to the eurozone crisis before changing our cautious outlook on the eurozone.
Whether we’re heading on a path to repeating the 2008 crisis is a question we often receive. There are many indications that the global banking system is in far better shape today than it was back then and that the crisis is likely to be relatively contained to the eurozone. But we don’t take pictures like the one below lightly either.
Foreign Banks Shovel Money to Fed
Source: FactSet and Federal Reserve Bank of St. Louis, as of September 9, 2011.
Foreign official and international accounts have deposited nearly $103 billion at the US Federal Reserve, up from less than $58 billion at the beginning of 2011 and well above the prior crisis high of less than $89 billion in January 2009. This indicates a loss of trust in the European banking system.
Lars Tranberg from Danske Bank said European banks have been reduced to borrowing dollar funds for “a week at a time,” as opposed to the typical six-to-12 months. “This closely resembles what happened in late 2008, though the difference this time is that the major central banks have dollar swap lines in place. If the dollar funding market completely freezes up, the ECB can act as a backstop.”
Growth under attack in the eurozone, pressuring the global economy
The eurozone is an important part of the global economy, as it accounts for nearly 20% of global GDP. While the eurozone has not recently been a big driver of growth, a breakdown in economic growth or the banking system would be felt globally. With growth already slowing globally, a recession in Europe would hurt. While we think a recession in several European countries is very likely, we believe a broader global recession akin to that experienced in 2008 can be avoided.
As a result of falling confidence in the longer-term viability of the euro and the potential that the ECB may need to pursue its version of quantitative easing by making unsterilized purchases of either sovereign or bank debt, the value of the euro has fallen. There’s also pressure (rightly so) on the ECB to lower short-term interest rates.
This has resulted in a corresponding increase in the US dollar, as you can see in the chart below. History is mixed as to whether a stronger dollar (which we expect) would necessarily be negative for the stock market. Recently, the two have moved inversely, but over long-term history, a stronger dollar has more often been met with a stronger stock market. Regardless, a stronger dollar would mean weaker profits for multi-national companies, but less inflation.
US Dollar Breaks Out on Upside
Source: FactSet, as of September 9, 2011.
The situation in the eurozone remains fluid, with key events still ahead, including final approval of the new Italian austerity package, French banks bracing for a potential downgrade by Moody’s and the European Commission pushing for a global agreement on a potential financial transaction tax later this month.
Importantly, the second Greek bailout and expanded European Financial Stability Facility has yet to be ratified by the parliaments of all 17 nations that comprise the euro, which is expected to occur in September and October. Additionally, Finland’s demand for a collateral guarantee in exchange for its bailout contribution is expected to be resolved in mid-September.
What’s an investor to do?
This all begs the question about how an investor should be thinking about portfolio positioning. From a stock perspective, we continue to think that the US market will remain a decent relative performer (though not necessarily a decent absolute performer). In fact, on a year-to-date basis, the US stock market is ranked seventh among the 33 largest stock markets globally. And we know readers will be shocked, just shocked, that Greece’s stock-market performance is dead last.
While we’ve been negative on Europe, we don’t believe in completely avoiding the continent, but instead supplementing diversified European exposure with an allocation to Switzerland’s defensive market. Elsewhere, we’re favorably disposed to Japan, where we believe there’s an improving environment in which companies can operate more competitively globally. In combination with low expectations and declines in valuations, it could bring about the long-awaited revival of Japanese stocks.
Lastly, we believe the global economic slowdown and strength in the dollar may provide emerging markets with inflation relief. That would enable a pause in monetary tightening to the potential benefit of stock-market performance, once the uncertainty and high correlations (degree to which asset classes move in tandem) eases.
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All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
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