A Different Greece

According to Margaret Thatcher, former Prime Minister of Britain, “the trouble with socialism is that sooner or later you run out of other people’s money.” That seems to be the point of the current European debt crisis. For the peripheral nations of the Euro-Zone, Greece, Portugal, Ireland, that day has come and gone. They have run out of money. But for each, joining the Euro-Zone provided them one big shot at still more ‘other people’s money’. When the three nations joined the Euro they each were introduced to much lower interest rates than they could qualify for on their own merits. They also were introduced to a much deeper and more liquid market for Euro-denominated securities. This was magical for the new Euro countries and provided a big lift to their economies. The Irish became the Celtic Tiger, the Greeks experienced a rebirth of economic growth, and the Portuguese, well there isn’t much hope for the Portuguese under any circumstances.

The Greeks had recently overturned a military junta to return to democratic government. Their economy was in ruins. The Socialists who then lead Greece promised a new economy on the model of the French and German economies, a generous welfare state. Public spending went up partly to jumpstart the economy, partly to enhance the public promise of a better life. The public sector in the Greek economy expanded and the state absorbed or expanded into new sectors of the economy. Without cheap credit from Euro-Zone membership, Greece probably couldn’t have afforded to move that quickly.

Fast forward to 2008 and you’ll see a different Greece. The welfare state is well established. The public sector had absorbed nearly 40% of the economy. Public sector debt was roughly one times GDP and rising. The economy had never really recovered from the huge binge of public spending that accompanied the 2004 Centennial Olympic Games. The debt attached to those games was itself a decent slice of GDP.

The real trouble the Greeks faced after 2008 was that the Euro-Zone bond market started discriminating between borrowers like it never had before. For years, Greek government bonds had traded at rates not that dissimilar to German government bonds. Now, Greeks had to pay more, a lot more. By 2010, the Greeks were having trouble selling bonds even with fat spreads over German bunds. The weight of their debts started to hamper the ability of the Greek government to meet their obligations. They had really run out of ‘other people’s money’ to spend on their social programs.

The first crisis hit in March of 2010 for Greek bond holders. The Greeks didn’t think they could float enough bonds to refinance their maturing debt let alone borrow more funds to meet their annual spending needs. They were running a deficit of 9% of GDP (the US was at 10% but who’s counting) and that required additional financing. The International Monetary Fund, the World Bank and the European Central Bank got together and developed a plan to rescue the Greeks. It called for €110 billion to meet Greece’s deficit needs for three years and provided sufficient liquidity to refinance their maturing debt over that same period. The deal also called for Greece to cut spending, raise taxes and curtail benefits, like raising retirement ages for pensions. The Greek people responded by rioting.

Since the austerity program began, the Greek economy has gotten much worse. Growth is now negative and revenue goals have not been met. Also, spending hasn’t been cut sufficiently to meet the goals in the rescue plan. Regardless, the Greeks were cut another deal that was supposed to provide enough liquidity to keep them afloat. Also, current lenders to Greece, mostly European domiciled banks, have had to agree to maturity extensions on their debts, effectively lowering the value of the asset on the bank’s books, a haircut.

This latest deal has just been agreed to but it is already falling apart. As we have mentioned before many times, whatever happens to Greece is setting a precedent for what will follow in Portugal, Ireland and maybe Spain. Some folks have taken out their pencils and determined that the same deal can’t work in Spain. The banks cannot take the same haircut on their Spanish debt and get away with it. The Greeks owe some €300 billion-plus and between them, the Portuguese and Irish there is about €700 billion in debt. Spain is about twice that.

Europe cannot afford to have all these nations default, but especially cannot let Spain fall. The analogy is to dominoes again. Greece is but the first domino.

Issue of the Week

European banks are the other dominoes that fall if Greece is allowed to default. Because banks are allowed to not recognize market prices for assets they say will be held to maturity, they have not necessarily recognized the decline in price of their loans and security holdings in the PIIGS. As mentioned above, the PIGS (excepting Italy for the moment) have something on the order of €2 trillion in outstanding debt.

When a bank recognizes that a borrower can’t repay, they recognize a reduction in the value of the asset on their books and also a reduction in their capital. It is this capital destruction that is at the heart of the matter. When the US initiated the TARP program during the financial crisis in 2008, the initial idea was to buy assets from the banks to replenish their assets and liquidity. That quickly morphed into just buying preferred stock in the banks to directly inject capital into the institutions. The same idea will probably follow for the European banks once the borrowers start to fail. For most large banks, the ratio of capital to assets is usually about 10%, maybe a little more for some, less for others. By injecting capital into the bank, the central bank or monetary authority replenishes the capital destroyed when writing-down bad loans or investments.

Giving the banks more capital keeps the banks from failing along with their borrowers. The banks are the big dominoes in the equation. Each bank will have links to other banks through funding requirements or via cross-lending. So, when one big bank starts to topple, all the banks begin to wobble. A bank doesn’t necessarily have to hold lots of PIG debt to be impacted by PIG default risk. Having funding from a bank that holds the debt or one that is owned by a bank that holds a lot of this debt could still impact your operations and make it harder to function.

The main point of all the deliberations of central bankers is to protect the banks from the effects of default by the sovereign borrowers, not necessarily stop the sovereigns from defaulting. The same ethos exists today that came to exist during the financial panic in 2008, which is to prop up the dominoes to keep all of them from falling. They want to keep a default problem from turning into a liquidity problem like we had to 2008. So long as the central bankers keep that in mind, we will buy enough time to sort out the mess that the sovereign debt issue has become.

Economic News

Retail sales were unchanged in August according to the Commerce Department. Excluding auto sales, which tend to be volatile from month to month, sales grew 0.1%. However, if we also exclude gasoline sales we also had no growth in August sales. There may have been a small impact from Hurricane Irene in these numbers, as many sales at vacation spots on the Atlantic Seaboard were skipped because of the impending storm. We should see a pop in sales of building materials next month due to the same storm.

August producer prices were unchanged according to the Bureau of Labor Statistics. The core version of this index, which excludes food and fuel costs, was up by 0.1% in August. In the last 12 months, producer prices are 6.5% higher and the core rate is up 2.5%. Intermediate goods prices slipped 0.1% while raw materials prices rose 0.2%.

The Bureau of Labor Statistics says consumer prices rose by 0.4% in August. The core rate, which excludes food and fuel from the calculation, rose by only 0.2%. The headline rate over the last 12 months has risen 3.8%, the core rate is 2.0%. A large number of categories within the basket of goods measured in CPI rose on the month.

Industrial Production rose by 0.2% in August according to the Commerce Department. The gain was largely in manufacturing, though mining Output also increased. Utilities output also decreased. Capacity utilization rose to 77.4% (a gain of 0.1%) in the same report.

Consumer Sentiment rose in September according to a survey by the University of Michigan and Reuters, but then it couldn’t have gotten a lot worse even if it had tried. The brouhaha over the debt limit increase and all the political theatre surrounding that really miffed a lot of the public and that sentiment came through in last month’s numbers. This month even a hurricane bearing down on New York, major fires in Texas, weak economic numbers and fears of European debt problems weren’t enough to put people that much further into a funk. Way to go Congress and President Obama!

Weekly Stuff

One oddity of last week, at least from the point of view of the recent experience on Wall Street, was that the dollar was tame while stocks appreciated. Either the rules of the risk-on trade have changed, or someone forgot to tell the risk-off guys that stocks weren’t part of their package. For the last many months, a package of the dollar, Treasury bonds and gold have been the go to investments for people who wanted to lower their risk, the risk-off trade. Stocks, many foreign currencies and commodities were the investments made by investors who wanted to raise their risk exposure, the risk-on trade.

Having the dollar behave differently is kind of odd, but when you consider the alternatives to the dollar, the euro, yen, Swiss francs or a package of emerging market currencies, none of them look like they are about to take-off. With the risks to the euro exploding having increased, the yen and franc having appreciated, the dollar is back to being the currency of choice for just about everyone. Dollars actually fell a smidgen last week, but there wasn’t the all-out selling of the dollar like we’ve seen is other risk-on trades.

Stocks were broadly higher as risks have seemed to recede a little bit after having a couple of weeks of huge shifts, on an almost daily basis, in the outlook for the Euro and European banks. With lower risks come higher stock prices pretty much around the world. We have decried the whole idea of macro-investing, buying and selling whole markets and asset classes rather than focusing on individual security’s fundamentals. But we must say that when the macro goes in your favor, you mind a lot less.

The fundamentals of most stock markets are a lot better than recent market behavior would indicate. The question now is whether we’re going to get another buying panic, which is just as indiscriminant as the selling, or if we’re going to see some good, old fashioned bull market rally action. We’re not optimistic we’ll see anything but a rush into risk assets, the riskier the better.

Commodities saw declines across a wide swath of the complex. Precious metals were down, industrial metals were down, most ag commodities were down, the only things we noted as being higher were some energy components and feeder cattle.  So, gas was where you had to be?

Perhaps unsurprisingly, the bond market lost ground with the “risk-on” trade in equities (similar on/off pattern we’ve almost become used to).  Rates on the 10-Year Treasury rose from 1.92% to 2.08%.  With rates this low on a nominal level, such a small move has become much larger in percentage terms.

Have a great week.

Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.