The recent month of February was quite interesting for U.S. stocks, because while the Dow Jones Industrial Average rose 2.6%, it didn't exactly take a direct route to those gains: There were eight separate triple-digit moves in the Dow, both up and down.
At the root of that volatility were political and economic developments that challenged the rationale for the huge rally out of the March 2009 low. Bulls were basically rethinking their beliefs that the home-price plunge had abated, employment was on the verge of a big turnaround, governments could cut taxes and boost spending without end, and that interest rates would remain at zero for years.
I had prepared subscribers for much of this turmoil. Back in early November, I highlighted signs of trouble in the market for government debt well before the troubles in Dubai and Greece came to a head. In December, we started a dialogue on what to expect as the U.S. Federal Reserve withdrew liquidity from the economy and lifted interest rates. The upshot was a series of letters detailing why you should expect the first nine months of the year to trade flattish with a lot of volatility.
These two issues continue to simmer and dampen confidence. The Federal Reserve is normalizing its policy by phasing out emergency lending facilities created in the wake of the 2008 credit crisis. The next big move will be the end of its direct purchases of mortgages within the next few weeks. Long-term interest rates will likely rise as a result.
Stocks can still rise in that environment, but much more tepidly and selectively than last year.
The Greek Tragedy
Meanwhile, across the Atlantic, policymakers and bank chiefs have been scrambling to structure a public-private bailout for high-debt, high-deficit Greece and prevent a further loss of confidence in the solidarity of the Eurozone. The fear is if Greece goes down and defaults on its debts, it will be closely followed by Spain, Portugal, Ireland, and even the United Kingdom, which are all interconnected and struggling under their own massive debts.
There are two ways the sovereign debt crisis can pull down economic growth.
The first is related to government spending, which has so far dampened the effects of the global recession. No matter what politicians in places like Greece do, they will need to tighten spending. Either they enact austerity measures over citizens' objections by raising taxes and cutting spending to please the bond market, or their borrowing costs skyrocket and they have to cut spending to divert funds to pay interest.
The second concerns the banking sector. German banks own $520 billion worth of debt issued by the governments of Greece, Italy, Portugal, and Spain. French banks hold $73 billion worth of Greek debt. If such banks are forced to recognize losses on these assets in the case of default, it will be a repeat of the 2008 credit crisis – lending will cease, banks will need to be bailed out, and the economy will fall back into recession.
Any major losses will trigger mark-to-market rules: Marked-down loans will cause the value of the collateral to erode; organizations would have to put up more collateral, which would require more asset sales at discounts, which leads to more mark-to-market losses.
Surely you remember this vicious cycle? It was only a year ago.
Spendthrift consumers and overzealous real estate investment caused the first crisis. The second – if it occurs – will be caused by spendthrift politicians and the zealotry of public employee unions fighting cuts to benefits and wages that are desperately needed to balance government finances.
Greece sold $5 billion worth of bonds last week, but that was not the final test. In April, the country will need to roll over nearly $20 billion in debt so a solution will need to be found by then. The clock is ticking like a time bomb.
Now we have fresh worries about the health of the American consumer despite strong retail numbers. New data shows the turnaround in the job market has stalled while home prices look vulnerable to another slide. Mortgage applications for new purchases dropped to a 12-year low last week. While many Wall Street economists expected payrolls to be expanding by now, it seems that net job creation will be pushed back to April at the earliest.
So where does this all leave us?
The sovereign debt issue has the greatest potential to scuttle the entire economic recovery. The other issues are of secondary concern. The Fed has indicated that it intends to keep short-term rates low for a long time. Businesses continue to invest, and with productivity gains at record levels, managers will soon have no other choice but to hire. And finally, the housing rebound has been adversely affected by bad weather.
As for the sovereign debt troubles, like the 2007-2008 period, much depends on the outcome of political processes. My research, experience, and intuition suggest that Europe will find a solution, even if it's just a way to push the problem a little further out in time.
Greek leaders, despite huge and sometimes violent protests, are showing courage by proposing deep and painful measures to fix their country's finances. And while leaders in Germany and France will continue to put pressure on their weaker neighbors to ensure these hard choices are made, they are loath to do anything that would blow more holes in the balance sheets of their financial institutions.
Greece's ability to float $5 billion worth of bonds that were oversubscribed by three-times has been hailed as a great breakthrough for its debt crisis. Although, three things must be noted:
First, at a certain yield almost any bond issue will sell well. Demand is not the issue – it's the price that's paid to court that demand. In order to help close its budget deficit to 8.7% this year from 12.7% of GDP last year, Greece set its coupon at 6.25%. That's a big premium over a German 20-year bond yield of 3.8% or British 20-year yield of 4.5%. Considering that there's a virtual EU guarantee on the bonds at this point, no wonder it was oversubscribed.
Second, you have to wonder if Greece can stand the pressures that lie ahead. The country has another 20 billion euros ($27 billion) worth of debt maturing over the next three months, and austerity measures have brought massive protests from Greek citizens. Even if the austerity measures go through, the effect they will have on the nation's economy – cutting public sector wages and buying far fewer Greek goods – will be difficult to weather.
Third, credit bears in the hedge fund community that bought one-year credit default swaps on Greek debt in recent days have seen their profits evaporate. These are not very liquid instruments, so they're a lot harder to sell than they are to buy. As hedge funds try to cover what are essentially Greek bond shorts, they will be squeezed heavily. Expect this to: A) boost the euro, which as you know by now has the effect of also goosing commodity prices; and B) cause the credit bears to sting quite a bit, potentially forcing them to retreat for a while if the world equity markets move higher against their positions.
Greece will likely fade from the headlines for a while from the perspective of the global stock markets. Germany and France will balk at helping out, but they are bound by honor, precedence, and law to muddle through to a solution. This may force credit bears to cover, which would be a positive. But expect the problems to come back, possibly in a bigger way, later in the summer.
As a result, I expect the issue to drag on for a few months before Europe's leaders establish a systematic solution to deal with fiscal troubles within the Eurozone. This is like the piecemeal fashion in which the U.S. government supported the financial system in 2007 and 2008 before the establishment of the Troubled Asset Relief Program (TARP) helped deal with the problem in a holistic way. Once a rescue apparatus was put in place, confidence returned and the stock market climbed. I expect a similar result here.
News and Related Story Links:
- Money Morning:
Is Government Debt the Next Crisis to Strike?
- Money Morning:
Fed's Discount-Rate Increase Illustrates Exit-Strategy Challenges That Await the U.S. Central Bank
- Money Morning:
Greece Cutting Back to Court EU Favor