In Warren Buffett’s 1993 letter to Berkshire’s shareholders he discussed the financial impact of Hurricane Andrew, which had caused the largest insured loss in history (later surpassed by Hurricane Katrina in 2005). As Buffett noted, Andrew destroyed a few insurers who discovered the hard way that “It’s only when the tide goes out that you learn who’s been swimming naked.”
During recent weeks a financial gale has been blowing through Europe, pounding home a similarly painful lesson for Portugal, Ireland, Italy, Greece and Spain (the PIIGS). A key issue facing investors is whether the gale force winds will soon dissipate, so that Europe’s travails end up constituting nothing more than a mild headwind for the global recovery, or will they gain speed, morphing into hurricane force winds, so that the PIIGS’s predicament becomes Europe’s sub-prime crisis.
Like America’s highly leveraged homeowners, the PIIGS enjoyed years of swimming in easy money during the global credit boom. However, with the onset of the global financial crisis, government revenues plunged (particularly from highly cyclical sectors like shipping, tourism and construction), budget deficits soared, and public debt levels quickly became untenable. To make matters worse, wages and prices rose much faster than in core Europe so that, over the last decade, unit labour costs in the PIIGS rose by 27% relative to Germany. This collapse in competitiveness has made it all but impossible to generate the private sector surpluses necessary to atone for rising public debt levels.
As a result, Euro membership, which for the better part of a decade had seemed to confer enormous benefits, suddenly and acutely turned into a trap. As Paul Krugman has pointed out, without their own currencies to devalue, the only way to reduce relative costs is through falling domestic wages and prices. Regrettably, deflation is always and everywhere a deeply painful process, that aggravates rather than solves debt problems (witness Japan’s quagmire). Consequently, Ken Rogoff of Harvard University believes that “we are likely to see a wave of defaults”, stressing that this is what typically occurs within a couple years of a major financial crisis.
There are two key points regarding the €110 billion EU-ECB-IMF plan announced on May 2. First, the primary motivation was not to rescue Greece per se, but to prevent contagion to the other PIIGS (think of Bear Stearns and Lehman in 2008) and to protect French and German banks from disorderly sovereign defaults that could threaten their own solvency. According to the FT’s Martin Wolf the plan was, “overtly a rescue of Greece, but covertly a bailout of banks”. Regardless, German Chancellor Angela Merkel has made it clear that banks do need to share the pain (with Greek citizens and European taxpayers), although her strong preference is for an “orderly sovereign default” (e.g., swapping for longer maturity bonds).
Second, as Martin Feldstein and others have emphasized, a restructuring of Greek debt seems inevitable, implying that all the May 2 plan accomplished was to “kick the can down the road.” That is, the plan has bought time so that the PIIGS can implement credible plans to dramatically reduce their primary structural deficits, and so that banks can strengthen their capital positions in advance of impending significant write-downs. It also seems inescapable that this crisis will claim other victims (Portugal, Ireland and Spain are already in the cross-hairs), which will result in additional EU-ECB-IMF plans and further sizable write-downs by European banks.
What are the implications for investors? Europe’s policy focus on the imperative of fiscal restraint implies a weak growth outlook, characterized by sizable output gaps, low inflation, and loose monetary policy for the foreseeable future. Consequently, a weaker Euro seems probable, especially given that, while down significantly from its 2009 highs, the currency remains well above its long-term mean. European equities face a challenging outlook, with export-oriented sectors outperforming financials, and the DAX stronger than other European markets. Within fixed income, Bunds should hold up well, although peripheral sovereigns and credit instruments across the board face severe headwinds.
What are the implications for Asian policy makers? On April 29 Mark Carney, Governor of the Bank of Canada, affirmed that the debt situation is the largest risk “to securing the global recovery.” Most Asian central bankers concur, concluding that the PIIGS crisis has provided them with a temporary amnesty from policy tightening. This is true even though inflation risks are rising, interest rates are far too low relative to fundamentals (particularly in China, Indonesia, Korea, Malaysia and Thailand), and almost all Asian currencies are trading leagues below equilibrium levels (especially the RMB, KRW, TWD, MYR and SGD). This underscores the need for Asian policy makers to tighten aggressively once the PIIGS crisis has passed.
Truly decisive and transparent action is necessary to rectify Europe’s predicament. Unfortunately, this appears unlikely in the short-term as sharp divisions persist within the EC and the ECB remains in “No-Crisis Mode”, with several influential policy makers, notably the Bundesbank’s Axel Weber (inexplicably favoured to be the next ECB president), arguing strongly against additional ECB measures (such as buying government bonds).
Speaking in DC on May 5, former Bear Stearns CEO Jimmy Cayne said that by taking on too much debt Bear had become a big fat goose, waiting to be eaten by its enemies. Unless European authorities soon surprise markets by acting aggressively and proactively, the PIIGS may well face a similar fate.
Kevin Hebner is macro strategist at Third Wave Global Advisors, based in Greenwich, Connecticut
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