Many readers are familiar with the adage, “Little children, little problems; big children, big problems.”. As with children, so with insolvent countries.
It’s been my feeling that too much financial media attention has been focused on today’s Greek elections. I believe that Germany has already indicated that whatever government may be formed, Greece will have a 100-day grace period before any financial sword of Damocles falls upon it. Meanwhile, much of the media has wrongly equated a Syriza win with a euro exit, though Syriza has indicated that it wants Greece to stay in the euro-zone, but with more aid granted to Greece from the creditor nations. Greece will try to get a better deal if possible, and to me, that’s all that we should say about it for now.
Spain is the current big fish that is truly floundering. Egan-Jones has lowered the Kingdom of Spain’s credit rating in three rapid steps from BBB on April to CCC+ last week. Italy was recently downgraded by the same rating agency on June 1 to a mere B+.
Last year on July 18, Egan-Jones lowered the rating of the United States. The stock market actually rallied a bit right after that, having declined into that date, but anyone who sold on that news had the opportunity to buy the S&P 500 about 15% cheaper a mere three weeks later. What happened in the intervening period? Standard & Poors followed suit with its (in)famous U.S. credit downgrade.
Egan-Jones has been ahead of the curve in Europe. Greece at its best was a tiny economic entity. It is already fully recognized by all market participants as being insolvent. If I were going to focus on a little country’s debt problems now, I would rather re-learn about Ireland, which may also be looking troubled once again despite all the work that went into its “bailout”. But mostly I’m thinking ‘Spitaly’.
In my investing, I am not trading based on rhetoric about central bank action: economies work due to the day-to-day actions of market participants, not due to marginal changes in interest rates. The ECB’s policy rate is a tiny 1%, after all. Remember please that the Federal Reserve first cut interest rates in August before the meltdown. Further remember that this emergency rate cut was in August 2007. The Fed cut, cut some more, etc. It brokered a Bear Stearns bailout months later. No matter. Fannie and Freddie were insolvent. Once their insolvencies occurred, the extend-and-pretend hopefulness of those who looked after financial institutions’ balance sheets saw that impairments of them, various forms of CDOs, etc., had to be recognized, and the rout was on. In September, 2008. Thirteen months after the Fed cheered market participants with its first emergency action. When did the stock market bottom? March 2009. Nineteen months after the Fed first took said emergency action. Why did the stock market bottom? Because the recession (depression) bottomed (by NBER terms) a few months later. From the time the Fed began QE 1 and then instituted its zero interest rate policy (ZIRP) late in 2008, stocks endured yet another bear market, dropping massively from Dec. 31 2008 to the March bottom.
So, bidding up stocks because of headlines about central bankers doing what everyone of us fully expects them to do– accommodate, ease, print, etc., makes little sense. If however, Europe’s economies are near the bottom of the business cycle, well then– interest rates in Germany and the U.K. that lower rates will be meaningless, and interest rates in the troubled countries are already high enough to be attractive to value investors. Thus this post is a plea to remember the primacy of business cycles in stock market analysis.
If Spain is now truly a deep junk credit as Egan-Jones judges it to be, then the current almost-7% interest rate for long-term debt is far too low. One starts to talk about 30% interest rates with CCC+ credits. Italy at B+ is a junk credit per Egan-Jones as well. If they are correct, even with no further downgrade, Italy’s borrowing costs across the yield curve are also too low. Unlike lending to corporations, lending to sovereign countries is risky in that one has difficulty collecting if they want to default.
Spain and Italy actually becoming bankrupt states would be such huge calamities that I wonder why these possibilities are not getting more press.
What I want to see as an investor is not hopium about how the ECB and Fed, etc., are going to magically turn insolvent to solvent. Political action involving massive transfers of resources or massive trading of Spanish/Italian assets for German/French/U.K. cash, etc., would be required for that. I can’t even begin to imagine the cycles of risk on/risk off headlines if that process gets underway.
In economic down-cycles such as most of Europe is enduring now, Uncle Warren Buffett is correct- one finds out who’s swimming naked. Spain is thrashing around and Italy’s looking troubled. Given that Germany, France and the U.K. are dealing with their own slowdowns or recessions, they are neither generating excess capital nor feeling optimistic enough to extend a strong helping hand of financial goodies to their southern friends whose wages the past decade went up faster than their own. Will there be a “Lehman moment” out of Europe? Will matters come close to that? Of course, I really have no idea, but my general sense is simply that there is insufficient evidence that the economic cycle in Europe is bottoming to want to try to catch this falling economic knife– especially Monday, when as of now it looks as though the initial posture will be a continuation of last week’s “risk on” stance.
Thus it continues to make sense to me to both be cautious on a global macro basis (meaning cash reserves “work” now) and to continue a ‘Fortress America’ investing strategy. Electricity will continue to power my Internet if Spain and even Italy need to restructure their debts. Electric utility stocks continue to pay investors up to nearly 5% for ‘A’-rated companies. While the dividends are not guaranteed, these are operating companies and over time they have the advantage over bonds that their sales and dividends gradually move up with the general price level. Thus, with this strategy I do not have to speculate as to what is going to happen next in Europe, or how whatever is happening is being “spun” in the media.
One does not need to conjure up a re-run of 2008, when the U.S. stock market dropped about 30% in one amazing week, to wonder why last summer we saw so much angst, with long runs of the VIX at 40 and above, when all that was really going on then was recession fears, whereas now we see a VIX close to 20 when more and more of the larger and larger sovereigns bulwarks of “Old Europe” are teetering on the brink of a once-unthinkable state of national governmental insolvency. Thus we have moved, factually and historically speaking, far down the wrong road from last summer. This general observation that last year’s panic may be more appropriate now, not expectations that 2012 will be a copy of the disaster of 2008, is one of the factors that troubles me about today’s markets.
Faith in the power of central bankers often is promoted by the media at just the wrong time for investors.