I am sure the Euro will oblige us to introduce a new set of economic policy
instruments. It is politically impossible to propose that now. But some day
there will be a crisis and new instruments will be created.”
- Romano
Prodi, EU Commission President, December 2001
Prodi and the other leaders who forged the
euro knew what they were doing. They knew a crisis would develop, as Milton
Friedman and many others had predicted. They accepted that as the price of
European unity. But now the payment is coming due, and it is far larger than
they probably thought.
This week we turn our eyes first to Europe
and then the US, and ask about the possibility of a yet another credit crisis
along the lines of late 2008. I then outline a few steps you might want to
consider now rather than waiting until the middle of a crisis. It is possible we
can avoid one but, as I admit, whether we do (and the extent of such a crisis)
depends on the political leaders of the developed world (the US, Europe, and
Japan) making the difficult choices and doing what is necessary. And in either
case, there are some areas of investing you clearly want to avoid. Finally, I
turn to that watering-hole favorite, the weather, and offer you a window into
the coming seasons. Can we catch a break here? There is a lot to cover, so we
will jump right in.
The
Consequences of Austerity
The markets are pricing in an almost 100%
certainty of a Greek default (OK, actually 91%), and the rumors in trading
circles of a default this weekend by Greece are rampant. Bloomberg (and everyone
else) reported that Germany is making contingency plans for the default. Of
course, Greece has issued three denials today that I can count. I am reminded of
that splendid quote from the British 80s sitcom, Yes, Prime Minister: Never believe anything until its
been officially denied.
Germany is assuming a 50% loss for their
banks and insurance companies. Sean Egan (head of very reliable bond-analyst
firm Egan-Jones) thinks the ultimate haircut will be closer to 90%. And that is
just for Greece. More on the contagion factor below.
The existence of a Plan B underscores
German concerns that Greeces failure to stick to budget-cutting targets
threatens European efforts to tame the debt crisis rattling the euro. German
lawmakers stepped up their criticism of Greece this week, threatening to
withhold aid unless it meets the terms of its austerity package, after an
international mission to Athens suspended its report on the countrys
progress.
Greece is on a knifes edge, German
Finance Minister Wolfgang Schaeuble told lawmakers at a closed-door meeting in
Berlin on Sept. 7, a report in parliaments bulletin showed yesterday. If the
government cant meet the aid terms, its up to Greece to figure out how to get
financing without the euro zones help, he later said in a speech to
parliament.
(There is an over/under betting pool in
Europe on whether Schaeuble remains as Finance Minister much longer after this
weekends G-7 meeting, given his clear disagreement with Merkel. I think I take
the under. Merkel is tough. Or maybe he decides to play nice. His press doesnt
make him sound like that type, though. They are playing high-level hardball in
Germany.)
Anyone reading my letter for the last
three years cannot be surprised that Greece will default. It is elementary
school arithmetic. The Greek debt-to-GDP is currently at 140%. It will be close
to 180% by years end (assuming someone gives them the money). The deficit is
north of 15%. They simply cannot afford to make the interest payments. True
market (not Eurozone-subsidized) interest rates on Greek short-term debt are
close to 100%, as I read the press. Their long-term debt simply cannot be
refinanced without Eurozone bailouts.
Was anyone surprised that the Greeks
announced a state fiscal deficit of 15.5 billion for the first six months of
2011, vs. 12.5 billion during the same period last year? What else would you
expect from increased austerity? If you reduce GDP by as much as Greece
attempted to do, OF COURSE you get less GDP and thus lower tax revenues. You
cant do it at 5% a year, as I have pointed out time and time again. These are
the consequences of allowing debt to get too high. It is the Endgame.
[Quick sidebar: If (when) the US goes into
recession, have you thought about what the result will be? A recession of course
means lower GDP, which will mean higher unemployment. That will increase costs
due to increased unemployment and other government aid, and of course lower
revenues as tax receipts (revenues) go down. Given the projections and path we
are currently on, that means even higher deficits than we have now. If Obama has
his plan enacted, and if we go into a recession, we will see record-level
deficits. Certainly over $1.5 trillion, and depending on the level of the
recession, we could scare $2 trillion. Think the Tea Party will like that?
Governments have less control than they think over these things. Ask Greece or
any other country in a debt crisis how well they predicted their budgets.]
The Greeks were off by over 25%. And they
are being asked to further cut their deficit by 4% or so every year for the next
3-4 years. That guarantees a full-blown depression. And it also means lower
revenues and higher deficits, even at the reduced budget levels, which means
they get further away from their goal, no matter how fast they run. They are now
in a debt death spiral. There is no way out, short of Europe simply bailing them
out for nothing, which is not likely.
Europe is going to deal with this Greek
crisis. The problem is that this is the beginning of a string of crises and not
the end. They do not appear, at least in public, to want to deal with the
systemic problem of too much debt in all the peripheral countries.
Without ECB support, the interest rates
that Italy and Spain would be paying would not be sustainable. I can see a path
for Italy (not a pretty one, but a path nonetheless) but Spain is more
difficult, given the weakness of its banks and massive private debt. These are
economies that matter.
How do they get out of this without a debt
crisis on the scale of 2008? By coming to grips with the problem. Germany is
apparently doing that this weekend, by preparing to use the money it was going
to pour into Greece to shore up its own banks. That is a much better plan. But
as a well-researched report (by Stephane Deo, Paul Donovan, and Larry Hathaway
in the London office – kudos, guys!) from UBS shows, solving the problem will be
very costly. The next few paragraphs are from their introduction.
Euro
Break-Up The Consequences
The
Euro should not exist (like this)
Under the current structure and with the
current membership, the Euro does not work. Either the current structure will
have to change, or the current membership will have to change.
Fiscal confederation, not break-up
Our base case with an overwhelming
probability is that the Euro moves slowly (and painfully) towards some kind of
fiscal integration. The risk case, of break-up, is considerably more costly and
close to zero probability. Countries cannot be expelled, but sovereign states
could choose to secede. However, popular discussion of the break-up option
considerably underestimates the consequences of such a move.
The
economic cost (part 1)
The cost of a weak country leaving the
Euro is significant. Consequences include sovereign default, corporate default,
collapse of the banking system and collapse of international trade. There is
little prospect of devaluation offering much assistance. We estimate that a weak
Euro country leaving the Euro would incur a cost of around 9,500 to 11,500 per
person in the exiting country during the first year. That cost would then
probably amount to 3,000 to 4,000 per person per year over subsequent years.
That equates to a range of 40% to 50% of GDP in the first year.
The
economic cost (part 2)
Were a stronger country such as Germany to
leave the Euro, the consequences would include corporate default,
recapitalization of the banking system and collapse of international trade. If
Germany were to leave, we believe the cost to be around 6,000 to 8,000 for
every German adult and child in the first year, and a range of 3,500 to 4,500
per person per year thereafter. That is the equivalent of 20% to 25% of GDP in
the first year. In comparison, the cost of bailing out Greece, Ireland and
Portugal entirely in the wake of the default of those countries would be a
little over 1,000 per person, in a single hit.
The
political cost
The economic cost is, in many ways, the
least of the concerns investors should have about a break-up. Fragmentation of
the Euro would incur political costs. Europes soft power influence
internationally would cease (as the concept of Europe as an integrated polity
becomes meaningless). It is also worth observing that almost no modern fiat
currency monetary unions have broken up without some form of authoritarian or
military government, or civil war.
Welcome to the Hotel California
Welcome to the Hotel California
Such a lovely place
Such a lovely face
They livin it up at the Hotel California
What a nice surprise, bring your alibis
Last thing I remember, I was running for
the door
I had to find the passage back to the place I was
beforeRelax, said the night man, We are programmed to
receive. You can check out any time you like, but you can
never leave!
- The Eagles, 1977
You can disagree with the UBS analysis in
various particulars, but what it shows is that there is no free lunch. It is not
a matter of pain or no pain, but of how much pain and how is it shared. And to
make it more difficult, breaking up may cost more than to stay and suffer, for
both weak and strong countries. There are no easy choices, no simple answers.
Like the Hotel California, you can check in but you cant leave! There are
simply no provisions for doing so, or even for expelling a member.
The costs of leaving for Greece would be
horrendous. But then so are the costs of staying. Choose wisely. Quoting again
from the UBS report:
the only way for a country to leave the
EMU in a legal manner is to negotiate an amendment of the treaty that creates an
opt-out clause. Having negotiated the right to exit, the Member State could
then, and only then, exercise its newly granted right. While this superficially
seems a viable exit process, there are in fact some major obstacles.
Negotiating an exit is likely to take an
extended period of time. Bear in mind the exiting country is not negotiating
with the Euro area, but with the entire European Union. All of the legislation
and treaties governing the Euro are European Union treaties (and, indeed, form
the constitution of the European Union). Several of the 27 countries that make
up the European Union require referenda to be held on treaty changes, and
several others may choose to hold a referendum. While enduring the protracted
process of negotiation, which may be vetoed by any single government or
electorate, the potential secessionist will experience most or all of the
problems we highlight in the next section (bank runs, sovereign default,
corporate default, and what may be euphemistically termed civil unrest).
Leaving abruptly would result in a lengthy
bank holiday and massive lawsuits and require the willingness to simply thumb
your nose in the face of any European court, as contracts of all sorts would
have to be voided. The Greek government would have to conveniently pass a law
that would require all Greek businesses to pay back euro contracts in the new
drachma, giving cover to their businesses, who simply could not find the euros
to repay. But then, what about business going forward?
Medical supplies? Food? the basics? You
have to find hard currencies for what you dont produce in the country. Greece
is not energy self-sufficient, importing more than 70% of its energy needs. They
have a massive trade deficit, which would almost disappear, as who outside of
Greece would want the new drachma? Banking? Parts for boats and business
equipment? The list goes on and on. Commerce would slump dramatically,
transportation would suffer, and unemployment would skyrocket.
If Germany were to leave, its export-driven
economy would be hit very hard. It is likely that the new mark would
appreciate in value, much like the Swiss Franc, making exports from Germany even
more costly. Not to mention potential trade barriers and the serious (and
probably lengthy) recession that many of their export and remaining Eurozone
trade partners would be thrown into. And German banks, which have loaned money
in euros, would have depreciating assets and would need massive government
support. (Just as they do now!)
Can a crisis be avoided? Yes. But that does
not mean there will be no pain. We can avoid a debt debacle in the US, but doing
so will mean reducing debt every year for 5-6 years in the teeth of a
slow-growth economy and high unemployment. It will require enormous political
will and mean many people will be unemployed longer and companies will be
lost.
Ray Dalio and his brilliant economics team
at Bridgewater have done a series of reports on a plan for Europe. Basically, it
involves deciding which institutions must be saved (and at what cost) and
letting the rest simply go their own way. If they are bankrupt, then so be it.
Use the capital of Europe to save the important institutions (not shareholders
or bondholders). Will they do it? Maybe.
The extraordinarily insightful and
brilliant John Hussman recently wrote on a similar theme. He is a must-read for
me. Quoting:
The global economy is at a crossroad that
demands a decision whom will our leaders defend? One choice is to defend
bondholders – existing owners of mismanaged banks, unserviceable peripheral
European debt, and lenders who misallocated capital by reaching for yield and
fees by making mortgage loans to anyone with a pulse. Defending bondholders will
require forced austerity in government spending of already depressed economies,
continued monetary distortions, and the use of public funds to recapitalize poor
stewards of capital. It will do nothing for job creation, foreclosure reduction,
or economic recovery.
The alternative is to defend the public by
focusing on the reduction of unserviceable debt burdens by restructuring
mortgages and peripheral sovereign debt, recognizing that most financial
institutions have more than enough shareholder capital and debt to their ownbondholders to absorb losses without
hurting customers or counterparties but also recognizing that properly
restructuring debt will wipe out many existing holders of mismanaged financials
and will require a transfer of ownership and recapitalization by better
stewards. That alternative also requires fiscal policy that couples the
willingness to accept larger deficits in the near term with significant changes
in the trajectory of long-term spending.
In game theory, there is a concept known
as Nash equilibrium (following the work of John Nash). The key feature is that
the strategy of each player is optimal, given the strategy chosen by the other
players. For example, I drive on the right / you drive on the right is a Nash
equilibrium, and so is I drive on the left / you drive on the left. Other
choices are fatal.
Presently, the global economy is in a
low-level Nash equilibrium where consumers are reluctant to spend because
corporations are reluctant to hire; while corporations are reluctant to hire
because consumers are reluctant to spend. Unfortunately, simply offering
consumers some tax relief, or trying to create hiring incentives in a vacuum,
will not change this equilibrium because it does not address the underlying
problem. Consumers are reluctant to spend because they continue to be
overburdened by debt, with a significant proportion of mortgages underwater,
fiscal policy that leans toward austerity, and monetary policy that distorts
financial markets in a way that encourages further misallocation of capital
while at the same time starving savers of any interest earnings at all.
We cannot simply shift to a high-level
equilibrium (consumers spend because employers hire, employers hire because
consumers spend) until the balance sheet problem is addressed. This requires
debt restructuring and mortgage restructuring. While there are certainly
strategies (such as property appreciation rights) that can coordinate
restructuring without public subsidies, large-scale restructuring will not be
painless, and may result in market turbulence and self-serving cries from the
financial sector about global financial meltdown. But keep in mind that the
global equity markets can lose $4-8 trillion of market value during a normal bear market. To
believe that bondholders simply cannot be allowed to sustain losses is an
absurdity. Debt restructuring is the best remaining option to treat a spreading
cancer. Other choices are fatal.
You think the worlds central banks and
main institutions are not worried? They are pulling back from bank debt in
Europe, as are US money-market funds. (Note: I would check and see what your
money-market funds are holding how much European bank debt and to whom? While
they are reportedly reducing their exposure, there is some $1.2 trillion still
in euro-area institutions that have PIIGS exposure.)
Look at the following graph from the St.
Louis Fed. It is the amount of deposits at the US Fed from foreign official and
international accounts, at rates that are next to nothing. It is higher now than
in 2008. What do they know that you dont?
The
Slow March to Recession in the US
Until there is a real crisis in Europe, the
US will continue on its path of slower growth. Economists who base their
projections on past history will not see this coming. Analysts who base their
earnings estimates on recent performance are going to miss it (again.) Note:
analysts, as I have written numerous times in this letter, are so very, very bad
as a group at predicting future earnings that I am amazed people pay attention
to them; but they seemingly do. They consistently miss tops and bottoms. That is
the one thing they are very good at.
John Hussman, in the same report, offers
the chart below, which is a variant on themes I have highlighted in past issues,
but with his own personal twist. It is a combination of four Fed indices and
four ISM reports. And it has been reliable as a predictor of recessions – one of
which it strongly suggests we are either in or heading into.
And recent revisions to economic data
suggest that companies are going to have even more trouble making those
powerhouse earnings that are being estimated. As Albert Edwards of Societe
Generale reports this week:
at the start of 2011, productivity
trends took a remarkable turn for the worse especially compared to what was
initially reported. An initial estimate that Q1 productivity grew by 1.8% was
transformed to show a decline of 0.6%. A slight 0.7% rise in Q1 ULC (unit labor
costs) was transformed to show a staggering surge of 4.8%! In addition to that
4.8% rise, ULC rose a further 2.2% in Q2. But the news gets even worse Last week
the BLS revised the ULC rise in Q2 up from 2.2% to 3.3% QoQ. US non-farm
business unit labor costs are now rising by 2% yoy. That is very bad news for
profits. Bad news for equities. And because the pace of ULC is a key driver of
inflation (upwards in this instance), it is bad news for an increasingly
criticized and divided Fed.
Preparing for a Credit Crisis
There is so much that could push us into
another 2008 Lehman-type credit crisis. As I say, it is not a given, but the
possibility should be on your radar screen. Lehman may have been the straw that
broke the camel’s back, but there were a lot of other problems. Prior to 2008,
we had seen several large companies in the financial world simply disappear.
REFCO comes to mind. Not a whimper in the markets. But Lehman was one of a dozen
problems all over the world resulting from the larger subprime crisis. Howard
Marks of Oaktree writes about simultaneous problems in the markets and what
happens:
Markets usually do a pretty good job of
coping with problems one at a time. When one arises, analysts analyze and
investors reach conclusions and calmly adjust their portfolios. But when theres
a confluence of negative events, the markets can become overwhelmed and lose
their cool. Things that might be tolerable
individually combine into an unfathomable mess whose extent and ramifications
seem beyond analysis. Market crises are chaotic, not orderly, and the
multiplicity and simultaneity of contributing causes play a big part in making
them so.
I did an interview with good friends David
Galland and Doug Casey of Casey Research yesterday. They are decidedly more
bearish than I am, so wanted an optimist to sit on their panel. But they
forced me to admit that some of my optimism depends on the probability of US
political leaders doing the right thing. Depending on your opinion about that,
you are more or less prone to think there is a crisis in our future. And while I
like to think it is not me showing a home-town bias, I think Europe has worse
problems and a tougher situation than the US. A crisis there is more likely, I
think.
But whether you want to make it 50-50 to
70-30 or (pick a number), there is a reasonable prospect of another credit
crisis. So what should you do?
First, think back to 2008. Were you liquid
enough? Did you have enough cash? If not, then think about raising that cash
now. When the crisis hits, you have to sell what you can for what you can get,
not what you want for reasonable prices.
I am personally raising more cash in my
business. I usually invest money as soon as I can. Now, I am still investing,
and you too should still put money to work in places that you think have the
potential to do well in a crisis. Go back and see what worked in 2008 and buy
more of it! Long-only funds did not work. Those that were more nimble did.
In the next crisis, opportunities to buy
assets on the cheap will grow, so having some cash will make it easier to buy
things you want to own for the next 10-20 years, whether income-producing or
just something you want for fun.
Think through your portfolio. In 2008 I
watched investors liquidate solid funds, or sell off assets at fire-sale prices,
because that was the only way they could raise cash, when that was the time to
invest more, not redeem. Make sure you are the strong hand.
Understand, I am not saying sell your
conviction stocks. I have some and am buying more. But no index funds, no
long-only, unhedged funds. I make very specific choices when it comes to
long-only investments that I am looking to hold over and beyond a ten-year
horizon. And those are risks I want to take (at least today).
I do not want to own anything that looks
like an index fund or long-only mutual fund. Think 2008. I want funds and
managers that have an edge and have a hedge, preferably both.
I would not be long money-center bank
stocks or bonds, not in the US and especially not in Europe. I have had private
off-the-record conversations with Republican leaders. There is simply no
willingness to do another TARP-like bailout of bondholders and shareholders. I
believe them. As Hussman suggested, this time bondholders will lose. I just
dont know which ones will be ready, and there are lots of other places to
deploy assets. If you feel you have some special insight, then be my guest; but
I just see too much risk for the potential reward, especially in large bank
bonds that pay so little. That is not to say they are all equally bad
certainly not the regionals with less exposure to Europe. But do your
homework.
(Caveat: I do think even the GOP leaders
will have to cave in and allow the government to be debtor-in-possession of
the too-big-to-fail banks we allowed to exist under the really bad financial
bill called Dodd-Frank, which needs to be repealed and replaced. We have to
preserve the system, but not shareholders and bondholders, who will lose this
time.)
Think through your business. Banking
relationships are not what they used to be. Spend time now getting commitments.
Remember the odd spike in 2008 in bank lending? It was from credit lines being
drawn down. But no one got new lines at the time. What can you do if sales get
tough? What can you do to increase market share when your competitors start to
pull back? The winners in 2008-09 were the companies that increased innovation
and did not pull back (according to a Boston Consulting Group survey).
If you plan correctly, the next crisis will
be an opportunity for you and not a personal crisis. And you will be better able
to help those who need it.
A special note. In a few weeks I will be
sending out an email that will contain a link to a totally free treasure trove
of business and marketing ideas you can use to keep your business at the cutting
edge, whether you are established are just starting out. It is one of those
things I can do that costs me very little, but that sometime may mean a lot to
you. I am just glad to be in the position to help a little.
I know I sound rather stark at times, but I
really dont want you to dig a hole and get in and cover yourself up. I do not.
While we are perhaps somewhat more cautious, we are also looking for ways to
grow and be more aggressive here at my business. I will keep repeating: look for
the opportunities. They are there. Just gauge your risk appropriately.
