A quick update on the situation in Greece

It seems I am writing these intra-month notes more often than hoped for.  However, I want to update you on the situation in Greece and reiterate our sentiment from last month's commentary that the current market activity, while volatile, still appears to be well within the normal range for a temporary market correction.  It is also important to note that our portfolios have little to no direct exposure to European equities and debt. 

The situation in Greece and periphery Europe has deteriorated over the past several days, and credit markets are pricing in a high likelihood of a Greek default.  With that said, we think there will be a last minute deal (as suggested yesterday by the EU Commissioner: Rehn Sees Markets Misreading EU Resolve).  If this does not happen, then Greece could default within the next several weeks.  While this will be a painful event, particularly for EUR denominated assets and EU banks, we maintain that it will not spread systemic risk as happened in 2007/08 (see Greece is Not Lehman).  If our thesis proves wrong over the next several days/weeks/months, then we have several options to ride out the storm.

(1) We can stay invested in equities, (2) we can exit or hedge (via options) our current positions and wait for calmer markets, or (3) we can go short and profit if the market enters a prolonged downturn.  As of today, despite weak performance, we have not seen outright sell signs that warrant exiting our long-term positions:

• The VIX Index, which is a measure of investor fear, has flashed the “fasten seatbelt” sign but investors are still far away from “jumping out of the plane”.
• Furthermore, by many metrics the market is oversold.  If/when any of the current issues are resolved (and all should be resolved within the next several months) markets should move higher as happened last year.

Additionally, while we do not think we will witness a widespread crisis, now is a good time to make sure your financial house is in order and double-check that your checking, saving/CD and brokerage accounts are insured against bank insolvency (i.e. provide the equivalent of FDIC/SIPC insurance).  This is particularly important for assets held at select European banks.

Finally, it is important to remember that as a long-term investor the current market volatility, while disconcerting, is just noise in the longer-term context of your portfolio’s returns.

IRS Loosens Aug. 31 Deadline for Offshore Tax Disclosures - Bloomberg

The Internal Revenue Service will let taxpayers with undeclared offshore accounts apply for a 90-day extension of the Aug. 31 deadline for coming forward.

The change, announced on the IRS website today, would let taxpayers seek the extension in writing by showing that they have made a “good-faith attempt” to meet the deadline and explain what information they are missing.

To read more please see: IRS Loosens Aug. 31 Deadline for Offshore Tax Disclosures - Bloomberg

How do you say Deja Vu in Greek?

The end of the search for Bin Laden and relatively dovish statements from Bernanke (meaning interest rates are going to stay low) should have provided a good start to May. However, negative headlines quickly outweighed positive ones and May 2011 turned into a near identical repeat of May 2010, which similarly witnessed concerns of over Greek debt and double-digit intra-month market swings. 

The euro’s slide and resulting USD strength, combined with what should have been a normal correction in an overheated commodities market, to form a wave of selling of across all markets several times greater than any single newsbyte warranted—a rogue wave of sorts. However, as mentioned last month we expect some positive swings in the USD over the short-term; over a longer-term horizon, however, we still maintain that the USD will remain relatively weak until interest rate differentials narrow. This should be positive for most commodities and non-USD assets.

As such, for new accounts, we used the corrections as buying opportunities in select markets that benefit from a weaker dollar and continued loose monetary policy in the US. For example:

After an initial sell-off in gold in USD terms, gold rallied to new highs in EUR terms and has provided relative stability against violent currency fluctuations. Gold remains a buy on pullbacks (more on this in a future article).

Furthermore, US Treasuries have proved their safe-haven characteristics, defying simple logic, and have rallied despite the imminent end of QE2. In fact, using history as our guide (see Figure 1 below), we think there is high likelihood that US rates will move lower (and bond prices higher), despite prevailing opinion that the end of the Fed’s buying will push rates higher (again more on this in a future article). 

Figure 1: With the Fed buying bonds in QE1 and QE2, one would expect rates to decrease. Instead the opposite occurred. Likewise, with the end of QE1 and QE2, one would expect rates to rise. QE1 proved differently. Will this be the same for the end of QE2?

Data Source: Federal Reserve

Bottom Line: Currently market activity, while volatile, appears to be well within the norm. For the most part, corrections are buying opportunities in select markets, rather than a reason to sell. Should this change and the markets show signs of prolonged deterioration, we will reduce exposure and then get re-invested as opportunities arise again in the future.

Greece is Not Lehman

Recently, there have been quite a few comparisons between a Greek default and the Lehman Brothers bankruptcy -- “Is Greece the 'next Lehman Brothers'?”, “Greek Restructuring Would Be 'Lehman Moment,' MIT's Johnson Says” and "Could Greece be the next Lehman Brothers? Yes - and potentially even worse" to cite a few. The comparisons, while tempting, are exaggerated and overstate Greece’s role in the European Union and more importantly in the global financial system. In short, it is our opinion that Greece’s debt issues alone do not pose the same threat that Lehman Brothers did in 2008. 

As such, while a Greek default would be extremely disruptive, the disruptive effect is not as much due to contagion and the spread of systemic risk, but more due to the disruption of the status quo—USD down / risk on. A Greek default will obviously be hugely painful, placing stress on EU relations, reducing confidence in the euro and generally decreasing risk appetite; however an all out freeze of the global financial system and movement of capital as experienced before, during and after Lehman’s collapse seems out of the question at this time. This is best illustrated by the Ted Spread, which still remains well within normal levels. See Figure 1 below.

Figure 1: The Ted Spread “represents the change between the three-month LIBOR rate and the three-month rate for U.S. Treasury bills. It is used to measure the amount of pressure on the credit markets. Generally, the spread has stayed under 50 basis points. The bigger the difference between the two, the more worry there is about the credit markets. Economists will look at this to determine how risk-averse banks and investors really are.” Source: Investopedia; Data Source: Federal Reserve

Lehman Brothers and the other now reincarnated investment banks were the pistons, gears and engine of the financial system. All were interlinked and as we ultimately learned the failure of one meant the virtual shutdown of all. The crisis of 2007/08, which I unfortunately had a front seat for as an ETF trader at Lehman, was a solvency crisis for investment banks and many commercial banks; it was a bubble bursting; it was a crisis of confidence; and importantly it was a liquidity crisis on a worldwide scale—money literally stopped moving. The spike in the TED Spread in 2007-2009 shows how capital movement virtually froze.

On the other hand, Greece and most of the periphery European countries, even the larger ones, are merely passengers of the financial system. They are not integral components to the continued viability and fluidity of the financial system. Spreads on Greek and some periphery European country debt have exploded relative to German Bunds, and yet we are not seeing the same general distrust amongst global banks that was so pervasive during the credit crisis.

Bottom Line: In some ways Greece’s relationship to Europe is like a tangled ball of yarn. Untangling the mess without serious disruption is possible but it will be difficult and at times painful. On the other hand, Lehman Brother’s relationship to the global financial system was somewhere between tangled yarn and a scrambled egg—maybe a tangled yarn dipped in egg. Untangling it was nearly impossible without serious blood, sweat and tears and despite best efforts by all everyone was left with a horrible mess on their hands. With that said, given the fragility of the global economic system, the possibility of a severe market downturn cannot completely be ruled out. As such, we are watching for warning signs that the above thesis is wrong—TED Spreads, Bund/Treasuries spreads, equity market volatility and credit spreads, among other things. So far all appear to be well within normal expectations.

Prepare for volatility and downward corrections but not outright collapse.