All Bark and No Bite

When it comes to euro crisis, European leaders, so far, are all bark and no bite. They seem to understand their dire situation, but have yet to really take decisive action (a “bailout” on the order of trillion(s) of EUR) to prevent and contain their predicament. The following quote from the June 25th issue of The Economist summarizes their options well: 

…the euro zone’s leaders will sooner or later face a choice between three options: massive transfers to Greece that would infuriate other Europeans; a disorderly default that destabilises markets and threatens the European project; or an orderly debt restructuring. This last option would entail a long period of external support for Greece, greater political union and a debate about the institutions Europe would then need. But it is the best way out for Greece and the euro. That option will not be available for much longer. Europe’s leaders must grab it while they can. Source: "The euro crisis: If Greece goes" | The Economist

The last two sentences are key and yet three months after the article was written, there is still no clarity on how European leaders are addressing and containing Greece’s insolvency. Worse still, their indecision has now led to other much larger more systemically important periphery European countries and more ominously banks and insurance companies to become intertwined in the mess (see last month’s post: “Griechenland Bezahl' Deine eigenen Rechnungen”).  This lack of clarity has led markets around the world to price in not only the possibility of the worst of the three options (a disorderly default) but the potential for a global recession as well (see chart below). 

12-Month Comparison: shows the 12-month performance of major global equities markets, as well as US Treasuries and Gold.  September 2010 = base year.

What may be surprising to some about this performance comparison is that despite all of the negative headlines, US equities have been relative out-performers when compared to their foreign counterparts. Even more surprising is that US Treasuries—the securities at the center of the S&P ratings downgrade—have been one of the year’s best performers.  The weakness in Emerging and Commodity Country markets and strength of US Treasuries suggests that many investors are expecting a global economic slowdown in the coming months/quarters.

Bottom line: With the 2007/08 mortgage crisis and extremely disorderly Lehman bankruptcy still fresh on investors’ minds, many investors have been quick on the sell trigger so as to not get burned again (ourselves included).  However, a Greek default should not have the same hugely negative market impact if it is properly contained.  We hope that European leaders will realize that their experiment—the EUR—has the potential to fail catastrophically and therefore will resist political gamesmanship and address the situation.  If they do (soon) then one of the major impediments to market and economic growth will be removed and we expect a significant buying opportunity as most markets have been sold to exceptionally cheap levels. 

Until then, we are positioned extremely defensively across all of our portfolios.  This means our portfolios are skewed more towards the possibility of a Greek default (orderly or disorderly) and a global slowdown, than to a satisfactory resolution to the crisis.  See table below for a quick and very basic scenario analysis: