One would think that after one of the biggest monthly rallies for equities since the ‘70s everything would be roses and smiles, but October’s rally was more symptomatic of a market that is under extreme stress than of long-term optimism. In large part, October's spectacular rally appears to be the result of traders (particularly hedge funds) reversing their negative bets on the euro and equity markets as rumors of an European deal slowly surfaced and US economic data came in stronger than expected.
However, there are still major questions that need to be answered before the “new” European plan has any bite. As a result, we continue to be positioned defensively across all of our portfolios and maintain that this was/is the right positioning given the current risks for two core reasons (among many):
(1) European debt markets still suggest a negative outcome. Debt markets, which are generally dominated by sophisticated, professional investors and traders (as opposed to individual investors), are often better or “smarter” at predicting the outcome of economic events than equity markets. As illustrated in the chart below, European debt markets are flashing warning signals and actually suggest that Europe’s problems are getting worse rather than better.
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| This chart shows credit spreads relative to German bunds— the wider the spread, the more credit risk associated with that country’s bonds. A spread above 450 generally suggests trouble ahead. As can be seen, Italy, the 3rd largest EMU economy, is coming dangerously close to the 450 mark (at the time of this writing Italian spreads have passed 450). |
(2) The “new” bailout plan, while a step in the right direction, is still more bark than bite (see last month’s commentary "All Bark and No Bite") and is deficient in many ways:
- Where is the $1 trillion going to come from? European leaders seem to be assuming that China or the IMF will come to the rescue and serve as the monetary anchor for the plan. However, neither China (which has issues of its own) nor the IMF (which was not designed to rescue large, “developed” countries) is in a position to take on such a big responsibility. Instead, there needs to be greater fiscal unification across the 17 euro countries and the ECB needs to be authorized to serve as the central anchor and to issue “Eurobonds”.
- How are the banks going to be recapitalized? It appears the new plan requires banks to seek private sources of funds for recapitalization first, then go to their home country, and then as a last resort go to the ECB or EFSF. In my opinion, this is flawed in that it exposes which banks and countries are too weak to raise money on their own at each step of the way. Exposing the weak will potentially have hugely negative destabilizing effects.
- Finally, by forcing a “voluntary” 50% haircut on Greek debt, European leaders have prevented Greece from technically defaulting. However, in the process, they have made European sovereign debt CDS (insurance on European debt) virtually obsolete. Large investors use CDS to reduce exposure and risk in the event of a catastrophic failure (bankruptcy or default). Now that these investors are no longer able to rely on the insurance-like protection of European CDS, their appetite to buy European bonds, particularly of weaker countries, will be substantially reduced. This is the exact opposite of what is desired from a successful bailout plan.
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On a somewhat lighter, albeit slightly disturbing, note: This article sums up the Greek issue well: Fast cars and loose fiscal morals: there are more Porsches in Greece than taxpayers declaring 50,000 euro incomes
