Why A European Sovereign Debt Crisis Can Be Avoided
The European sovereign debt crisis has dominated financial news and been the primary driver of markets for the past month. I would argue that we are in an actual crisis in Europe and this is no longer about fears of a crisis. When banks can’t finance independently through the market and when large countries can’t issue debt at reasonable interest rates you are in the throes of a crisis. The outlook regarding how this unfolds is really the dominant driver behind any and all short and medium term investment decisions right now. If one believes that this crisis can’t be contained and it will be a 2008-2009 redux, then it would make no sense to be invested and a lot of sense to be short. If one believes this can be contained, then markets are at extremely distressed levels and it would be sensible to position for a bounce back. The latter, is the course I am advocating for those willing to invest, bear heightened risks, and take an optimistic view. Perhaps the S&P 500 getting above 1,200 for a few days is the first signal that the optimistic view will be correct. Or perhaps this has been noise and we have drifted to the high end of the market’s recent trading range based on hope (some financial writers now replace the word hope with hopium – my how cynical).
Firstly, when evaluating a crisis it is necessary to determine how it is similar to past crisis and how it is different. Furthermore, one must determine if it is fixable. I believe that sovereign debt crisis in Europe is very different than the cause of the original credit crisis in 2008, and that it is fixable. Market participants who have drawn up all the similarities between the mortgage crisis and sovereign debt crisis (and talked about Lehman events to come) have ignored a crucial element to the equation. There are dramatic differences between an individual mortgage contract (debt borne at the household level) and a sovereign debt contract (debt borne at the country level). The incentives to default or ride things out are dramatically different for borrowers.
A mortgage borrower who bought at the peak of the market and ended up with a house worth $300,000 and a loan for $450,000 is $150,000 underwater. The borrower has two options, to ride things out for many years, make all the payments on the mortgage and the next $150,000 goes towards getting the equity in the house from a negative amount back to zero. A second option, particularly if this borrower only had $40k, $20k or even less invested in the house as a down payment would be to default on the mortgage, mail the keys to the bank, impair ones credit and invest the next $150,000 worth of after-tax cash flow into an investment that would generate positive equity and not zero equity. This example is an over-simplification but you catch my point. The mortgage crisis in the US was a clear-cut solvency issue with borrowers (in many cases) having little incentive to avoid default.
Now a sovereign borrower on the other hand isn’t an individual it is a government representative of all the citizens of that nation. A country doesn’t go bankrupt in the same way that a company or an individual does. There is no liquidation of assets or fire sale because a country continues to endure. Italy is a good example because it has been coming up a lot as a border-line case and the major economy in Europe that could tip the current crisis into the realm of uncontrollable. Given the incentives Italy has to remain a part of the Eurozone, and avoid default I see very little chance that default could happen in Italy or even any country in Europe save Greece. As long as the political will exists to remain part of the Eurozone union there is the ability to continually chip away at the problem simply by existing as a nation. So long as Italy says it will continue to service its debt each year, and as long as the Eurozone continues to support the functions of the ECB, the interest costs can be contained or subsidized through ECB purchases of Italian debt and Italy can continue to function as an economy each and every year. With the new awareness of the limits of sovereign borrowing capacity it is likely that Italian debt will need to grow at a rate at or slower than nominal GDP growth – but this is already in the plan. Even if Italy chugs along with very low, or no, real GDP growth for a number of years, this would not be a crisis. Thinking about the alternatives, exiting the EU-17 or the Euro would be disastrous for Italy. The country would go into a depression, contracts which have been inked in euros over the past decade would need to be restructured which would grind trade to a halt for Italy. There would be a banking crisis. The rest of Europe would also surely impose export tariffs on Italy as a result of operating with a devalued Lira. Plan B is much worse.
An escalation to a crisis is worse for all of the involved parties in Europe, and for the rest of the world as well! This leads me to believe that there is high likelihood that a crisis is avoided. The largest obstacle is getting over the legal and political issues to addressing the crisis in a large-scale enough fashion to restore confidence in Europe. I believe that the Germans have taken a flawed approach thus far – in thinking that they can set the terms and conditions for the Eurozone policy going forward. Germany has little ability to dictate the outcome in the matter as it will be the markets which ultimately dictate what is needed to restore confidence. The faster German politicians realize that the more minimalist the approach to solving the crisis that Germany proposes the larger the actual commitments and expenditures will need to be when the market doesn’t believe it sees enough of a commitment. A different approach would be to preemptively come “over the top” at the markets which would restore confidence quicker and make the costs to solving things much less in the longer term. This is a difficult political course of action for Germany to take but I believe there are enough well respected economists and global leaders advocating this type of approach that the probabilities are growing that it will transpire.
If I had to handicap things I would put the odds at 3 in 4 that Europe comes around relatively soon and announces a large scale fix. Again, I have no doubts about the ability of the EU and ECB to implement a fix (they can simply threaten to print more euros when it comes down to it) but what is uncertain is what the political will is for a fix (and how long it will take). 3 in 4 odds are pretty good. The problem is that 1 in 4 odds that the Eurozone languishes and underestimates the severity of the problem and overestimates how much time they have to solve it is uncomfortably high. I believe investors are being adequately compensated to bear this risk but it doesn’t make it any more comfortable while the process bears out so risk-inverse investors may want to sacrifice some potential returns for the tradeoff of more stability right now. There has been a 7% recovery from approximate S&P 500 lows of 1,125 and I believe there is another 7% to go, just to get back to the realm of normalized valuations. I see this as an opportunity albeit a risky and volatility filled opportunity.
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