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In last month's letter we noted it looked like we were seeing a replay of the previous summer's stock market horror show as equities worldwide declined in unison.Well the movie has stayed on script but it looks like someone turned it to fast forward. Fears of the sovereign debt crisis infecting the European (and by extension the world's) banking system resulted in a remarkably quick selloff that saw the S&P 500 decline over 16% in just 13 trading days - and four straight days where the market moved up or down at least 4%. The European Union has been pushing their debt issue down the road for as long as they can but with the debts of their larger member states and larger banks being scrutinized, it is not a question of 'if' or 'when' they come to a comprehensive solution but 'how soon'.
The particular stressors of the last month have been yields on Italian bonds:
and the European banking industry (chart is of the EuroStoxx Banking Sector Index):
Because it now seems to be Italy's turn in the barrel... we point out that while the Italians have a large debt load they also have a relatively manageable fiscal deficit. In addition, while they are known for the inefficiency of their tax system and rigid labor markets this actually means they have some low lying fruit in terms of structural changes to improve their fiscal and competitive position.
What is happening here is that markets are moving their collective doubt from one member of the European Union to the next until they find a target big enough to force a collective European response.
In May of 2010, we wrote that the ultimate decision in Europe will come down to "whether or not the richer northern countries provide outright aid to their more spendthrift southern brethren". Over a year (and hundreds of billion of Euros) later the decision is still the same. Taken collectively, the European Union has a fiscal deficit of 4.4% and a debt to GDP ratio of 87%. Those are manageable numbers (and comparable or better than U.S. figures) but the northern Euro countries, lead by Germany, are not going to assume the deficits of the periphery nations without some sort of fiscal controls over those nations. We find it impossible to envision Greece or Portugal (let alone Italy) agreeing to that.
Therefore we are increasingly of the belief that we will see a split in the Euro currency as that will allow the more stable countries to maintain a strong, internationally valued currency while allowing the Southern periphery countries to devalue and restructure.
In the United States, the downgrade of our debt to AA+ by Standard and Poor dominated the news cycle and was popularly seen as the culprit for the stock market's fall. As noted above, we believe the fear of the European sovereign debt problem infecting the global banking system has been the primary cause of weakness in global markets- but an unprecedented event, such as the downgrade- adds to the uncertainty, and thus the volatility, of markets. While we have found the attempts in Washington to label S&P's actions culpable in some manner more suitable to a banana republic than that of the world's greatest nation we will share our opinion of the ratings agency's actions with you:
First off, it should be noted that S&P always states that their ratings are an opinion and not a forecast of default. And their role in the financial crisis, where mortgage backed securities they had consistently rated AAA collapsed in value shows they have more in common with the blindness of the Greek prophet Tiresias than with his clairvoyance. However, they do have a point that the finances of the country have significantly worsened over the last few years.
What we find most curious... the 18 countries that they continue to label AAA, including tiny Liechtenstein. Liechtenstein occupies an area of 160 square kilometers, has a population under 36,000 and uses another country's currency, the Swiss Franc, as its own. Liechtenstein owes it wealth to its status as a tax haven within Europe. To compare a landlocked country, with few natural resources, no military to speak of, and a concentrated economy to the nation with the world's largest and most diversified economy, greatest military capabilities and vast natural and geographical resources is nonsensical. If Liechtenstein is a AAA rated country then there aren't enough A's in a Scrabble set to describe the relative U.S. position. In any case, markets not rating agencies will be the ultimate judge of the credit quality... and rates on U.S. government bonds are scraping all time lows:
Standard and Poor's actions should be seen as a warning on the long term direction of the U.S. financial situation but little more.
Markets have stabilized somewhat over the last week and the 18% decline in the S&P 500 from its peak would nearly mirror the decline seen last year. "Have we reached the lows?" That answer will depend upon actions across the Atlantic as the Europeans sort out their debt issues.
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