Saturday, May 08, 2010

Greece Does Have Germany, But Does it Matter?

So in the past 18 months we shifted debt in the US from the consumer and banks to the government, and in Europe from the banks to the government. Given the state of the economies, governments decided they needed to push massive fiscal stimulus to rebuild growth. That created even more government debt.

So now we sit with sovereign debt and deficit ratios that are unsustainable without a minimum level of growth and exposed to a potential increase in interest rates. If growth doesn't pick up, government receipts will not service debt.

Likewise, if interest rates pick up and governments have a significant amount of short term debt (like the US), the cost of debt service will go up. In fact these two issues are linked in that if growth does not pick up, investors will demand higher rates - a pro-cyclical event similar to hitting the proverbial wall.

The events of the past couple weeks reflect this situation: Greece has already hit this wall and needs a restructuring (default). The EZ hasn't accepted this reality yet, as they believe the Greek economy can absorb the austerity plan that the government has passed without a revolution or a slow down in growth that would prevent debt service. The ECB can start buying Greek sovereign debt (quantitative easing), but this is their failsafe - they would have no other weapons. It's turning into a showdown.

The sovereign CDS market provides a ready guide for the status of other EZ countries and the list goes as follows (cost of insuring this debt): Greece 700bp, Portugal 340, Ireland 205, Spain 195, Italy 152, Belgium 92, UK 81 and the US for reference is at 97, up 60% from the end of '09 and up 7x in the past year. Clearly the market is worried about the collective governments' ability carry their debt.

Where do we go from here? Without growth, the system will require a great depression like austerity to preserve any belief in fiat currency. At the end of the day, currency is a promissory note and requires faith in the balance sheet of the issuing country. This balance sheet is backed by the economy, not gold. We currently have countries that appear insolvent, much like banks were insolvent a year ago.

The only real choice is for governments to continue to paper over problems, and inflate their way out of this hole. The US (and as a result much of the world) has had aggressively loose monetary policy for a decade now so it not should come as a surprise that gold is over $1200, many commodities are back to pre-crash highs and picassos are going for $150mm.

With the fiscal stimulus still moving forward, consumers have come back to spend. But for how long? Job growth is still too low to make any impact in the coming months and housing prices do not appear to have completely stabilized. If we add in equity market volatility, then surely the consumer will continue to reassess their savings plan. This new austerity behavior will take time to establish a foothold in the minds of the world's great consumers, but it will eventually. There is no choice.

Despite trading this year long rally poorly, the calls on paper have been pretty good. 10,500-11,000 on the Dow is a big resistance level, and I think technical analysis is as good as any other in a market with poor anchorage. I do think the EZ will figure out some solution that will calm the markets, the UK will work out a better than expected coalition plan, and the US economy will continue to recover. But the recovery will face a reduction in fiscal spending and increased taxes that the sovereign debt markets will demand. And this adjustment will come this year. This correction may include the market's recognition of this difficult position.


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