Commentary

Print

Beware of Greeks Bearing Bonds

Phil Diamond, CFA | March, 1, 2010

Okay, this past week we've had another disaster, not the earthquake in Chile, that's a natural disaster, not man-made. Okay, so Greece isn't a new disaster, they just got their debt downgraded by Standard & Poor's. Does that come as a surprise to anyone? Maybe it happened a little quicker than most folks expected, but given the history of credit ratings, at least they didn't wait until after they defaulted to cut it. Any default is at least years in the future according to most folks who supposedly know about these things. Also, a report states that Greece, since its war of independence from the Ottoman Empire in 1832, has spent just about half of their modern history in default on some or all of their foreign debt. A new default would be more in character for Greece than for most European countries.

The issue here is really a slippery-slope kind of deal for the European Union. Once the EU starts bailing-out members we'll get a new, improved definition of moral hazard. Moral hazard today means more or less that society has compelled some group or organization to perform some service or accept some limit on their freedom and thus society has a responsibility to protect the organization against the repercussions of those limits or services. So, once the US decided to make the major US banks the agents of its monetary policy, it felt it had to save them from the repercussions of US monetary policy.

The Europeans are facing a similar problem, once it lets a member state of the EU welch on its bargain to keep government deficits below 3% of GDP or maintain other requirements of membership in the EU, what do they do? If the Greeks can run large deficits, why can’t the Portuguese? Why not the Spaniards? Why not the Germans? If the rules don’t work, how can you enforce the rules? The EU would prefer to save the Greeks, so long as it isn’t too expensive, in order to save the euro. But, if the price is too high, do they kick Greece out of the EU? Does the European Currency Unit (ECU) have to be amended in some major way? Can they continue to grow the Euro-zone? All these questions because Greece broke the rules.

As things stand today, the Greeks can pay their current debts, but they are approaching the limit of how much debt they can shoulder. The point may come where Greece can’t service their debt but they still need to borrow. That day will be real interesting. Any package of EU fixes will be directed at maintaining Greek access to credit markets and postponing the day when the Greek crisis becomes the Greek tragedy!

Also, the EU would like to create a template for how to handle all the other miscreants in the EU with the PIGS moniker -- Portugal, Ireland, Italy, Iceland, and Spain. Whatever they come up with, it had better be flexible, fair, effective and affordable. Yeah, there’s nothing they can do but kick them out.

The new wrinkle in this whole sad affair is the attack on the euro by hedge funds. Because of the Greek tragedy, many people in the hedge fund world think the euro is overvalued and needs to come down. If enough hedge funds sell enough euros, can they make that happen? The euro is a huge market and there is some question as to whether the hedge funds have enough ammunition to take it down. This will at least cause a lot of volatility in the euro (versus other key currencies) over coming weeks and maybe months. It could also mean that many hedge funds are going to have a lot of eggs in the euro basket. If the attack on the euro fails miserably, it could cause a lot of bleeding for a lot of hedge funds. Beware of the Trojan horse!


We would like to thank our colleagues and business partners at FocusPoint Solutions for their contribution to our Commentary. Particular thanks go to Phil Diamond, CFA; Ryan Long, CFA and all within their research staff. We look forward to their on-going Commentary contributions.

Why does Greece matter? The European economy is as large as that of the US. We feel it when they go into recessions, for many of our largest companies make a lot of money in Europe. A crisis will also make the euro go down, which reduces corporate profits and makes it harder for us to sell our products into Europe, not to mention compete with European companies for global trade. And that means we all buy less from China, which means they will buy less of our bonds, and on and on go the connections. And it will all make it much harder to start new companies, which are the source of real growth in jobs. And then in January of 2011 we are going to have the largest tax increase in US history. The research shows that tax increases have a negative 3-times effect on GDP, or the growth of the economy. I think it is likely that the level of tax increases, when combined with the increase in state and local taxes (or the reductions in spending), will be enough to throw us back into recession, even without problems coming from Europe. And sadly, that means even higher unemployment. And this next time, we won't be able to fight the recession with even greater debt and lower interest rates, as we did this last time. Rates are as low as they can go, and this week the bond market is showing that it does not like the massive borrowing the US is engaged in. It is worried about the possibility of "Greece R Us." Bond markets require confidence above all else. If Greece defaults, then how far away is Spain or Japan? What makes the US so different, if we do not control our debt? When confidence goes, the end is very near. And it always comes faster than anyone expects.

The good news? We will get through this. We pulled through some rough times as a nation in the '70s. No one, in 2020, is going to want to go back to the good old days of 2010, as the amazing innovations in medicine and other technologies will have made life so much better. In 1975 we did not know where the new jobs would come from. It was fairly bleak. But the jobs did come, as they will once again. The even better news? You guys are young, still babies, really. Hell, I didn't have a good year income-wise until I was in my mid-30s. But we get through bad stuff. That is what we do as a family and as the larger family of our nation and world. So, what's the final message? Do what you are doing. Work hard, save, watch your spending, and think about whether your job is the right one if we have another recession. Pay attention to how profitable the company you work for is, and make yourself their most important worker. And know that things will get better. The 2020s are going to be one very cool time, as we shrug off the ending of the debt supercycle and hit the reset button. (March 27, 2010)

J. Mauldin

Comment on this article—name and email are required (*)

Name:* Email:*
all comments subject to review and approval
Disclaimer: All articles are for informational purposes only and do not constitute offers/solicitations to sell or purchase any security or investment product or service; this information is provided solely for your personal use and is not intended to be investment advice; all investments are subject to risks, including possible loss of the principal amount invested; diversification does not protect against a loss in a declining market or ensure a profit; stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries; foreign investing involves additional risks including currency fluctuations and political uncertainty; prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks; investments in bonds are subject to interest rate, credit, and inflation risk; past performance is no guarantee of future results; nothing constitutes tax or legal advice; investment products described herein are not bank deposits; are not insured by the FDIC or any other governmental entity; are neither obligations of, nor guaranteed by Green Valley Wealth Advisors, LLC. We are not responsible for the accuracy or content on third party websites; any and all links are offered only for use at your own discretion; and our privacy policies do not apply to linked websites.