The European Debt Crisis is Spreading
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Standard & Poor’s Downgrades US Debt Rating
2. What is “Sovereign Debt”?
3. Euro Zone Debt Crisis Getting Worse, Not Better
4. Northern Europe Defending the Euro
5. Spain & Italy – The Next to Go?
6. US & Global Stock Markets Collapse – Why?
** Note: Today’s E-Letter is a little longer than usual due to all of the alarming financial events that have occurred in recent days.
In my July 19 E-Letter, I focused on why the Greek debt crisis matters to you and me. If you recall, I reprinted a recent piece from Stratfor.com warning that European nations like Spain and Italy could be going the way of Greece before long. I also included a piece from GaveKal which thinks the European debt crisis will be even worse than Stratfor’s warning. Both Stratfor and GaveKal predicted that the euro will not ultimately survive.
In the same week that I wrote my July 19 E-Letter, a major monetary summit took place in Europe with the primary goal of approving another large bailout loan for Greece. A new loan of €109 billion was approved, and EU leaders vowed to guarantee Greek bonds held by money market funds. This all sounded very reassuring, and EU leaders expected that the tensions in their credit markets would settle down. They didn’t.
Yields on Spanish and Italian government debt have continued to ratchet higher and now stand near a record premium over German bonds. As Stratfor and GaveKal predicted, the debt crisis has spread to Spain and Italy. I made the following statement in my July 19 E-Letter: Quite simply, all hell is about to break loose in Europe, if it hasn’t already! Since I wrote that, it certainly has! I will discuss the European debt crisis in more detail as we go along today.
You may also recall that I predicted the European debt crisis would be bearish for US stocks. I did not feel that the US equities markets had priced in the worsening debt crisis in Europe. As you know, US stock prices have plunged around 15% since then. While the media blamed the plunge on the US debt ceiling stalemate, I don’t agree. US Treasury bonds soared during the debt ceiling debacle. US stocks plunged primarily due to worries about Europe and to a lesser extent, in my opinion, because of the downgrade of US debt to AA+.
It remains to be seen how the European debt crisis will play out. The European Financial Stability Facility (the so-called sovereign debt bailout fund) has nowhere near enough money to bail out Spain and Italy. Ditto for the European Central Bank which pledged on Sunday to buy Italian and Spanish bonds. If the crisis continues to intensify, the Eurozone countries will be asked to pony up a lot more money to bail out their neighbors. Time will tell. In any event, expect this crisis to get worse before it gets better. This will continue to weigh on the US and global stock markets.
Before getting into the widening debt crisis in Europe, I will take a few moments to discuss the issue of “sovereign debt” generally, since it is a term that many investors don’t fully understand. Following that discussion, I will update you on what is happening in Greece and why Spain and Italy are now experiencing similar problems.
What is “Sovereign Debt”?
As is often the case in the world of finance, the term “sovereign debt” means different things to different people. To some, it means all of the debt owed by a government. To others, it only means government debt that is owed to foreigners. For purposes of this discussion, sovereign debt will include all of the outstanding debt owed by a government.
Simply put, sovereign debt is money or credit owed by a central government. Sovereign debt may also be referred to as government debt, national debt or public debt. Since most governments draw the bulk of their income from much of their own populations (ie – income taxes), sovereign debt is ultimately a debt of the taxpayers.
Here is perhaps the most interesting thing about sovereign debt. Under the doctrine of "sovereign immunity," the repayment of sovereign debt cannot be forced by the creditors, and it is thus subject to compulsory rescheduling, interest rate reduction, or even repudiation (default). The only protection available to the creditors is the threat of the loss of credibility and lowering of the international standing (ie - credit rating) of a debtor country, which may make it more difficult and expensive to borrow in the future.
The fact that creditors cannot force the repayment by government borrowers explains why some countries such as Greece and others are having such a hard time peddling their debt. The creditors know they may never get their money back, and they also know that if they have to unload their sovereign debt securities in the secondary market, they may do so at a considerable loss.
It is no wonder then that more solvent Eurozone countries like Germany and France are very hesitant to bail out countries like Greece, Portugal and Ireland as they know they may never get their money back. And now, Spain and Italy are knocking on the door, as discussed below.
Here is a look at the sovereign debt owed by countries around the world with AAA credit ratings. This chart was, of course, prepared before last Friday’s downgrade of US debt to AA+ status by Standard & Poor’s. US debt continues to be rated AAA by Moody’s and Fitch. As you can see, the US has more than half of all AAA rated sovereign debt in existence. Notice also that there are only 19 nations that currently qualify for the AAA credit rating.
Please note that the $9.448 trillion shown for the US only includes Treasury debt held by the public. It does not include the other roughly $5 trillion that is owed to various government agencies, thus making up our national debt of $14.4 trillion. If we used the $14.4 trillion figure, the US share of total AAA sovereign debt outstanding would be even more staggering!
Eurozone Debt Crisis Getting Worse, Not Better
In an attempt to explain how the European debt crisis is unfolding, we need to understand the European Financial Stability Facility (EFSF). This is an organization formed by 16 countries – the so-called “Member States” – that share the euro currency. The EFSF was formed in June 2010 to “preserve financial stability of Europe’s monetary union by providing temporary financial assistance to euro area Member States in difficulty.” In other words, it’s a bailout fund.
The EFSF has the authority to issue bonds or other debt instruments on the market to raise the funds needed to make bailout loans to countries that get into trouble. These bonds are guaranteed by the Member States on a pro-rata basis up to a cap of €440 billion (US$625 billion). These bonds currently carry a AAA rating.
With a cap of only €440 billion, the EFSF is woefully underfunded. As noted above, the EFSF just made a second loan to Greece of €109 billion in addition to the first loan of €110 billion. Plus there will be additional loans to Portugal and Ireland, and everyone agrees that Greece will need even more money before the crisis is over. Simply put, the EFSF does not have enough money to bail out Spain or Italy.
At the July European Summit, when the €109 billion loan to Greece was approved, the Member States reportedly considered expanding the €440 loan cap, perhaps significantly, but no formal decision was reached. That decision is not expected until sometime in the fall, if at all. Increasing the EFSF cap may meet stiff resistance from Member States like Germany and other Northern European countries. As noted above, they have to guarantee the debt.
Northern Europe Defending the Euro
The European debt crisis hinges on one question: Are the economically and financially strong countries of Northern Europe willing to bail out their southern neighbors just to preserve the euro? It’s really that simple. If this were just about Greece, Northern Europe would not bat an eye if there was a Greek default. But the euro currency is at stake. Remember that Stratfor and GaveKal do not believe the euro will survive, as I wrote in detail in my July 19 E-Letter.
Most observers agree that the governments of Northern Europe are very committed to preserving the euro. They take pride in having a unified currency. But how about the citizens of those same countries? How much of their nations’ wealth are they willing to see go to deadbeats like Greece? Not much, I would suspect. This will be THE issue in the next elections in those countries.
Likewise, the austerity programs put in place by debtor nations will also be at the top of the list during their next elections. Thus, we have one group of Europeans upset about bailing out profligate nations, while voters in those debtor nations resent the economic reforms forced upon them in order to qualify for a bailout. It should make for some very interesting/troubling electoral results in the coming years.
Let’s get back to Greece. In my July 19 letter, I discussed a proposed plan to allow Greece to restructure its debt owed to banks and private lenders. Apparently, such a plan has been adopted. According to the Institute of International Finance, the world’s only global association of financial institutions, Greece’s creditors can take a 21% haircut on the debt securities they currently hold in return for a longer-term bond with a 9% interest rate.
As this is written, it is not clear if the Greek debt restructuring described above has actually begun. As such, it remains to be seen if the rating agencies will declare the plan a “default.” Not that it matters much – Greek debt is already rated as junk.
Spain & Italy – The Next to Go?
Italy and Spain are the Eurozone’s third and fourth largest economies, respectively. Italy’s sovereign debt is the second largest in the EU. Italy has been in the crosshairs of the bond markets since early July as doubts have grown about the sustainability of its huge public debt and the ability of its fractious government to implement deep economic reforms. Bond rates in Spain and Italy soared above 6% in late July, a 14-year high.
Italy’s sovereign debt is reported to be apprx. €1.9 trillion (US$2.7 trillion), making it the world’s third most indebted nation and the Eurozone’s biggest borrower. Italy’s debt rating is AA (not AAA). Italy’s debt is 120% of GDP, third only to Greece at 160% and Japan at 200+%. Italy’s debt is more than that of Greece, Portugal and Ireland combined.
As it became clear in recent weeks that some kind of “selective default” was going to occur with Greece, that news created real turmoil in the European debt markets which sent rates on Spanish and Italian bonds to 14-year highs. This at a time when it is increasingly clear that the European economy is slowing down.
Does all this mean that Italy is headed down the path of Greece? Not necessarily. While Italy’s debt-to-GDP ratio is huge at 120%, its budget deficits are not terribly high – currently around 4% of GDP which is fairly low. Italy’s multi-year fiscal plan is on track to balance the budget in 2014. So it’s not nearly as bad as Greece in that respect. Also, Bloomberg estimates that Italy will only have to refinance 26% of its outstanding debt between now and the end of 2012.
In addition, I read last week that Italy’s Finance Ministry has accumulated a pool of cash of around €60 billion. If push comes to shove, that is reportedly enough money for the government to buy up all of its own bond issues through the end of the year. If true, then some folks at the Finance Ministry had their thinking caps on ahead of time.
In Spain, things are a little different. Obviously, its economy is smaller than Italy’s; its outstanding sovereign debt is considerably smaller at apprx. €615 billion; and its debt to GDP ratio is around 60%. Spain’s debt rating by Moody’s was cut back in March to AA2. Moody’s announced in late July that it was placing Spain’s rating under review for another possible downgrade – no decision on that yet.
Spanish Prime Minister Zapatero canceled his August vacation in late July as the rate on the Spanish 10-year bond soared to 6.45%. Investors have been dumping Spanish bonds, largely in favor of German bonds at about half the yield or less.
The bottom line is, it remains uncertain whether Italy and/or Spain are headed down the path of Greece, Portugal and Ireland. On the one hand, the financial situation in Italy and Spain is not as dire as it has been in Greece, Portugal and Ireland. On the other hand, monetary authorities in Italy and Spain have been slow to react to the developing debt crisis until recently.
This probably explains why the European Central Bank (ECB) announced last week that it is increasing its purchases of bonds from regional governments that are threatened by the debt crisis. This likely also means that the ECB will elect later this month to put on hold its plans to increase interest rates.
The ECB raised interest rates earlier this year out of fear of rising inflation. Given the events of the last few weeks, ECB monetary authorities (and the US Fed for that matter) are likely to realize that inflation is not the problem and begin to concentrate on measures to prevent deflation from rearing its ugly head in coming months.
US & Global Stock Markets Collapse – Why?
Investors around the world are stunned at how the global equity markets fell off a cliff immediately after the US avoided defaulting on its debt on August 2 when the debt ceiling deal was struck. Most analysts wholeheartedly believed that the US and global equity markets would rally strongly once the US debt ceiling was raised.
Of course, I maintained all along – and I’m sure most of my readers did too – that there was no doubt the US debt ceiling would ultimately be raised, even if at the last moment. What began to concern me seriously in the first half of July was the fact that everyone was focused on the US debt ceiling debate, while few were noticing that the European debt crisis was worsening.
As discussed earlier, the European Summit in July resulted in a second bailout loan for Greece of €109 billion. Frankly, that should not have surprised anyone, since Germany and the other Northern European nations are nowhere near ready to give up on the euro. But the agreement to grant Greece another large bailout loan fostered a false sense of security that the European debt crisis had been averted, at least until the end of this year.
I never believed that for a moment, and neither did global traders in European sovereign debt. Bond yields on European sovereign debt continued to soar in the second half of July, led by Italy and Spain as discussed above. This is what caused me to issue the following warning on July 19 when I shared with you the latest dire predictions from Stratfor and GaveKal:
"If Stratfor and GaveKal are remotely correct, we are very likely facing another global financial crisis that could be sparked if Greece defaults on its debt. If this happens, I would expect the US stock markets to plunge again, perhaps as they did in 2008. And this could happen at any time. Most US investors are NOT prepared for this scenario and believe that US equity prices will remain in a bull market for the balance of this year and next... Quite simply, all hell is about to break loose in Europe, if it hasn't already."
This reminder is not in any way intended as an “I told you so” pat on the back. It was simply that I had one of those moments when my strong sense was that the investment public and the markets had been distracted from the real danger in Europe by all the hoopla over the US debt ceiling impasse. Frankly, it was a serious gamble for me to suggest that the US equity markets could experience another waterfall decline such as we saw in 2008. It was just a strong feeling as I noted again last week:
“I am getting more and more worried about a second recession, or something even worse, in the next year or two. I’ll share more about these concerns in the weeks ahead.”
My recent concerns have been validated in spades over the last few weeks. No one has any idea where the investment markets are headed just ahead, but the major trend in the stock markets now appears to be down pretty much across the developed nations. How much lower the markets will go is anyone’s guess.
I do not wish to suggest that the latest plunge in the stock markets is solely the result of the continued debt crisis in Europe. There is much more to it than just that. The US debt ceiling debacle certainly served to bring the global debt crisis to investors’ attention. The downgrade of US debt to AA+ by Standard & Poor’s was certainly another very negative development. Of course, the recent US economic data showing that growth is near a standstill is another, among others.
At the end of the day, the stock markets are in a major downtrend. US Treasury bonds have exploded to new recent highs, despite the downgrade to AA+, as investors are fleeing stocks for the supposed safety of bonds. Yet interest rates can’t go much lower and will move higher at some point in the future. When they do, Treasury investors – especially those who bought in only recently – will get hammered. Treasuries are one of two current market bubbles.
The other place investors are herding into is gold. Gold has skyrocketed since the financial crisis in 2008. As I write this, gold is above $1,700 per ounce and soaring. Gold is clearly in a massive bubble that will end very, very ugly at some point.
The bottom line is, I wouldn’t herd into T-bonds now or the gold bubble for that matter. Investors buying these two bubbles now have no idea how much risk they are taking. Yet they are cashiering stocks to buy bonds and gold anyway out of fear. Think of it this way: stocks are now under-valued while gold and T-bonds are clearly over-valued.
As noted above, I will not be surprised if stocks have more on the downside before this crisis is over. But at some point, US stocks will be a screaming buy. Gold and T-bonds, on the other hand, may have a lot more downside risk than recent buyers ever imagined!
If you are looking for a good place to move some of your investment portfolio, I highly recommend that you look at two particular professionally managed programs I recommend: Wellesley Investment Advisors and Metropolitan Capital Strategies.
I should also mention that Scotia Partners, Ltd. which I last recommended on to you on July 19 has hit the ball out of the park during the latest market meltdown! Of course, past performance is no guarantee of future results, and Scotia is not suitable for all investors.
Wishing you limited losses,
Gary D. Halbert
Samuelson: The Big Danger is Europe
Kudlow: Don’t Panic, This Isn’t 2008
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