“And the men who spurred us on sit in judgment of all wrong…Then I’ll get on my knees and pray...We don’t get fooled again!”  - The Who

 

We sit today on the eve of the Great European Summit.  The Summit to end all summits with Germany and France promising to deliver a magical array of policies and elixirs sure to cure the ills facing the 17-member currency union.  Despite the potential peril that would accompany any less than a “successful” summit, stock market investors seem content to demonstrate a willing suspension of disbelief.  Even some bond investors seem to be taken in by the recent news out of Europe. 

Italian 10-year bonds pierced 6% in early August of this year, fell back to 5% briefly before soaring above 7% in November.  The resulting financial stress led to the resignation of Italian Prime Minister Silvio Berlusconi in favor of the technocrat Mario Monti.  Monti, an advisor to Goldman Sachs, spent 10 years as a European Union commissioner most recently ruling on fair trade and competition.  He is well known for rejecting GE’s $42 billion bid to acquire Honeywell back in 2001.  This week, bond investors brightened to Monti’s announced austerity plan aimed at cutting $40 billion out of the Italian budget deficit through 2014 with the goal of a balanced budget in 2013.  To be clear, the plan is the right medicine with a necessary mix of spending cuts and new taxes.  However, Italy’s annual budget deficit has run twice the size of the proposed package, or about $80 billion a year since 2009 leaving us with a plan that is too little, too late.  In addition, when governments cut spending and raise taxes, the impact on the economy always turns out to be more negative than estimated resulting in lower than expected deficit savings.  Greece and Ireland started down this same road 18 months ago and to everyone’s dismay, continually fell short of expectations for many of the same reasons.  Nonetheless, bond investors, with the help of the ECB’s bond buying program, cheered the announcement and pushed Italian 10-year yields below 6% once again.

 

Subordinated 

Speaking of the ECB’s bond buying program, over $275 billion of peripheral debt has now been acquired by the central bank since early 2010.  The stated goal of the program is to reduce market rates and, therefore, the cost of funds for issuers such as Greece, Italy, Spain and Portugal.  I don’t know if it is an unintended consequence of the program but it creates a mushrooming problem for new and existing holders of peripheral debt.  As the ECB’s share of outstanding debt grows, the size of any haircut necessary to complete a workable restructuring also grows.  The ECB will not, cannot, accept a loss on its debt holdings.  And don’t forget the IMF.   The more money the IMF lends to Greece, etc., existing holders of Greek debt become more subordinated.  In the case of Greece, for instance, 40% of debt is now held by the ECB or the IMF.  For a restructuring of Greek debt to work, the haircut on the remaining 60% would need to be well above the 50% currently being contemplated and probably much closer to 100%.  Extend this scenario to the other peripherals and it becomes clear that you don’t want to be the last one to get up from the table because the bill will be large and you will find yourself in sad company.  As market participants increasingly come to this realization, the peripheral issuers will find fewer and fewer willing investors showing up to their bond auctions.

This leads us to an interesting dilemma that is about to be played out in the coming weeks.  There is approximately 11 billion euros in Greek notes and bills maturing between December 16^th and the  29^th.  Will holders of that debt get paid out in full?  There has been little made of these Greek maturities but Kyle Bass of Hayman Capital has recently discussed the potential for the IMF to step in and prevent the full payout of the maturing debts.  It’s hard to imagine those holders getting paid and walking away scot-free.  And yet anything short of that would likely be considered a hard default ushering in a new and more dangerous phase of the European debt crisis.

 

“The promise given was a necessity of the past: the word broken is a necessity of the present.”   -Machiavelli

 

Promises Made – “The Wealth Effect”

The entire developed world is grappling with how to keep or, more precisely, pay for the promises of the past.  Unfunded pensions, healthcare and other entitlements total in the tens (perhaps hundreds) of trillions and only compound the debt issues currently taking up the collective brain power of the world’s political leaders.  The news is full of examples where benefits or payments from the various government transfer programs were promised but never adequately funded.  As we speak, the state of Michigan is performing a review of Detroit’s finances which will likely lead to the state taking control of the City’s finances.  Government workers, many of whom are unionized, will be forced to accept cuts to their income and benefits.  This same story will play out all over the world for many years to come. 

One of the elements that most concerns me about the story, however, is the associated loss of “wealth” that recipients will feel when cuts are made.  Economists often talk about the wealth effect on the economy when investors experience a large change in the balance of their 401Ks, for example, when the stock market rises or falls.  After an extended “bull” market, investors feel more wealthy and are apt to spend more which propels economic growth.  Conversely, a sizeable stock market loss can incite investors to become more frugal thereby slowing economic activity.  While recipients of pensions, medicare, social security, welfare or other entitlements can’t point to a specific dollar value loss or decline in bank balance, a reduction in future benefits will no doubt leave them feeling less wealthy.  When you consider that cuts to benefits around the world are going to total in the tens of trillions, the psychological impact on the economy will be significant.  The market capitalization of the world’s stock market is approximately $60 trillion in aggregate.  The U.S.A. Today estimated in June 2011 that the unfunded liabilities in the U.S. alone exceed $60 trillion.  As recipients become aware that the promises of the past will be broken, the resulting (loss of) wealth effect will be yet another headwind for the global economy.

 

Fiduciary Responsibility

Kyle Bass, who I mentioned earlier, ended his latest investor letter with the following; “I am eagerly awaiting the day to finally arrive when our fiduciary duty compels us to worry less and invest more.  It is our job to avoid nursing 50+% losses because we failed to believe that a cluster of sovereign defaults was possible (let alone probable).  We urge you to consider the ramifications of our thesis being correct (that there will be sovereign defaults), preparing yourself for the worst while hoping for the best.”  I cannot express my feelings any better than Kyle.  In an investment environment where the yield on a 10-year U.S. Treasury is 2%, recouping even a 10% loss would take far too long.  As a fiduciary, I can only stress the importance of preserving capital given the size and scope of risks that exist.  These are global solvency risks, not liquidity risks.  We will not see the green light until our leaders understand the risks and then choose to deal with them in a forthright manner. 

 

(c) Sextant Investment Advisors

www.sextantinvestment.com