Does it ever feel like THIS to be a stock market investor these days? Last month, the equity markets were rocked by the Standard & Poors ratings downgrade of longer-term U.S. Treasury securities. A week later, it was problems with European debt. It’s not immediately obvious, even for some financial professionals, why U.S. stocks should suffer because Greece or Italy have trouble paying their debt obligations. But in a recent posting, Mohamed El-Erian, who serves as CEO and co-CIO of the world’s largest bond management company, made an interesting analogy that helps to make the situation a bit clearer.
His analogy suggests that we think of the European Central Bank as a Coast Guard cutter in the Mediterranean, and it gets a warning that a relatively small cruise ship called Greece is in trouble. The ship passed through a significant storm called 2008, and now, through poor planning, has run out of food and fuel and is in danger of sinking. True to its mission, the Coast Guard cutter sets out to tow the battered ship back to shore.
But then the rescue ship receives another message. A somewhat larger cruise ship is also in trouble, as a result of the same storm. Another call comes in, a third ship is foundering. And then one of the larger vessels, called Italy, announces that it is in trouble as well. Playing with the analogy here at CKAG, we have added to El Erian’s story: we discover that some of the passengers on these various vessels have been rescued by other cruise ships that are also foundering (Portugal, Ireland, Iceland, Spain) and that some passengers on the ship United States have also rescued passengers. If some of these European ships sink, some passengers on the United States cruise ship will also suffer and this is true for all the cruise ships including the Coast Guard vessel.
What to do? Nobody prepared for the possibility that more than one ship would be in danger at once, much less four or five. The Coast Guard vessel can think of only one thing to do; it radios the two largest cruise ships in the Mediterranean, called Germany and France, and asks them to participate in the rescue operation, by cutting short their trips, sharing the food and fuel that was set aside for their passengers, and basically rescuing the cruise ship business before too many future passengers become disenchanted and cancel their tickets.
The captain, the cruise ship lines (the leaders of France and Germany) and even the passengers are willing to help out when they think the rescue mission will only take a few minutes, but when the passengers realize the depth of the problem they become extremely restless. Why should their entire trip be sacrificed? Why should a significant amount of the food they paid for be shared with the passengers of less stable or thrifty cruise lines? The captains of the France and Germany cruise ships are afraid their passengers will mutiny if they execute a complete rescue, and, at the same time they are afraid of the consequences to the cruise industry if there is no rescue and one of the smaller cruise ships goes down with passengers and crew.
The world, of course, is watching. The overwhelming hope is that the larger ships will come and save the day at no cost to the rest of the world. The fear is that they may not. Meanwhile, El-Erian says, the crew of the struggling rescue vessel is struggling with a once-unthinkable decision: should they throw somebody overboard to lighten the vessel and save the rest of the passengers?
This, El-Erian says, is the European Central Bank’s (ECB) situation today. However, it is more dire than that; the ECB has bought so many bad sovereign notes from the weak Euro countries or the banks in the system that should Greece or one of the larger countries renege on its obligations, the ECB may be perceived as or become insolvent. And if we have learned anything since 2008, it is that in such a highly-connected global economy, if one major entity is allowed to go under the waves (think Lehman Brothers), the entire global system will be negatively affected. Hence, investors sell stocks in fear of another 4th quarter of 2008.
How likely is that? El-Erian points out that there are three possible endgames to the European sovereign debt crisis. One is a disorderly breakup of the eurozone, which would mean temporary economic chaos. This could happen if the countries with the largest debt problems – Greece, Ireland, Portugal, Iceland, Spain and Italy – fail to address their fiscal balance sheets due to pressure from their voters. To return to the cruise ship analogy, the people aboard the vessel named Greece believed that they paid for an appropriate ticket, and now the captain is telling them that they will have to sacrifice their vacation and pay back the Coast Guard and the other cruise ships. The response, for some, has been rioting.
A second possibility is a tighter fiscal union among the European countries, which basically means that Germany (and, to a lesser extent, France) reaches into its pocket and bails out the debtor nations to the south. In return, Germany gets more control over the economic governance of the other members of the European Union. The Euro zone moves closer to being the United States of Europe. The slogan of this approach: never again will we float unsafe vessels. This is similar to the response to the sinking of the Titanic.
And the third? Several economists, El-Erian says, have floated the idea that two or three “peripheral economies” (Greece and Italy) would take a sabbatical from the euro. They would go back to their own currencies, which would allow them to devalue immediately, making their exports more competitive and their debt less costly. Instead of imposing an unpopular new tax on the population, the countries would impose a stealth tax in the form of higher inflation. Meanwhile, the euro becomes stronger. The motto: fix your own vessels, and then come back to see us when you’re finished. El-Erian, however, is not taking into account that should Greece default (which is what a sabbatical really means), the ECB would probably become insolvent. This would throw the world into a crisis of the same magnitude, if not worse, than when Lehman Brothers was allowed to fail by the US government. Hopefully, the Europeans have learned from our error and will not shoot their noses off to spite their faces!
The real problem is that the failure of Greece would cause several German and French banks to lose so much capital that they become insolvent. We saw the same thing occur when Lehman Brothers went bankrupt. Since the crisis began, the ECB has been purchasing toxic loans from the banks to shore up the banks’ balance sheets. The result is that the ECB’s own capital has been eroding. So the values of European bank notes and the sovereign debt of some Euro nations may drop, threatening the US financial system due to the European equities and debt held by US entities. In 2008 the Federal Reserve provided more than $100 billion dollars to European banks to assist them with their liquidity. If the ECB were to fail, the Federal Reserve would probably step in and help prop up the European Central Bank. This possibility creates nightmares for many US money managers.
As one of these scenarios plays out, it might become obvious that many American and European stocks are currently being affected more by anxiety and uncertainty than by any direct connection with the euro’s woes. A report recently noted that Apple Computer was worth more than all 32 of Europe’s largest banks. If chaos reigns across the Atlantic, there could be a flood of capital looking for a safe, liquid home in the U.S. stock market after the initial drop. So, the US looks safe, but the true consequences may be different than anticipated. This underlines the reasons why we have been cautious with your accounts, and we are confident that we can ride out any potential drop in the equity markets as long as we refrain from selling at the low!
Source: http://www.project-syndicate.org/commentary/elerian8/Englishhttp://www.cultofmac.com/apple-was-worth-more-than-all-the-banks-in-europe-earlier-today/109642
