EUROPE STILL FRONT PAGE NEWS
It’s necessary to comment on the situation in Europe despite the fact that after two years of drama this story is getting to be very old. First, here’s a very simplified recap of how we got here…
How do we define the tipping point? Well, there are three “legs to the stool” required to support the path of ever-increasing indebtedness that these countries were on: 1) the ability to borrow more money, 2) the ability to do so at reasonably low interest rates, and 3) stable or increasing income that can be used to service the debt. The tipping point is reached when one of these three legs is weakened to the point of breaking. In Europe’s case, it’s all three at once. On the first and second point, investors are no longer willing to lend money to these countries without charging prohibitively high interest rates. On the third point, government revenues are increasingly unstable as the region tips into recession.
The vast majority of European sovereign debt is held by European banks, and most of it by banks in the healthier core countries such as Germany and France. Historically European banks have been able to treat sovereign debt as “riskless” on their balance sheets and have not had to hold capital to hedge against any default risk (how could a riskless loan ever default, right?). As a result European banks carry leverage ratios that are roughly 3-4 times higher than US banks.
So, why does this matter? It matters because the European banking system, while remaining solvent on paper, is actually bankrupt. A country like Italy, which carries the second highest debt-to-GDP ratio in the Eurozone and has three times more debt than Greece, Ireland and Portugal combined, is simply too big to fail. Any material restructuring of Italian sovereign debt would wipe out enough bank capital to take down the entire system.
European leaders know this and will be forced to do whatever is necessary to bail the system out. All attempts thus far have been awkward and inadequate, which is why this issue is still by far the greatest macro-level risk facing investors. However, the most recent summit which concluded just last night may turn out to be a historical turning point in which the Eurozone finally begins taking steps towards a central governing body similar to the US Federal government. This would essentially mean that Germany would step up to the plate and backstop the debt of bankrupt countries, and in return those countries would cede a great extent of their independence and sovereignty to Germany. This is a lose-lose for the Europeans, but from our perspective they really have no other choice.
We didn’t intend to focus exclusively on Europe in this post, but for the sake of time we will reserve other topics for the next write-up. Meanwhile, our current positioning is actually leaning bullish for the following reasons:
We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.