Season Investments


Macro Update: Europe Debt Crisis

Posted on February 3, 2012


 “A Greek, an Italian and a Spaniard walk into a bar…who pays? The German.”
– David Wessel, WSJ

A disorderly unraveling of the crisis in Europe is still the greatest “known” threat to investors of all types. While a number of potential outcomes are possible, we do not believe a worst-cases scenario is the most likely. In our view, all European participants are in a slow creep towards the “Lose-Lose Win” scenario in which fiscally sound countries (ie Germany) will reluctantly backstop losses for creditors of the fiscally rogue countries (ie Greece). In return, the rogue countries will have to cede a certain amount of control over budgetary policy to those footing the bill. This evolution is unfolding at a painstakingly slow pace as policy makers are engaging in political gamesmanship for the sake of appearances, despite realizing that certain eventual outcomes are inevitable. These outcomes will NOT be popular among anyone’s constituency. German taxpayers won’t appreciate being a source of bailout funds, and Greek citizens won’t appreciate being put under the strict thumb of a German-led governance authority.

Picture a set of reluctant parents trying to deal with the reality that their children, now in their mid-twenties, have accumulated such a vast amount of credit card debt that they are effectively bankrupt. Unfortunately the parents co-signed on the debt and thus are forced to take control and deal with the situation head on. In return for allowing the children to move back into the house and take shelter from creditors, mom and dad will be confiscating the credit cards, putting restrictions on the bank account, forcing the kids to get a job and collecting rent in the meantime. They will also negotiate more favorable interest rates and a haircut in principal with the creditors in return for pledging their personal balance and not simply declaring bankruptcy. No one in this scenario is happy (it’s Lose-Lose), but in general the situation is stabilized, the runway is extended and the problem can be worked out over time (in that sense it’s a Win).

While the above is our general view of how the situation will continue to play out, we realize we could be wrong. The various moving parts are numerous and complicated.

Negotiations are currently raging between the Greek government and private bond holders as to how much of a haircut will be taken “consensually” (probably in the 60-80% range). If this deal is struck correctly it will avoid a technical default in the eyes of the credit rating agencies, and thus a technicality will prevent those who speculated on the demise of Greek bonds by purchasing Credit Default Swaps (CDS) from collecting on what should have been a windfall profit. This will spur a flood of outrage and litigation against sovereign governments, ratings agencies and policy committees – all fully justified in our view. Beyond Greece the question becomes what happens to Portugal’s bonds, and then who is next after that? After all, if the Greeks don’t have to pay 100 cents on the dollar why should anyone else?

A weakening regional economy is also not helping the situation. Data reveals the severe disparities between member countries. Germany’s unemployment rate, for instance, declined to a healthy 6.8% in December while Spain’s was 23%. Compounding the problem is the fact that the weakest economies are also the ones with the most debt. The more government austerity is pushed through the system, the worse economic growth will be in the short run. This acts as an additional headwind to progress as governments will collect fewer tax receipts and will have a harder time trimming deficits and paying off debt.

Finally, the European Central Bank (ECB) is still somewhat of a wild card. Historically the ECB, which is heavily influenced by German banking officials, has taken a very rigid stance against inflation and shied away from “looser” monetary policies such as the quantitative easing programs that the U.S. Fed has implemented in recent years. Hypothetically, if the ECB was more willing to print money for the sake of buying up European sovereign debt it could have a substantial impact on the situation by pushing yields lower and allowing countries to rollover their debt at artificially lower yields. (Europe must roll over $1 trillion worth of debt in 2012.) Perhaps the greatest impact this would have would be to boost overall investor sentiment towards the region by ring-fencing the problems as a “lender of last resort”. We believe that as member countries continue to creep towards a fiscal alliance (co-mingling government budgets), the ECB will become more and more willing to print money and proactively address the sovereign debt issue. In fact recent actions by the ECB suggest they’ve already started down this path.

In summary, the situation in Europe is very messy and will not have a swift and clean resolution by any stretch of the imagination. However, a high degree of pessimism towards the region is already priced into assets, and we believe the stakes are high enough that European officials will continue down the Lose-Lose Win” path outlined above. This includes the “parents” (Germans, ECB) footing the bill while the “kids” (Greece, Portugal, Spain, Italy) play by a new set of rules and the “creditors” (bond holders, banks) absorb a portion of the losses.

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.