5.14.10

5.14.10

          The leaders of the European Union, International Monetary Fund, and global central banks, met in seeming panic last weekend, emerged, and announced a dramatic and expensive rescue plan for Europe’s spreading debt crisis. The next step would normally be for them to be all over the media promoting the positives of the plan and how successful it will be. Instilling confidence in nervous markets by showing confidence is at least as important as the plan itself.        Instead, this morning Jean-Claude Trichet, President of the European Central Bank, is quoted by the German Newspaper Der Spiegel, with the quotes spreading globally, that Europe’s economy “is in its most difficult situation since World War II or perhaps even World War I.” And that the current debt crisis is similar to the 2008 collapse of Lehman Brothers, after which “the markets didn’t work anymore.”

          Even if the rescue plan works to solve the debt problems, there’s already enough concern about the austerity programs the plan requires of countries accepting aid. Austerity (pay and pension cuts, fewer government services, etc.) is anti-growth, and has markets worried about Europe’s fragile economy (just 0.8% GDP growth in the 1st quarter) double-dipping into recession and dragging the rest of the world down with it.

          That kind of gloomy talk from leaders is not going to help calm markets and restore confidence. It’s a shame to spend that kind of money on a rescue plan and then pull the rug out from under its chances of success with scary talk from leaders.

          In January, global stock markets declined in a 10% correction on concerns about a potential government debt crisis in Greece, and initial moves by China to slow its economy. But the clouds blew over and most stock markets recovered. Three weeks ago the storm re-gathered, and global markets began to decline again. The debt crisis in Greece turned out to be real, and this time there were also fears it would spread to other European countries. There were also more fiscal moves by China to slow its economy.

          Our market’s decline worsened with a 1000 point intraday mini-crash (and quick partial recovery) a week ago Thursday, and another triple-digit decline the next day. Fears of a real crash then circled the globe, pushing European leaders into panicked secret meetings over the weekend. The surprise announcement that came out of those meetings last Sunday night, of a massive $trillion rescue plan for troubled European countries brought instant relief. The sun came out on Monday, with most global markets soaring. But there was no follow-through. The market was down three of the last four days.

          Look to the east, and we see Asian markets tanking, not having responded nearly as enthusiastically to the announcement from Europe. The Chinese stock market is at an 11-month low, down 24% since its peak last July. Hong Kong is down 15% from its peak of last November. Look in the opposite direction, to Europe, and the government debt crisis in Greece is spreading to Portugal and Spain. After protest marches and strikes in Greece last week, Spain’s largest labor union is calling for Spain’s public workers to strike, in protest of the austerity measures, pay and pension cuts, required by the IU/IMF rescue plan. Meanwhile, European stock markets rallied only briefly in response to the rescue plan announcement, skeptical that it will be successful. As a proxy for European stock markets, the VanGuard European etf (VGK) is down 16% from its top last November. Look south and the stock market of Brazil is down 12.4%, Latin America is down 14%.

          The storm clouds are worldwide. Record debt levels taken on by consumers in the bubble times were passed on to banking systems when the bubbles burst and households defaulted on their mortgages and loans. With the resulting near-collapse of financial systems globally, the banks passed the debt load on to the balance sheets of governments as part of the government rescue efforts. So it’s governments that now sit with the record high debt levels and record annual budget deficits.

Experts say governments have only three choices.

          Smaller countries could default on their debts, essentially declaring bankruptcy, stiffing the investors in their bonds, and like all bankrupts trying to start over with crippled access to credit markets. Large developed countries, particularly the U.S., could not consider that route. But as we have seen recently, just the potential for a default by even a small country creates panic in markets. Given the entanglement of international debts and loans, one or two small countries actually defaulting could well create another financial melt-down similar to what followed the bankruptcy of Lehman Brothers.

That leaves two other choices.

          Governments can pass the responsibility for paying down the debt back to consumers, where it started, through higher taxes and lessened services. That’s the austerity approach demanded by the EU/IMF as conditions for their big European rescue package announced last weekend. We can already see from the protest marches and strikes that will be a difficult plan to implement. An austerity approach also means less consumer, business, and government spending, resulting in a slowing economies.

          The third choice would be to try to inflate the way out, by allowing inflation to rise so governments could pay down debts faster (with inflation-devalued currencies). That has worked sometimes in the past. Unfortunately, markets don’t like rising inflation. So they were not good times for investors.

          Meanwhile, although other global markets have reacted quite negatively to the situation, the U.S. market hit a new bull market high just three weeks ago, and although more volatile since, is down only 6% from that high.

          Was the big rally on Monday an all-clear signal as some believe, justifying the complacency? Or is the lack of follow-through since an indication that we’re in the eye of a storm?

          The week ahead should be an interesting one, but filled with risks that we are not willing to assume. We remain 100% in CASH.

Till next time

The MTA Staff