Greece, Fiscal Cliff Would Only Be The Beginning
Here's what everyone must understand, regardless of the current focus on the Fiscal Cliff and Greece. By themselves, taken either separately or together, they are not lethal threats to markets or the global economy.
- The consensus worst case result of Fiscal Cliff is a 4% hit to GDP. Painful but not expected to crash markets or the global economy.
- Similarly, at its current debt levels, a Greek default is painful but can be absorbed. It's arguably more a bigger threat than the US Fiscal Cliff because of the contagion risk it implies, but at this stage most expect the EU to prevent a default that prevents contagion.
However, if near term uncertainty about these isn't removed in the coming weeks, the risk of a major pullback or crash rise significantly. Why? Spain.
Markets have not worried about Spain in recent weeks because:
- It claimed it had enough cash to remain solvent through the end of 2012
- The ECB's OMT program was ready to buy Spain bonds and subsidize lower borrowing costs whenever Spain was ready to request it and accept additional austerity measures and outside audits in return for these new loans at subsidized low rates.
Thus Spanish borrowing costs remained low enough for it to avoid needing the OMT program.
Unfortunately, (unless arrangements have been made in secret) Spain and the ECB have not used this time to finalize an agreement about the details of these conditions in case the OMT program was suddenly needed.
That omission could prove disastrous. Consider:
- Spain needs to sell bonds soon: From late November through the end of January, Spain needs to sell well over € 20 bln of bonds.
- In that same December 2012 - January 2013 period, too-big-to-fail-or-bail-Spain is vulnerable to anything that causes significant risk aversion that would cause its borrowing costs to spike higher and need an OMT program which isn't ready because conditions have not been settled. Note how prolonged negotiations have become over further aid to Greece. Spain will need far more help than Greece, so despite the stakes, the EU funding nations are unlikely to risk taxpayer cash without a fight, so negotiations are unlikely to move fast. During that time of uncertainty, markets could get very nervous, making further borrowing for virtually all EU states much more expensive, and voila, a new EU crisis.
If the past is any guide, as we approach this sensitive time:
- The Fiscal Cliff negotiations are likely to come down to year end, and may well end in yet another agreement that hikes US debt, shows Washington's inability to deal with its debt, and scares markets.
- The EU will likewise be doing little more than the minimum needed to avoid a Greek default and preserve uncertainty about the timing and consequences of its default.
In sum, risk aversion, and Spanish borrowing costs, are likely to be spiking just when Spain needs its bond rates to stay relatively low, and the OMT may well not be ready before markets have gotten a nasty contagion scare and selloff.
As we discuss here, Greece and the Fiscal Cliff are not the only threats to market stability.
- Fiscal Cliff Fuels Technically Driven Selloff: Fear of increased dividend and capital gains taxes could bring exceptional year end selling that fuels the ongoing technical breakdown in stocks. The bellwether S&P 500 is sitting near its 200 day moving average. If that extra selling pulls the index and others decisively below that support, we could get additional technically driven selling that creates further risk aversion.
- Ongoing Slowdown Plus Economic Calendar: This week's calendar could further highlight the global slowdown as it's exceptionally packed with top tier reports from the EU, US, and China. Thursday and Friday also feature bank holidays in the US and Japan, meaning both of these markets should show very light volume. That can bring quiet trading, but it can also lead to exceptionally volatile moves if big news hits. The long holiday weekend and thin liquidity can be a tempting time to announce market moving news for those positioned to benefit from exaggerated volatility, as demonstrated when Dubai World announced its default as liquidity drained from markets and traders took off for the long weekend.
However, Greece and the Fiscal Cliff are the two most obvious ones as of this writing. If they're still around when Spain needs to tap credit markets, things could unravel fast.
We have about 6 weeks to go.
How many of you believe that near term risks from both the Fiscal Cliff and Greek default will be gone by then?
The Key Lesson
Yes, the above suggests a bearish bias in the coming weeks. There are many sources about how to cope with that.
I'll stick to just one of the implied lessons that are not likely to come up elsewhere.
The most likely scenarios for near term resolution of both Greece and the Fiscal Cliff will involve more debt and more money printing to fund it in both the US and EU.
If Spain needs aid fast, and the OMT isn't ready, the EU, and others (read US and other G20 nations) are likely to need some kind of stopgap plan to prevent default and calm markets that also requires more cash printing.
New elections in Japan are expected to bring more money printing from Japan.
Other export nations are also likely to debase their currencies in order to defend their exporter's market share.
Whether these policies are right or wrong, they are terrible for anyone trying to build assets denominated in these currencies.