I have been asked many times what will derail the market and each time my answer has been the same "nothing we currently know about." Now that we know the answer to what we didn't know, the next question is the most important: how much is this exogenous shock worth to the market and where will it go from here? Bottom line is that I feel I have time to add exposure but not due to this event; rather the market needs a breather.
Right now we are dealing with the unknown, post the retraction of the unprecedented proposal of taxing insured depositors. To me the issue is not whether Cyprus - maybe it will - or other countries actually do this - they won't - but whether the ECB can convince Spanish, Italian, etc., depositors, that they will not suffer a similar fate. Frankly, but for the fact that the unintended consequence of this action will be to tighten credit as depositors likely pull funds from other banks in more troubled regions, the Euro should arguably be stronger. The ECB, complicit in this move although not the depth of it, has drawn the line with Cyprus, a country of 1 million that accounts for a half percent of EU GDP where it is speculated that half of the bank deposits are allegedly looking for safe haven from money laundering laws. More importantly, given that the size of the needed bailout was almost at parity to the country's GDP, and the bank debt more than 8X GDP according to a World Bank report, there would be no likelihood of repayment. Arguably, the Troika's tough stance should strengthen the Euro since it is finally showing the limits of what Germany/ECB will do but of course won't provide a floor until a bailout is finalized. Alternatively, if Cyrpus leaves the Euro, either from reluctance to do what is required by the Troika or self-selecting to exit, this should also provide for a stronger currency, but again, it will take time for the markets to digest this as well. And in a well-reasoned world, US banks should attract more deposits and the equities more capital but contagion fears will overrule logic near-term.
So what now? It seems to me that the next move is up to Draghi and he will have to lower rates to offset the tightening caused by this incident. US Treasuries will catch a bid as other suspect Eurozone countries look for a safe haven and US banks may ultimately benefit. However, the stocks may initially trade lower as that nagging and unjustified feeling of contagion momentarily takes hold.
Bottom line: We were due for a 2-5% correction and this is as good a catalyst as any although the actual impact on global growth is non-existent thus creating a buying opportunity. However, my larger concern, one that is growing, is China. While they have the funds to paper over any bailout issues, their bad debt dwarfs that of any other regions Local government loans equate to more than $1.5 trillion. The faltering Chinese steel industry has bank loans of $400 billion in an industry that China's prior regime promised to downsize but instead production has grown. And it goes on. China won't be recovering any time soon and the impact on commodities will continue. I have no plans to increase exposure at this point but am also not sure this will be a big downside catalyst. I am, however, adding to my short in iron ore.