Living in Florida I’ve been in the eye of several hurricanes. In the eye, one side of the storm has passed and there is great relief. There’s some rubble and signs of destruction, but the sun is shining. We begin to pick up the pieces. There’s a hopeful feeling the danger has passed. Then you listen to the weather forecasters and learn it’s just a temporary respite. You’re in the eye of the storm. The other side of it is about to arrive, sometimes with more fury than the first side.
Unfortunately, economic radar is not as advanced as weather radar.
However, we can look at conditions off in the distance and surmise whether what was just experienced was an isolated financial cold front passing through, or ongoing problems that have us in the eye of a storm.
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.
The 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.
The eye of the storm?
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%, the iShares Latin America etf (ILF) 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?
Disclosure: No positions