It is quite a spectacle watching the market grind up on low volume day after day. I believe the day of reckoning is approaching for a myriad reasons. Higher gas prices, the end of QE2, the dire state of the Federal and state budgets, Middle Eastern turmoil, acceleration of inflation, the moribund housing market and a half dozen other core challenges. Personally, my biggest concern is the European Debt contagion, which is getting worse by the day and which the markets seem to be completely ignoring. Here are five countries in Europe that are problematic and bear watching. Personally, I don’t think we will successfully make it through the summer before the markets hit a major landmine due to the situation in Europe.
- Greece – Where do you even start with Europe’s first bailout? The debt markets are basically telling you that Greece is not going to make it without a significant restructuring. 10 Year Greek Debt is yielding approximately 16% and two year notes go for more than 24%. The country also just reported that its deficit was a worse than expected 10.5% of GDP for 2010, higher than the 9.4% figure reported just a few months ago. Despite all the austerity measures and the bailout package, Greece just cannot sustain this trajectory without major debt restructuring; the only question is when and how the markets will react. At current rates of deceleration in the economy, I don’t see how Greece makes it through the summer without a major restructuring.
- Ireland – Our second European country that went hat in hand to the European Union. Although Ireland’s problems were caused by a housing bubble and an unwise choice by the government to guarantee all its bank’s deposits and debts during the height of crisis (as opposed to profligate government spending in Greece), its problems are just as dire as its fellow bailout friend to the south. Ireland’s deficit for 2010 was 32.4% of its GDP and total government debt now stands at 96.2% of total GDP with projections it will 102% by year end. I don’t believe there is any way Ireland can institute enough austerity measures or grow enough to overcome its debts. It will likely last longer than Greece before the inevitable restructuring, but it will eventually have to happen.
- Portugal – Our third little piggy is still negotiating its bailout package. The previous government had to step down because it could not get support it needed to institute further austerity steps. Portugal also just reported that its deficit for 2010 at 9.1% of GDP is quite a bit higher than the initial 7.3% number reported. Portugal’s cumulative debt now stands at 93% of GDP. All three of our bailout countries are in trouble that they are not going to be able to get out of without restructuring. This will disrupt the markets when it occurs, but not nearly to the extent that it will if our fourth candidate has to go to its European neighbors to be rescued.
- Spain – For right now it looks to be stabilizing at least in the eyes of the bond markets(of course we don’t know how much of its debt the ECB is buying). However, given inflation just hit a yearly high in Europe’s biggest economy, Germany; the ECB is likely to have to bump up interest rates again soon. This will not be good for the Spanish economy, which has little to no growth and a 20% unemployment rate. It also has a housing overhang that makes the United States housing crisis look like a walk in the park. It will be interesting to see how Spanish debt markets react when one of the bailout countries has to be restructured.
- Finland – Yes, Finland. It has the potential to disrupt the whole bailout cycle. The anti-eurozone party, True Finns just won enough of the vote to probably be included in any coalition government. This could make efforts to expand the European Union’s lending facility problematic and is likely to be followed by elections of governments in other countries with the same bent. It is a political reality based on human nature, that eventually the European populace will tire of bailing out other more profligate countries within the Union. I believe the original conception behind the bailout mechanism was to get all European economies through to 2013 when new rules will take effect and hopefully the countries within the Union would be in better fiscal and economic shape. More importantly, this would allow the banks time to rebuild their capital to the point where they could either extend maturities, lower interest rates on the sovereign debt they hold, or take a minor haircut. If the bailout conveyor is stopped somehow before then, the European banks will need to take a major haircut now. This will be a huge blow to lending, economic growth, and the liquidity of the markets as they do not have the capital to withstand this type of event at the moment
Combined with the other headwinds I listed at the top of the article, the tragedy in Japan, and the efforts by the Chinese government to cool its economy and property market, I think we are entering a very dangerous phase for the markets. Be careful out there, stay liquid; better entry points will present themselves in the near future.