It’s only a matter of time.
While market participants and the media spent much the last week fussing about what Fed Chairman Ben Bernanke would say on Friday in Jackson Hole, the situation in Europe continued to unravel right before our eyes. European leaders were never able to get ahead of the crisis as it unfolded over the last few years, and it now appears that the day of reckoning is drawing near. As a result, it is worthwhile to consider how to prepare accordingly, particularly given a U.S. equity market that continues to defy reality.
Greece provided us with the most glaring evidence of the deteriorating situation in Europe. During the past week alone, Greece’s 2-year government bond yields rose by over 8 percentage points to 46%. Yes, that’s 46% for Greece to borrow money for two years. The message delivered by the market by these yields is that an official technical default for Greece is imminent. Not a “soft restructuring” or some of the other unique phrases that have been offered up in recent months in the desperate attempt to get around the issue, but an actual official technical default.
Several issues are at the core of this recent development for Greece. First, the eurozone countries that are deciding whether to rescue Greece are now mulling collateral demands for their loans. And the voters in these rescuing countries are showing increasing signs of fatigue and reluctance to take on any further debt responsibilities of their at risk neighbors, putting politicians on the hot seat if they decide to move forward. At the same time, the legality of the European Central Bank’s bailout efforts to this point is being called into question. Finally, the Greek’s are debating whether they might just decide to opt out of the bailout plan anyway. All of these issues and more need to be resolved in the next few weeks of September. It’s an extremely tall order to say the least.
Regardless of whether the Greek bailout deal gets approved in the next few weeks or not, how events are currently unfolding today have essentially sealed the fate for the euro currency. This is true for four key reasons.
First, Greece is a relatively small problem for the eurozone in terms of the size of their economy and debt obligations. If it has been this difficult to get a rescue deal done for what was a manageable situation like Greece, it is unrealistic to expect that something can be put together for a much larger nation in the region that may need similar support any time in the near future.
Second, the response by European leaders to the ongoing crisis across the region remains far too slow. For example, the situation in Greece did not just pop up yesterday. Instead, this has been brewing underneath the surface for a few years and has been a headline crisis since the spring of 2010. That’s nearly 18 months ago, yet here we are today with a problem that is not only unresolved, but far worse.
Third, the response has been disorganized and lacking clarity. At no point did the message ever become fully unified and unequivocal across nations and governing bodies like the ECB and the IMF. Instead, it has been a steady stream of mixed messages and newly hashed plans bearing few details hitting the headlines almost daily. Moreover, we’ve seen instances along the way including most recently both the actions by the ECB and the rumored collateral deal struck between Greece and Finland where it appears that those in charge of the situation may not be fully aware of the rules under which they are operating. And over the weekend, IMF head Christine Lagarde introduced the idea of capital injections directly into financial institutions across the region. This was just the latest in a long line of divergent policy ideas contributing to the confusion of how this problem actually gets fixed.
Finally, it appears that the voters across the region may have had enough. It would be one thing if everyone if all of the citizens across the eurozone were 100% behind doing whatever it takes to fix the situation. But instead, many voters in rescuing nations don’t want to be on the hook for the debt of their neighbors. And many voters in the nations being rescued would rather default on their debt anyway instead of suffering the seemingly endless pain of austerity.
The opportunity existed at one time for European leaders to get out in front of the problem and put it to bed. But this opportunity has long since passed. And as the situation in Greece descends into darkness, the day of reckoning for the euro currency may be soon upon us.
The beginning of the end for the eurozone could come as soon as September 7, when the German courts are scheduled to decide on whether the recent bailout actions by the ECB are in violation of European Union treaties. If this goes badly, watch for credit spreads to potentially explode across the region.
If we manage to clear this hurdle, the next will be the official votes on the Greek bailout plan from rescuing governments in Germany, France, the Netherlands, Finland and others. Many of these votes will be coming in late September. And all of this assumes that the Greek’s continue to want to accept the bailout.
Adding another wrinkle in the coming days is the stability of Spanish and Italian government bond yields. The ECB recently intervened and brought 10-year government bond yields in these countries down from above 6% to 5%. While the ECB had been successful in recent days in keeping both countries essentially on the 5% level, Italian yields edged out to 5.07% at the end of last week. If these yields start to blow out again, the situation in Greece could quickly become an afterthought.
Given the potential threat of the eurozone crisis to financial markets in the coming weeks, it is important to keep a close eye on the situation and plan accordingly. Not all asset classes will necessarily suffer if a contagion episode were to unfold. For example, safe haven assets are likely to perform well as investors flock to protect capital. This includes gold (GLD) and U.S. Treasuries (IEI), (IEF), (TLT), (TIP). Silver (SLV) may also be worth consideration along with the Swiss franc (FXF) and the Japanese yen (FXY). Even the U.S. dollar (UUP) may start have tactical appeal at some point, as the euro (FXE) is unlikely to hold its currently elevated level versus the U.S. dollar if a collapse started to appear imminent. It should be noted that short-term volatility might occur for any of these safe haven asset classes depending on what forced liquidation activity might occur along the way.
Stock positions should also be considered carefully with the looming eurozone threat on the horizon. It doesn’t help that September is the worst month of the year for stock returns with an average -1% decline historically. But if a contagion event unfolds, performance could end up being far worse. Fortunately, U.S. stocks have been floating higher in recent days seemingly oblivious to the mounting risks. If nothing else, this provides a good opportunity to lock in gains and reposition for what might lie ahead. Moreover, if a contagion event were to ultimately erupt, the downside impact would not necessarily be immediate. After all, it took about two weeks after the collapse of Lehman Brothers before stocks plunged into crisis. This argues for maintaining allocations at least for now to selected high quality stock positions that can perform well in a rising market but are also suited to hold up better during a crisis event. Representative names include PepsiCo (PEP), General Mills (GIS), HJ Heinz (HNZ) and Procter & Gamble (PG).
Perhaps the eurozone will finally figure out a way to solve the problem. Or perhaps a coordinated global response that includes the U.S. Federal Reserve will come in and save the day for the eurozone. If so, this would remove a major overhang of uncertainty for investment markets. But until then, it is worthwhile to keep a close eye on the markets and stand ready to move if necessary.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
Disclosure: I am long GLD, IEI, IEF, TLT, TIP, SLV, PEP, GIS, HNZ, PG.