Ten years on and in many ways it still seems like yesterday.
Like all of us, I will always remember the tragic day of September 11, 2001. I recall the deep concern for my family, friends and associates as events dramatically unfolded that morning. And I still feel genuine sadness a decade later for all of the people that died and the families that were forever affected. It was a day that we all will never forget.
The events of 9/11 were also instructive in many ways that continue to impact our lives today. It provided us with important lessons about protecting against the risk of terrorism and making safety an utmost priority. It also granted stories that remind us of the courage and resilience of the human spirit in the face of incredible adversity. These principles have relevant application throughout our lives each and every day. This even includes how we navigate our way through the financial crisis that has been overhanging the global economy and the stock market the last few years.
One of my most vivid memories of 9/11 came when watching events unfold at the World Trade Center that morning on CNBC. I recall my original thought when the towers were hit - if they did not fall from the initial impact, they would remain standing. So when the unexpected images of the South Tower collapsing at 9:59 AM came across the television screen, my next thoughts immediately turned to its twin that was still standing. The North Tower was soon to fall too. It was no longer a question of if, but when. And there were likely thousands of people still in the North Tower that needed to be evacuated and saved as soon as possible before it finally happened.
Although vastly paling in comparison, several instructive parallels can be drawn between the tragic events of 9/11 and the unfolding of the financial crisis over the last several years. Both the United States and Europe have long been the two pillars of global financial markets, making up over 70% of the world’s stock market capitalization and an even greater percentage of the world’s fixed income markets between the two. When the financial crisis struck in 2008, the most severe initial impact was sustained from the unraveling of the housing market in the United States. And just like when the South Tower first fell, the resulting initial collapse of global financial markets was unexpected and shocking to many. But just like the North Tower, it quickly became apparent in the aftermath of the U.S. crisis that it was likely to only be a matter of time before the situation in Europe would eventually lead to crisis as well.
Once again, it was no longer a question of if, but when, as many sovereigns across the region had assumed debts that they were likely not going to be able to pay back in the wake of the crisis. But this second crisis would not be unexpected and actions could be taken to prepare as much as possible in advance. As a result, the priority over the last several years from global policy makers has been to try to protect the global financial system and its participants, as well as save as many financial institutions as possible before the new crisis finally arrives.
A great deal has happened since 2008, and it appears that we are now drawing close to this second crisis outcome emanating from Europe. And as we prepare for this final result, it is worthwhile to consider two questions in determining whether the situation in Europe is about to fall.
The first question surrounds the catalyst event. It would most likely come in the form of a default. In September 2008, it was the collapse of Lehman Brothers. Today, it is highly likely that it could be a default by Greece. And if the system can withstand a Greek default like it did with Bear Stearns in early 2008, then the focus will then likely turn to Italy.
The next question would be the indicators to watch that may signal such a default outcome in advance. These are listed below.
The Stock Market Itself
The stock market has been showing a great deal of stress in recent weeks. After plunging sharply lower in early August, the market has been whipsawing up and down in the weeks since. This alone suggests a great deal of strain and uncertainty lurking under the market surface.
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Of course, the key is to isolate indicators that will provide a signal in advance as to whether stocks will ultimately break to the upside or the downside from its current swinging channel. Many of these follow below.
Government Bond Yields
At present, three key government bond readings are worth watching most. These are the yields on the Greek 2-year, the Italian 10-year and the Spanish 10-year. At present, the Greek 2-year bond is signaling that default is imminent. Yields were at 55% on Wednesday, and they closed on Friday at 57%. This is simply unsustainable.
The situation in Italy also remains shaky at best. The key here is that 10-year government bond yields stay below 6%. But following ECB rescue efforts that briefly brought yields down to the 5% level, they are once again back on the rise due to uncertainty over the sustainability of Italian austerity measures required for the continuation of ECB support. Yields were 5.26% on Wednesday and they closed on Friday at 5.41%. Also not a good sign.
Spain is measured in the same way as Italy, with the priority to keep yields below 6%. And while Spain has been faring better than Italy since the ECB brought yields in both countries back down to 5%, they are now also on the rise. After closing at essentially 5% on Wednesday, 10-year Spanish yields are back up to 5.16%.
Credit Default Swaps
Another indicator worth watching to monitor for a default episode is credit default swaps (CDS). The higher the reading, the more likely a default is to occur. In Greece, these readings skyrocketed on Friday to all time highs - once again, confirming that default may be imminent.
So too have these readings spiked to new all time highs in Italy. Although still at relatively low levels on an absolute basis, the sharp roughly 100 point increase since the beginning of September alone is reason for pause.
A tour of CDS readings across Europe shows a similar alarming trend with readings also spiking sharply higher in even the strongest of sovereigns. Illustrating this point, the following is the CDS chart from the very heart of the eurozone in Germany. Although the absolute numbers are low, the trend is clear that underlying strain are building.
Common Stocks – European Banks
What would ultimately lead to a second financial crisis would not necessarily be a sovereign defaulting on its debt. Instead, it would be the impact on the capital position of the many banks across the European region that hold this sovereign debt. In other words, if a country declares default, it could end up taking many banks down with it. And this is where contagion quickly ensues.
The most straightforward measure of a bank’s financial strength is its stock price, as it essentially serves as a reflection of its health, including its ability to raise capital if needed. On the flip side, if a bank’s stock price plunges into chronic decline, it can be foreshadowing an increasing problem. As a result, the fact that European banks as measured by the iShares European Financial Sector ETF (EUFN), collectively fell to fresh new lows on Friday is another signal that strains are building.
Preferred Stock Market
Since preferred stocks reside one step up on the capital structure from common stocks and the preferred stock market is made up of roughly 85% financials, this area provides a good reading on investor sentiment toward the future solvency of the global banking system. The iShares S&P U.S. Preferred Stock Index ETF (PFF), 24% of which consists of European financial institutions, is trying to find its footing and is still holding its recent upward sloping trend line. But while the preferred stock market is still well above August 8 lows, it has been down six out of the last seven trading days. Any further deterioration in the coming days would be particularly worrisome.
High Yield Bonds
Like the preferred stock market, another category that continues to fight to find its footing has been high yield bonds. According to the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the category is currently holding its recent uptrend off of its August 8 lows, but it has found tough resistance at previous support levels near $87. Once again, rapid deterioration here would spell trouble.
Investment Grade Corporate Bond Markets
The investment grade corporate bond market is worthwhile for stock investors to watch as a last line of defense. From the moment that Lehman Brothers collapsed in September 2008, the category as measured by the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) started falling sharply. If we see a similar reaction from any sovereign default event in Europe, this would be an indicator for stock investors to move to the sidelines in earnest, as such a move would signal solvency concerns among higher quality institutions.
Today, no such signs of stress are emanating from the LQD, but is should be noted that a sharp drop in the LQD is effectively a coincident indicator, not a leading indicator. In other words, it would help investors confirm that a new crisis may be underway.
Flipping the readings upside down, as long as gold continues to rise, concerns over currency debasement and crisis continue to grip the market. And despite a few heavy hits in recent days, gold (GLD) remains resilient and continues to find itself near fresh new all time highs.
Safety seeking investors concerned over the threat of a crisis outbreak in Europe continue to seek refuge in U.S. Treasuries (IEI, IEF, TLT, TIP). On Friday, the 10-year Treasury yield tacked sharply lower to end the day at a fresh new low of 1.91%. And the longer duration segment of the Treasury market also continues to perform well, indicating that the demand for safety in Treasuries remains considerable.
These are some of the key indicators to watch in the days and weeks ahead for a potential default event and subsequent second crisis. But with these current risks in mind, it is also important to look ahead at the positives.
Remembering The Positives That Lie Beyond Crisis
On September 11, 2001, the United States endured an excruciating tragedy. But look at how far we’ve come in the 10 years since. A beautiful new memorial on the World Trade Center site is being dedicated today, on the tenth anniversary, with people coming together to celebrate America, remember the lives lost and the courageous heroes from that fateful day. We will also have the opportunity to look up from the WTC memorial site to see a magnificent new building in the process of rising to previously unreached heights on the New York City skyline.
The resolve of the United States and the free world is amazingly strong, and despite the hardships that we may endure along the way, we’ve always found the ability to overcome, to innovate and to reach new heights. And where we stand today, 10 years after the events of 9/11, is a testament to the resiliency of the American spirit. For this, we should be very proud.
It’s also important to remember that these events come 10 years on. The World Trade Center site was not restored immediately after the tragedy. The rebuilding has taken time, and the process along the way has been complex and challenging with some uncomfortable decisions and controversy along the way. And even today, the magnificent Freedom Tower on the WTC site is still under construction, projected for completion in 2013.
The same should be remembered for the global economy and markets in the wake of the financial crisis. The financial crisis has been a traumatic shock thus far, and it should not be expected that things are going to be restored to normal right away. Instead, the healing and rebuilding process for the global financial system is going to take time once the dust settles. And the deleveraging and cleansing process needs to be allowed to play itself out. Moreover, the system will be forever changed by the events that have occurred over the last several years. But while lives lost can only be remembered, wealth lost can always be restored.
We have faced down hardship and challenges in the past, and we will continue to do so in the future. We overcame the events of 9/11, and we will overcome the financial crisis. And just as the events of 9/11 made America stronger as a nation, so too will the financial crisis make the global economy and markets stronger in the end. While the experience is painful and the rebuilding process lengthy, the resilience of the human spirit and the ability to overcome hardship helped guide us through the past decade since 9/11 and will eventually help lead us to a resolution to the financial crisis. Along the way, it’s important to remember that while the healing process just takes time, our economy and our markets will ultimately be stronger in the end.