The euro debt crisis is a repeat of what happened in the US in ’08 but their problems are magnified by constraints on individual countries to react according to their individual problems. Unemployment in Greece, coupled with risky asset lending and a severe recession in shipping dry and wet goods, the main engine of the Greek economy, has created the perfect storm with regards to the likelihood of a Greek default on their sovereign debt.
However, the ECB is not mandated to inject capital into Greece. Instead, any bailout must come from other euro participants, such as Germany. We can compare it to Texas bailing out California, which would never happen. Thus, individual actors must consider the “greater good” of the entire system rather than their individual economies. This makes taking action difficult. Consider a German citizen who loses his job due to austerity measures taken after Germany bails out Greece in order to offset the currency spent on the bailout. That unemployed German has no recourse other than to say “my euros are safe, at least.”
On the other hand, because of direct German support of Greece, previously unemployed Greek citizens may find jobs again. This mobility of capital does nothing to help the mobility of labor and does a lot to contribute to the potential of moral hazard; a modern phenomenon tested for the first time in the history of the euro’s short life. In the US, we scream bloody murder when the Fed steps in to bail out a bank or a large hedge fund to prevent systemic financial calamity.
In Europe, it’s the opposite. Their citizens scream bloody murder when the ECB and its individual constituents don’t come to the rescue of their neighbors. Whether the problem is contained in Greece or evolves into a true “crisis” by hitting a larger economy such as Italy, will decide the outcome of the euro. Until then expect the euro to continue falling as money rotates out of euro-denominated assets as well as continued pressure on the euro from other fronts. The easiest way to trade this particular global macro theme is to short the EUR against the JPY.
Nation-States bound by a currency and nothing else is an extremely cutting edge economic idea never before attempted without a Federal Government. In the US, if policymakers fear a recession, they don’t go state by state to see how each individual state is doing. They make decisions based on aggregate national conditions. Excessive weakness in Florida, California or New York doesn’t impact the overall fiscal and monetary policies coming out of Washington as the data from those 3 states contributes to the overall picture. Thus a lowering of national interest rates will help the weaker states but policy makers don’t fear setting off inflation in Oregon or Texas for example.
The Founding Fathers gave individual states a great deal of power and autonomy to be able to govern themselves according to the wishes of their constituent residents. California is a perfect example. As the most powerful state in the Union, California is governed by popular mandates in the form of propositions that voters can put on the ballot and have special elections to decide on matters important to the population. At present, California is facing a severe but slowly improving budget deficit.
The state can’t go knock on Oregon’s door and ask for money, or other states which have enacted laws that dictate surplus revenues to be saved for times of budget deficits. California doesn’t have a law in place forcing legislators to save surpluses during good times so they find public projects to spend the money as a matter of law.
The play is to focus on US markets since we’re near the 2007 highs. Remember in times of uncertainty, capital flows inward from the periphery (i.e. emerging and frontier markets) to USD denominated assets, but only to a certain extent. If the fear spreads, or the hedge funds continue to bear raid the currencies and bonds of the outlier countries, and then gain the confidence for a coordinated attack on the euro, forcing Greece to drop out of the ERM like the UK did in the 90s, then it’s just history repeating itself, as it always does.
This seems to be a bonanza for US companies especially in the energy and technology sectors as fears of rising inflation have abated regarding labor costs bringing down production costs and pushing up top line revenue, which will continue to rise as benefits of a weak dollar will continue. However, if there is a breakaway of even 1 country out of the ERM, then global asset markets will take a beating. US stocks are overpriced. They’ve been shrugging off negative news and trading as if they are in a vacuum, untouched by global financial crises. This is the same mindset we saw in the past that led to major equity pullbacks in the US. As we’ll see soon if Greece does in fact pull out.
The rest is yet to come, but not visible at this moment because Germany has been keen to keep its cards close to their chest to let the euro depreciate before executing a full bailout, if that is in fact their intent. The fog is thick with respect to European Debt but I’m still not ready to declare it a “crisis” like the talking heads on TV. The focus for asset traders in the US should be US equities, vulture real estate buying, and trying to see where to begin legging in on these expanding spreads in European debt.
But like LTCM step in early and with leverage and blow up. I don’t know if we have anymore LTCM’s out there to blow up, but it’s possible for several funds to blow up and thus create a similar situation as LTCM. If Greece is forced out of the euro, I think we’ll witness a major bear raid on the euro. This will actually help eurozone economies but will devastate Asia as their goods will become non-competitive, leaving it to the US to pick up the slack, just like China did in 2008.
From a trading perspective, I would focus on the energy sector, or more specifically, drilling companies like Nobel as they benefit from new oil and gas discoveries around the world. I also think the US interest in East Africa is crucial to watch. African frontier economies have remained immune for the most part and if China takes a beating, they’ll reduce their wide footprint in Africa and leave an opening for US companies to rush in.
Also, aerospace companies like Raytheon (NYSE:RTN), General Electric (NYSE:GE), and Lockheed Martin (NYSE:LMT) are also interesting long-term because they are benefiting from a new generation of weapons thus permitting greater sales of prior generation weaponry to countries that wouldn’t have had these options 10 years ago. The upcoming Singapore and Dubai Air Shows and Aerospace conventions are basically huge bazaars for arms dealing.
Right now, it’s difficult to pick individual stocks, making the most appropriate strategy one that is market neutral, or 60/40 leaning on the long side, with Black Swan insurance using deep out of the money puts as the VIX decline has created a buying opportunity for those that wish to place Black Swan bets. But soon, the VIX will hit 40 if fear continues to spread, and even deep out of the money puts will become expensive.
Hedge fund managers can look to put on spreads in the debt markets when they widen further. I think hedge funds that are putting this trade on now, or already had it on are feeling pain and will cause spreads to widen further if they haven’t contributed significantly to the widening already. This 2nd major widening of spreads, if it leads to 6+ Standard Deviations will then give Bond traders bread and butter plain vanilla spread trades. Step into this trade too early and risk blowing up if gearing is greater than 4 to 6X.
This is just one trader’s view but if you’ve been focused on US stocks since we called the bottom in March of 2009, then you’re keen to have already exited most long positions and biased yourself short 70/30 or 65/35. If any of you watch Boardwalk Empire, Arnold Rothstein in the latest episode says to Eunuch Thomson “do nothing, just wait. I made my life as a professional gambler, sometimes I’ll have 20 bets on at once, sometimes I won’t have any, I’ll go weeks and months without doing anything and garnering my resources until I see the right bet, then I bet it all.”
Market participants would be apt to heed this advice in today’s market. From Thanksgiving to Christmas, we could see a continued drop in liquidity as US based funds pullback to lock in gains and hence their bonuses for the year. Don’t push it when there aren’t any bets to be made. When buying with both hands during the exact minutes of the bottom in 2009; that was a perfect “all in” scenario. If you show patience, I would venture to say the opportunities will present themselves by mid-January through the end of February.