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Greece and Contagion

The equity market melted down today, partly due to a trading error, but also out of fear of contagion from Greece to Spain and Portugal. As we mentioned to our advisors on a conference call on Tuesday, the Europeans will need to draw a line in the sand to prevent this, or risk a broad loss of liquidity across Europe. Thus, we expect a strong policy response, possibly including a European guarantee of the sovereign debt of all members of the EU and surely support for the European credit markets from the ECB to calm the markets. Markets will remain quite volatile until this strong policy action is taken.
Some of today’s market decline was purely trading error. It appears that stocks like Proctor and Gamble, Accenture and Exxon Mobil declined precipitously because some traders sold far more of these shares than intended. So stocks melted down very briefly and recovered rapidly as these problems were cleaned up.
Uncertainty remains high with respect to Greece. The Europeans have agreed to lend Greece enough money to give the Greeks time to implement an austere fiscal program. However, investors are unsure Greece will implement that agreed upon budget cuts, since the Greek public is objecting so strongly. (Some of these public demonstrations have been led by anarchists and communists who wish to undermine Greek society, so they are not necessarily representative of the public true support; the broader public may be unhappy about the budget cuts that are coming, yet also understand that these cuts are necessary.) 
In addition to Greece, which by itself is actually a small country in Europe, investors are becoming ever more nervous that Spain, Portugal and Italy might be unable to sell bonds at any kind of reasonable interest rate, as has occurred to the Greeks. This is where the Europeans must draw the line. Allowing a run against these other countries would undermine the entire European economy. Therefore, a very strong policy action must be taken to calm investors. Most likely, that support will come in the form of strong guarantees so that Spain, Portugal and Italy will be able to borrow in the market, when they need to do so. This support could come in several forms that might include a pan-European guarantee of European sovereign debt for some period like three years. It may also include support from the ECB, which could buy as much sovereign debt as necessary to calm markets down. In effect, the Greek situation is like what happened here after Lehman failed and our government stepped up to guarantee money funds, bank debt issues, and assorted other forms of credit to financial institutions. Europe may be forced to engage in similar support programs.
We have raised some cash in anticipation of continued turmoil in markets until that line in the sand has been drawn and that strong policy actions are announced. Depending on market conditions, we may raise some more. However, our current thinking is that we want to be prepared to redeploy that cash back into the market if and when we think a strong policy response appears to be coming, much as we did in 2009. As always, the kind of volatility we have seen creates severe misalignments in asset values and we wish to be able to take advantage of those as soon as we become more comfortable that the right support programs are in place. The situation will remain fluid, so we must remain flexible. 

Disclosure: No Positions