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A Big Fat Greek Deficit—Redux

http://www.marketminder.com/a/fisher-investments-a-big-fat-greek-deficit—redux/8a2548d8-1215-4c85-8478-c6007eadee76.aspx

Story Highlights:
 
  • Markets dropped significantly Thursday—possibly due to fears that government debt is too high in some EU countries.
  • Worries over Greece’s deficit have been cycling through the press for several weeks, but a new concern arose today—other troubled countries are proof of a debt contagion. 
  • It’s likely stocks are overreacting to something that’s not positive for a specific nation—but it shouldn’t affect the globe overall.
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The market fell significantly Thursday on worries over government debt burdens in Greece, Spain, and Portugal. Sovereign debt problems are nothing new—Greece’s woes have been regularly rehashed in the media of late. But with the addition of Spain and Portugal, folks were fretting a nasty debt “contagion” could spread to other EU countries.
Is Europe in for a nasty cold? A closer look proves the worries are mostly overblown, so far.

The biggest problems remain in tiny Greece (0.6% of global GDP), whose bond yields and bund-spread (the spread between its bonds and ultra-safe German bonds) are highest in the EU. With the world’s focus again shifting there, perhaps domestic resistanceto Greece’s deficit reduction plan further contributed to Thursday’s volatility. But remember: The EU basically said it won’t let Greece destroy the union—a not-insignificant vow seemingly ignored by investors amid today’s worry.
Elsewhere, government risk premia rose—but didn’t come close to equaling Greece’s. Portugal made headlines when a one-year note auction was undersubscribed to the tune of €200 million. Its bund-spread ticked higher, but remained well below Greece’s. Meanwhile, Spain’s cardinal sin was raising its projected deficit over the next two years. Scary indeed. Yet a recent sale of three-year notes was oversubscribed by nearly five times (not unlike a Greek auction last week). And amid the hubbub, Spanish yields only ticked up slightly compared to Germany’s—also remaining well below Greece’s. The other two countries on Europe’s periphery, Ireland and Italy, seem excused from all this—viewed as healthier by investors. Perhaps Europe’s immune system is a little stronger than it appears.
Spanish stocks took it on the chin, led by Financials. But that’s no surprise. Spanish banks are heavily exposed to European sovereign debt—the perceived source of the “contagion.” Should the “contagion” prove less potent than widely perceived, Spanish bank losses would slow. And a few troubled Spanish banks should little impact global markets at large.
Anything that gets serious enough to blow apart the European Monetary Union would be a legitimate risk for markets—but we are a long way off from that becoming real and imminent. In our view, it seems stocks are overreacting to a bad Portuguese debt auction and rising, but relatively contained, risk premia. Is this a legitimate correction? We'll know when we know. Either way, nothing to be done about it. Sidestepping corrections is treacherous—you must have surgical timing on both ends to justify the transactions costs and tax consequences. But this has the feel of a correction story.
Yes, Greece and Portugal have some struggles ahead, but taken together, are barely a blip on world GDP and just a small portion of the EU. We suspect, given a few months, these nations' woes won't have subsided, but the fear of imminent global meltdown because of them will have. Meanwhile, we'll have moved on to fretting the next story that ultimately has little market impact. (Swine flu anyone?) That’s the way of the bull.


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