Thursday, August 11, 2011

Economic Commentary: Eurocrisis - Ari Paul

Just as the world was breathing a sigh of relief over the resolution of the US debt ceiling issue, the Eurozone entered full blown crisis. A quick rehash of the fundamentals: Greece and to a lesser extent Ireland, Italy, Ireland, Portugal, and Spain, run excessive fiscal deficits and have much lower labor productivity than Germany. Generally this would be resolved through currency devaluation, but as members of the EU, they're stuck with the Euro and have monetary policy imposed on them by the European Central Bank (ECB). In 2010 the focus was Greece, and a few months ago that crisis seemed to have been averted with a nearly unlimited lending facility to Greece.

Now the market is "attacking" Italy and Spain by refusing to buy its bonds. As bond yields sharply increased over the last few weeks, economists did the math and saw that Italy and Spain could not afford to finance its debt at the new, higher yields. Since European banks hold tremendous amounts of Spanish and Italian debt, speculators presumed that they were suddenly insolvent as well. The situation closely resembled the week that led up to the collapse of Lehman Brothers in 2008. The ECB quickly intervened to buy Spanish and Italian bonds, temporarily halting the crisis. Ultimately however, this is a problem of productivity and leverage, not solvency. When we say that the "EU" bailed out Greece, we really mean Germany, since Germany (and to a lesser extent France) is the local powerhouse with a current account surplus and a balance sheet to handle the additional debt. However, Germany and France can't afford to bail out all the PIIGS. Investors have already begun doing the math that if we shift all EU debt to Germany and France, both have perilously high debt to GDP ratios.

For the past two years I've been skeptical of the US economic recovery, but my bullish friends could point to the reasonably robust GDP growth. It turns out the data they were relying on was simply wrong. The BEA released a massive second revision (detailed breakdown here) of the GDP over the past few years. Under the new data, the economy has yet to recover to its 2007 highs. The data coming out from most corners of the globe suggests slowing growth. Two months ago most economists were predicting accelerating global growth. Now the talk is of a high likelihood of global recession within the next 6 months.

The key factor working in the global economy's favor is that central bankers appear very pro-active. Switzerland, Japan, and the ECB have begun serious money printing operations and China is easing its monetary policy. Somewhat ironically, the US' Federal Reserve has been the laggard and provided little evidence of a third round of quantitative easing in their latest communication.
With the talk of global slowdown, all risk assets have been selling off sharply and treasuries have rallied. My purchase of silver puts appears very poorly timed as silver has been dragged up with gold. Gold is rallying as people purchase it to hedge their losing equity positions as well as on speculation that the money printing will cause inflation.

My best guess of how this plays out remains unchanged from 2008. Equities will remain weak for at least the next 2 years and unlike in 2009, they will not recover swiftly. Rather, they will stay at depressed levels for several additional years as "mom and pop" swear off the equity market.