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Why Greece Matters to You and Me

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 19, 2011

IN THIS ISSUE:

1.   How Greece Got in This Mess 

2.   Kicking the Can Down the Road

4.   Stratfor Sounds Warning on European Debt Crisis

5.   Is It Time to Short the Stock Market?

Introduction

I have not written in detail about the Greek debt crisis because it has been so widely chronicled in the media and by financial writers. But over the last few months the debt crisis in Europe has worsened, and we have new information on the exposure of US banks to European debt that is quite troubling.  Today, I will argue that a Greek default could trigger another global financial crisis which could have serious shocks for some major US banks.  

US banks reportedly have sold $70-$90 billion of “at risk” (unhedged) Credit Default Swaps (CDS) guaranteeing against a default by the Greek, Portuguese and Irish governments, and even more to other European nations. While no one knows exactly how much of that exposure is to Greece, we do know that if Greece defaults, some major US banks will have to pay up.

For the past year and a half, Greece has avoided defaulting on its debt only because of dozens of bailout loans from the International Monetary Fund (IMF), Eurozone neighbor countries and the European Central Bank. Hundreds of billions have been loaned to tiny Greece thus far, and it remains to be seen how much longer they can kick the can down the road.

In today’s letter, I have reprinted a very troubling analysis from our friends at Stratfor.com. Among other things, Stratfor predicts that several European nations beyond Greece, Portugal and Ireland will be facing their own debt crises before long – think Spain, Italy, Belgium and Austria. Stratfor predicts that the Euro will not survive. It’s a disturbing report.

Hong Kong-based and well-known GaveKal Research published an editorial in the Times of London last week that makes Stratfor’s predictions seem tame. Specifically, GaveKal cites the latest plunge in the Italian bond market and warns that a financial implosion in Europe could begin any day now. I will provide a link to that scary editorial below.

If Stratfor and GaveKal are remotely correct, we are very likely facing another global financial crisis that could be sparked if Greece defaults on its debt. If this happens, I would expect the US stock markets to plunge again, perhaps as they did in 2008. And this could happen at any time. Most US investors are NOT prepared for this scenario and believe that US equity prices will remain in a bull market for the balance of this year and next.

At the end of today’s E-Letter, I will provide a link to one of my favorite professional money managers, Scotia Partners, Ltd.,that invests long and short in the S&P 500 Index and has had its best performance during periods when the stock markets trend lower. As always, past performance is no guarantee of future results.

You may want to consider this successful program given what I will discuss today about Greece and its neighbors.  Also, we will be presenting an Internet Webinar with Scotia on July 28 at 2:00p.m. EST, and you can register to attend online at the end of today’s E-Letter.

 If you are not fully up to speed on the Greek debt crisis (and other EU countries), I suggest you read this E-Letter closely and begin to think about your investment portfolio in case another financial crisis is headed our way.

 How Greece Got in This Mess

Greece has long lived beyond its means and spent much of the last two centuries defaulting on its debts. Thus, it was no surprise that the European Union initially refused to allow Greece to join the Euro when the new currency started in 1999. But in 2000, Greece allegedly falsified its financial data to meet the stringent EU member requirements for entry, but it continued to run large budget deficits after it was admitted.

At the time Greece joined the EU and converted to the Euro, unemployment was 10% and its inflation rate was 4%, well above the European average rate. The yield on Greek bonds was over 10%. By joining the EU, however, Greece suddenly enjoyed substantially lower interest rates, because it was able to borrow in Euros at rates as low as 2-3%.

Greece then went on a huge spending spree, allowing public sector workers' wages to nearly double over the next decade, while it continued to fund one of the most generous pension systems in the world. When workers retired, often in their fifties, they usually got a pension equating to 92% of their pre-retirement salary. As Greece has one of the fastest aging populations in Europe, the bill to fund these pensions skyrocketed.

Tax evasion, endemic among Greece’s wealthy and middle classes, meant that the government’s tax revenues were not coming in fast enough to fund its obligations. Hosting the Olympics in 2004, which cost double the original estimate of €4.5 billion, only made matters worse. According to the Bank for International Settlements, Greece’s national debt was €310 billion ($450 billion) or 150% of GDP at the end of May of this year.

I have put together a condensed timeline on the events that have occurred in Greece as the debt crisis has unfolded. To read that timeline, CLICK HERE.

Kicking the Can Down the Road

It is obvious to all that these continued bailout loans to Greece from the IMF and its neighbors in the EU cannot continue forever, and they do not represent a real solution to Greece’s debt crisis. You can’t get out of debt by taking on more debt. Yet no one, other than the Greek labor unions, wants Greece to default on its debt. But is there a way for Greece to restructure its debt without defaulting? Unfortunately, the answer to this question is still up in the air, although most observers would say no. 

For the past couple of months, Eurozone leaders have been trying to put together a long-term bailout plan that will be “voluntary” so as not to trigger a Greek default, but are having a hard time doing so. Last month, the French suggested a plan to have European banks voluntarily roll over the proceeds of maturing Greek debt into new long-term bonds.

Eurozone banks were to reinvest at least 70% of the proceeds from the maturity of shorter-term debt into new 30-year Greek bonds, which would buy Greece more time. The problem is, the Eurozone banks that would reinvest in these 30-year bonds would only receive an interest rate around 5% when similar Greek bonds are yielding 15-20% in the secondary market.

The core of the French strategy depends on what your definition of “voluntary” is.  I don’t think there’s a bank in the world that would do this voluntarily unless they felt this action is the lesser of two evils, with outright default being the alternative. In any case, the French plan seems to have fallen out of favor because, among other things, some of the credit rating agencies have said that it would be a “selective default.”

The big question then becomes whether or not a selective default would trigger claims on the Credit Default Swaps (CDS) contracts that insure the value of these Greek bonds.  According to the Bank for International Settlements (BIS), US banks had outstanding CDS of more than $200 billion to Greece, Ireland, Portugal and Spain at the end of 2010 (not to mention another $200 billion to Italy alone).  If you count Italy, US banks have outstanding CDS of over $400 billion to these five Eurozone countries.

What we do not know is how much of this $400+ billion risk is “hedged” or otherwise offset.  The number being kicked around is that US banks have between $70 and $90 billion of unhedged CDS on Greek, Portuguese, Spanish and Irish debt. That’s huge! While no one knows exactly how much of the reportedly $70-$90 billion of CDS is in Greek debt guarantees, if Greece defaults, there is a real possibility of another financial crisis in Europe and the US.

Furthermore, if Greece defaults this could cause other countries to consider doing the same. Ireland, Portugal and Spain are also facing a debt crisis. Of late, there are even concerns about Italy, which has the world’s third largest bond market behind the US and Japan. This is the reason I titled today’s E-Letter “Why Greece Matters to You and Me.”

Just as was the case in 2008, a new Greece-triggered financial crisis would almost certainly lead to another scary plunge in the US stock markets, with investors stampeding out of equities and into Treasuries.  While the calmer heads among us seek to assure investors that the Greek debt simply isn’t large enough to cause another worldwide credit crisis, investors may remember:

  1.  That’s exactly what they said about the subprime mortgage market; and
  2.  Ireland, Portugal and Spain all have their own debt crises, which could make a Greek default look like a Sunday picnic.  In fact, Portugal’s debt rating has already been downgraded to junk by Moody’s.  Some fear Italy may not be too far behind (more on this below).

Some believe that the consequences of a Greek default are so dire that Eurozone leaders will never let it happen, and they may be right. Over the past week or so, the Greek government has enacted even more severe austerity measures in order to qualify for the next round of bailout money from the EU and the IMF. Of course, most everyone agrees that these frequent bailout loans can’t continue forever and a financial crisis could follow when they stop.

Actually, there’s a lot more at stake than just a global financial meltdown. Some also question the continued viability of the European Union and the Euro as its currency if member states begin defaulting. Several longer-term rescue plans have been suggested in recent months as the debt rollover plan described above has fallen out of favor, but as Stratfor will describe below, none of these options are good.

Stratfor Sounds Warning on European Debt Crisis

As clients and long-time readers know, Stratfor.com is one of the premier private intelligence networks in the world. Their geopolitical analysis is unrivaled in my opinion. Here is their latest take on the sovereign debt crisis in Europe. Read what follows very carefully.

QUOTE: It’s hard to be bullish on much in Europe these days. The government bonds of Ireland, Portugal and Greece have all been downgraded to junk, the Europeans have been sent back to the drawing board by the markets on their new bailout regimen and now the markets are talking about Italy being the next country to suffer a default. It’s easy to see why: next to Greece, Italy has the highest debt in Europe at about 120 percent of GDP. Its government is, shall we say, eccentric, and it has the highest debt relative to GDP of any country in the world with the exception of course of Greece and Japan. The sheer size of that debt, some 2 trillion euro, is larger than the combined government debts of the three states that are currently in receivership combined. In fact, it’s more than double the total envisioned amount of the bailout fund [€750 billion] in its grandest incarnation.

Italy certainly deserves to be under the microscope, but STRATFOR does not see it as ripe for a bailout. Unlike Ireland or Portugal or Greece, Italy has a strong and large banking system, or at least healthy as compared to say, Ireland. So while Italy’s debt load is 120 percent of GDP, only 50 percent of GDP needs to be handled by outside investors, the banks handle everything else. But let’s keep such optimism in context. It’s now been 16 months since the first bailout of Greece back in March of last year and it’s becoming ever more apparent that the fear isn’t so much that the contagion from the weak states will infect the strong ones, but there are just a lot more weak states out there than anybody gave the Europeans credit for when this all started. So long as there is no federal entity with the political and fiscal capacity of dealing with the crisis, this is just going to get worse and it’s only a matter of months before what we think of as real states such as Belgium, Austria and Spain, are to be starting to flirt with conservatorship themselves.

Ad hoc crisis management can deal, has dealt, with the small peripheral economies, but it’s not capable of dealing with the problem that is now looming: potential financial instability and multi-trillion euro economies. With the illusions of stability that have sustained the euro to this point being peeled away one by one with every revelation of new debt improprieties, it’s only a matter of time before the euro collapses. This is of course unless one of three things happens. [Emphasis added, GDH.]

Option one is for the stronger nations to just directly subsidize the weaker nations, basically having the North transfer wealth in large amounts to the South year after year after year. Conservatively, that’s one trillion euros a year, and it is difficult to see how that would be politically palatable in a place like Germany. [Emphasis added, GDH.]

Option two is to create something called Eurobonds. Right now the markets are scared of anything that has the word Portugal or Greece attached, and Greek debt is currently selling for about 16 percent versus the 3 percent of Germany. Eurobonds would allow European states to issue debt as a collective, so the full faith and credit of the European Union would back up any debt, which means that this 13 percent premium on Greek debt would largely disappear overnight. Of course that would mean that the European whole would be ultimately responsible for those debts at the end of the day, which means after a few years we’d be back in the same situation we are right now, with the debt ultimately landing on Germany’s doorstep once again. In STRATFOR’s view, the only difference between direct subsidization in the Eurobond plan would be when the Germans pay, now or later.

The third and final option is to simply print currency to buy up the government debt directly, either via the ECB or with the ECB granting a loan to the bailout fund to purchase the debt itself. This is an option that the Europeans are sliding toward because it puts off the hard decisions on political and economic power to another day. However it comes at a cost: inflation. Printing currency is a seriously inflationary business and for Europe this would put them in a double bind. Europe already has to import most of its energy, it already has a rapidly aging labor force and it already has very little free land upon which to build. Combined, this already makes the European Union the most inflationary of the world’s major developed economies, and that’s before you figure in printing currency. END QUOTE

Folks, I have been reading Stratfor for over a decade, I know its founder Dr. George Friedman personally, and I can tell you that this is one of the most alarming analyses I have ever seen from them. They are openly predicting the end of the Euro most likely, and that is a very strong statement coming from a very high profile group like Stratfor.

In the paragraphs just above, Stratfor presents three options to avoid major debt defaults in Europe. But if you read them carefully, it is obvious that NONE of them are very feasible, and Stratfor even admits that. Germany and France are NOT going to bail out all of the smaller periphery nations of Europe.

I’m sure you noticed that Stratfor also suggested that such stalwarts as Italy, Belgium and Austria may not be far from their own sovereign debt crises. I have heard no one else mention Belgium and Austria. I encourage you to subscribe to Stratfor at www.Stratfor.com.

Hong Kong-based and highly respected GaveKal Research published an editorial in the Times of London last week that makes Stratfor’s predictions seem tame. Specifically, GaveKal sites the latest plunge in the Italian bond market and warns that a financial implosion in Europe could begin any day now. As noted above, Italy’s bond market is the third largest in the world. To read this troubling editorial, CLICK HERE.

Quite simply, all hell is about to break loose in Europe, if it hasn’t already!

Conclusions

It is impossible to know if Greece will default on its debt, but as you have read above, the situation has become extremely dire. Stratfor believes that several other European nations are also going the way of Greece before long. Stratfor also predicts that the Euro currency most likely will not survive. If so, that means the end of the European Union, or at least a major downsizing.

GaveKal warns that Italy, with the third largest bond market in the world, may be facing a sovereign debt crisis of its own. GaveKal doesn’t issue these kinds of warnings unless it is extremely concerned. Like Stratfor, GaveKal is fearful that the Euro will not survive.

It is also impossible to know just how heavily exposed US banks are to Credit Default Swaps on Greece and other European nations such as Portugal, Spain and Ireland. Some put the at-risk (unhedged) CDS exposure at $70-$90 billion (not counting Italy), but no one knows for sure. Even if the number is half that, it’s still huge. If Greece (or others) default, these large US banks will have to pay up. This is not good!

If Stratfor is remotely correct in its analysis (and they usually are), we could
be facing another global financial crisis within the next year, and maybe within the next few months as suggested by GaveKal. I will keep you posted as events unfold.

Is It Time to Short the Stock Market?

If the situation in Europe deteriorates further, I think it could be quite bearish for equities, both in the US and Europe. The last time that happened, stocks lost half their value on average in just over a year. Despite what happens in Europe, US stocks have picked an ugly spot to turn sideways to slightly lower. The S&P 500 Index has heavy overhead resistance at 1400 and above.  Technically speaking, this is not a good level to stall.
 

Individual investors are definitely paying attention to the market’s reaction to both the US debt ceiling issue as well as the Eurozone sovereign debt crisis. The Investment Company Institute (ICI) reports that retail investors have withdrawn over $4.4 billion from domestic equity mutual funds so far in July, and that’s on top of over $21 billion of outflows in June. 

While some investors are seeking the safety of bonds and money market funds, many of the more aggressive investors are not content to sit on the sidelines and instead are seeking out investments that have the potential to actually make money should the markets take a dive. I have just the suggestion: Scotia Partners, Ltd., one of the dozen or so professional money managers I recommend. The Scotia Partners S&P Plus and S&P Moderate investment programs are two such options. These strategies trade the S&P 500 Index bothlong and short and use leverage to amplify returns. 

Best of all, Scotia’s strategies have historically performed better in down markets when volatility and uncertainty are high. During the 2008 bear market, Scotia S&P Plus delivered a total positive return of 77.19%, net of all fees and expenses. While past performance can’t guarantee future results, where would you rather have your aggressive allocation when the next bear market comes around?

If the Eurozone sovereign debt situation turns out anything like Stratfor and GaveKal predict, that’s just the type of market environment we might be heading for. For those who want to add a little spice to a diversified portfolio, Scotia might be just what you’re looking for. I have some of my own money with Scotia.Click on the following link to learn more about these innovative programs with the potential for outsized performance during down markets:

Link to Scotia Advisor Profile


Be sure to read Important Notes on page 4 for more details on performance, risk factors, etc.

We are also featuring Scotia in an online Webinar on July 28 at 2:00p.m. EST.  This venue allows you to hear how the strategy works directly from the portfolio manager, Cliff Montgomery. Best of all, there will be a thirty minute period at the end when you can ask questions regarding how the program works, its historical performance, etc. If you’re interested in sitting in on this presentation, click the link below to register:

Scotia Webinar Registration Link
 

Wishing you profits in the next bear market,

 

 

Gary D. Halbert

 

SPECIAL ARTICLES

Plan D stands for default and death of euro
http://www.ft.com/intl/cms/s/0/500fddce-b0a7-11e0-a5a7-00144feab49a.html#axzz1SUVSvVqF

Emergency EU summit on Thursday to address Greek debt crisis
http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/07/19/bloomberg1376-LOJG0Q0YHQ0X01-7VVHKAEIUOE7GUPNBF0R030TRK.DTL&ao=2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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