Rolling Sovereign Debt Defaults and Euro Break-Up Ahead
Bryan Rich: In this inaugural issue of Global Investor Weekly, I’d like to focus on the big picture. Stepping back and taking a big picture perspective on where we stand in this global economic environment can give clarity in a time of uncertainty.
In a world defined by crisis, we’ve seen very clearly that all economies are interconnected, and that all markets can, in times of panic, move lock-in-step with each other – making widely accepted diversification tactics useless.
With that said, there are few places to hide when the waves of global risk aversion hit. More dangerous, the unprecedented government intervention over the past two-and-a-half years has given investors a false since of security and has skewed their rationale.
Given the roadmap of recent years, many individual and institutional investors alike now expect governments to prohibit losses in stock markets, or any entity or interest that could systemically threaten the world and derail recovery. In fact, anyone that has bought the downdrafts in risky assets since early 2009 has felt little pain and experienced handsome rewards – until recently.
The problem: The white knights are out of fiscal and monetary bullets. And whatever respect and credibility they once had, that allowed them to verbally manipulate markets and sentiment, is long-gone.
In essence, the crisis that began in 2007 and erupted with the failure of Lehman Brothers in 2008 has only been stabilized by more than two-years of government intervention and perception manipulation by global politicians. There have been no solutions, and there has been no organic growth of economies to pick up where the stimulus left off.
All the while, the crisis has gone from a private balance sheet crisis, to both a private and public balance sheet crisis.
But this is nothing new. When we look back through the history of global financial crises, this is how they tend to play out. In the first stage, governments respond to instability in the financial system and the resulting economic recession by pumping stimulus into the economy, either turning budget surplus’ into deficits or turning deficits into bigger deficits.
In the second stage, with a languishing economy, deficit spending turns into more government debt. And then, in the third stage, growing government debt tends to be followed by sovereign debt downgrades. Finally, downgrades tend to lead to defaults.
This is exactly the script that is playing out around the world. But it’s in slow-motion, and growing even more destructive, all thanks to the constant government intervention along the way. And still the politicians swear off the possibility of default. And still, investors believe them.
No place is this more clear than in Europe (NYSE:VGK), where they continue their attempt to preserve a house of cards that should have fallen two years ago.
Intervention has Slowed but Grown the Fallout
Dubai sounded a wake-up call to the rest of the world in late 2009 by defaulting on its sovereign debt. Shortly thereafter, Greece hit the radar as the next domino in-line, and with it came fears of global sovereign debt contagion.
At that point, the core of the global banking system was already under government life support. It’s there, that the real contagion began. Not a contagion of bank failures or debt defaults, but the snowballing contagion of arrogant government intervention – government fingers in the ever crumbling dike, each one giving way to bigger and more calamitous breaches.
As Greece’s insolvency threatened the banking system in Europe and the euro currency, all of the European Monetary Union, along with the IMF, came in at the last hour with a massive verbal commitment of money to ensure that Greece wouldn’t bring down the euro zone.
But just as TARP (in the U.S.) didn’t solve the banking or mortgage problems in the U.S., the euro zone’s trillion dollar promise last year to rehabilitate Greece and the rest of the PIGS (Portugal, Ireland, Greece and Spain) didn’t solve any problems in Europe. The insolvent country list in Europe keeps growing. And the vulnerability of euro zone banks to a sovereign debt default keeps growing.
That’s why we now face fallout that could make the Lehman Brother’s failure look like, just the opening act.
Here’s why …
If (when) Greece defaults, Greek banks will go down. Greek banks own about half of all Greek sovereign debt. Who owns much of the rest of it? Big euro zone banks — mainly in Germany and France.
Moreover, the other dominoes in Europe are almost certain to follow: Portugal and Ireland. Again, that leads to more bank failures across Europe. And the fallout then will continue across Italy, Spain and perhaps France and Belgium.
But it’s not just Europe’s problem.
Take a look at the map below from the Bank for International Settlements (BIS). This will give you a quick reminder of just how interconnected the financial system is globally.
Source: BIS consolidated banking statistics
The size of the circles represents each bank nationality’s share of the total global banking system, in terms of bank to bank claims. The thickness of the arrows represents the size of those claims with foreign banks.
In short, the big yellow circles and the thick gray and black lines means banks around the world are heavily exposed to failing foreign banking institutions.
Last week, many took the announcement by global central banks that they would coordinate to provide “dollar liquidity,” or access to dollars, to European banks as another confirmation that government intervention was alive and well — Lone Ranger to the rescue. As such, stocks rallied, the euro rallied and views were circulating that another breach in the dike was being plugged.
But what they might not realize is that it could be the first clue that the governments are preparing and banks are bracing for sovereign debt defaults to hit.
While bond markets and credit default swaps are beginning to price in such an event, other, more mainstream proxies are still behaving in a Pavlovian fashion – expecting government intervention to ward off any investor pain.
The Australian dollar, the world’s favorite risk currency remains just sniffing distance from record highs, even though the Reserve Bank of Australia will likely be slashing interest rates over the next twelve months. Crude oil remains nearly 200% higher than its 2008 crisis-induced lows, though the second round of global recession is lurking. And the euro, with break-up in the sights, still trades closer to its all-time highs versus the dollar (NYSE:UUP), than its all-time lows.
In my opinion, these markets indicate that global investors have become convinced that they too will continue to get bailed-out of any wealth destructing market event.
Bryan Rich began his currency trading career with a $600 million family office hedge fund in London. Later, he was a senior trader for a $750 million leading global hedge fund in South Florida. There, he helped manage and trade a multi-billion dollar foreign exchange options portfolio. Today, Bryan runs Logic Fund Management, a currency research, advisory, consulting and money management firm.