Tuesday, July 12, 2011

(Very) General Commentary...

...written the previous Sunday Evening.

Full fathom five[1] thy father lies;
Of his bones are coral made;
Those are pearls that were his eyes;
Nothing of him that doth fade,
But doth suffer a sea-change
Into something rich and strange.
Sea-nymphs hourly ring his knell:
Hark! now I hear them — Ding-dong, bell.

-William Shakespeare

The world indeed is experiencing a Sea-Change of its own, and capital markets are beginning to understand the danger. Let me make this clear: Historically speaking, the following events have a way of unwinding with violent speed and ferocity.

This week is a pivotal one for global markets and the future of political stability in the Euro-area. Italian credit spreads (representing the difference in bond yields between Italian Debt and "safe" German Debt) have soared to record highs in the wake of the news that a partial default is on the table for Greek debt. This possibility is putting tremendous pressure on Italian financial assets. For example, UniCredit, Italy's largest Bank by assets, traded limit down and was suspended from further trading last Friday. Think of that. Imagine Citi or Bank of America's shares being suspended from trading, and you understand the plight of Italian finance.

The reason for this capital flight is as old as English Common Law. Why? Because it establishes a dangerous Precedent in how Euro-area debt will be handled, as it effectively opens the possibility of wide-spread default in several Euro-Area countries, in addition to causing a severe banking crisis as the debt from Greece and Italy are held by other Euro-area banks which must write down these losses. Let me reiterate that. If Greece, Italian, Portuguese, Spanish (and let throw in the Irish as well) debt can repudiated, these assets are worth far less than face value and the holders of that debt must take the losses. This creates a cascade of defaulting institutions far larger than the Credit Crisis in the U.S. that engulfed AIG, Lehman, Bear-Stearns, Merrill Lynch, and countless other smaller firms.

Thus, with Italy boasting the highest Debt to GDP ratio (after listless Greece, of course) in the Euro area, markets have naturally smelled the blood in the water and have decided to sell first and ask questions later.

There are many fissures at the moment globally. But fundamentally, the problem is a lack of aggregate demand. This demand was supplied by the United States for most of the last 10 years, but present difficulties (to say nothing of impending budget cuts and tax increases) indicate that this will not return for some time. Again, this "sea-change" effects ALL global assets, from New York to Milan to Shanghai. The world is a much more politically charged place, as leaders in their respective countries vie for advantage, and Devil take the Hindmost.

This fundamental constraint is absent in the Euro-area, where member countries are effectively forbidden to take steps to alleviate the pain its constituents are experiencing through traditional methods. In the past, if Italy or Greece experienced this kind of financial pressure, they would devalue the Lira or Drachma, respectively, and inflate away their debt while at the same time repairing their trade balances through favorable terms of trade via a weaker currency. But they cannot do this. These countries desperately need EUROS to fund their short-term debt in an environment of economic weakness. Citizens are understandably angry that their leaders have failed to see this outcome and have effectively out-sourced the most powerful asset a country has: its sovereignty. This will have dire consequences and as such the end of the Euro experiment is either a drawn-out muddle or something far more ominous.

In this environment, U.S. assets have typically performed well, being the one port in the storm that boasts deep capital markets, relatively transparent financial statements, and a court system that ranks among the most fair in the world. Most importantly, it is the United States perpetual ability to reinvent itself in light of global demand, which is a story for another commentary.

There are storms ahead in these waters, best to return to port and re-schedule the junket for more favorable conditions.

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