The recent sharp drop in the euro and risk assets underscores investor frustration that policymakers are still reactive rather than proactive in their attempts to end the fiscal crisis and contagion risk within the euro area. Authorities have provided a new package for Greece and the European Central Bank (ECB) relaxed its collateral requirements, but both were in response to the market riot. There remains plenty of uncertainty regarding the feasibility of fiscal restructuring within the region, which means that policymakers will need to be aggressive and demonstrate a willingness to offset and facilitate the adjustment. Moreover, investors want clarity and a broader framework of how problems with other member nations will be handled. The financial crisis in Europe is massively deflationary.
Greece’s finances are too far out of kilter to be put right without devaluation or deflation. Italy and Spain need impossible nominal wage cuts of 20% to stay in the euro. By suspending the minimum credit rating required for Greek government-backed assets used in its liquidity operations, the ECB is reacting the same way as the Fed did in response to the 2008 crisis. The quality of the balance sheet of the central bank will deteriorate but this will provide a much needed lifeline to the banking system. In addition, given the region’s degree of cross-border bank exposure, the ECB’s decision will reduce the risk of further financial system strains. Nonetheless, a severe contraction in GDP (and a surge in its debt-to-GDP ratio) may still careen Greece toward some form of default. Ireland has already seen its GDP contract 14%; Greece will fare much worse. The bailout package resolves Greece’s near term funding squeeze, but not its solvency risk
But forget Greece; focus on China and Germany. In China, an upward move in interest rates is more likely than a major yuan strengthening. With the trade surplus shrinking, now would have been a good time for Beijing to strengthen the yuan were it not for the Greek debt debacle. China’s fears of heightened global uncertainty – similar to the panic that gripped it at the end of 2008 when exports collapsed amid the global financial crisis and recession – have been reaffirmed. Yet, because inflationary pressures continue to build, interest rate hikes are likely to be more acceptable than a major yuan move. Such a response should help re-balance Chinese growth. None-the-less, the yuan should still be higher by year end. Unfortunately, on the other side of the globe, the Euro area remains troubled by weak domestic demand and dependence on export-led growth. This needs to change. But slow growth along the Mediterranean and fiscal conservatism in Germany – high taxes and savings – may firmly commit Europe to a renewed recession. This may help trigger the next perfect storm in an area that few are mentioning, Eastern Europe. For Hungary in particular, an exposed banking system, over-leveraged government and an economy that is basically an export hub are perfect ingredients for the next market crisis.
Thankfully, economic and earnings growth in the U.S. and most emerging market countries seems intact. Economic fundamentals are improving, U.S. banks have deleveraged and have much stronger balance sheets and household balance sheets have improved. And with respect to real estate, both commercial and residential properties are at substantially lower values than four years ago. Most business confidence measures are rising; and if US output growth is above-trend in Q2 and Q3 – as looks likely – the Fed may decide to tighten, starting by unwinding Quantitative Easing. Nonetheless, expect uncertainty to ebb and flow throughout 2010, whether it is driven by ambiguous fiscal and monetary policy, geopolitical concerns, viability of the euro, or even terror plots. Uncertainty always leads to heightened volatility.
Many closed-end funds (CEFs) are trading at slight to high premiums which tends to increase volatility. In addition, because short term rates, like LIBOR, are beginning to increase, the underlying fundamentals for outperformance by floating rate CEFs has improved. Also, Muni CEFs continue to edge up as people seek value in tax protection, low relative risk and good yields. We remain optimistic, but expect increased volatility into the summer.
Michael Ashley Schulman, CFA
Hollencrest Capital Management