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Crisis Olympics

Caution and patience are likely to be the winning strategies as the European financial crisis unfolds

Now is the winter of our discontent,” wrote William Shakespeare in Richard III. Make it summer and the line is a perfect description of the dilemma facing every investor.

Canada’s S&P/TSX Composite Index dropped seven per cent between January 1, 2012 and June 30, 2012. The American S&P 500 did a lot better in the period, up four per cent for the first half of the year. In the lingo of the markets, valuations are becoming more attractive as stock prices plunge. The problem, as they say, is that you can get hurt trying to catch a falling knife.

In Canada, bank shares are under pressure. Commodities are hurt by the slowdown in China’s manufacturing output. Energy prices are down because of dropping Chinese demand for coal and the huge resource flow created by tapping unconventional oils via fracking, The continuing employment gap in the U.S., eight per cent officially and twice that if one counts discouraged workers no longer seeking jobs, doesn’t help. Canadian retailers are feeling contractionary pressures and the condo markets in Vancouver and Toronto have inflated to the bursting point. And then there is the heart of the matter — the Euro crisis.

European bonds

The Mediterranean trio of Spain, Italy and Greece have issued sovereign bonds that they cannot afford to pay or redeem. Spanish bond interest rates hover over seven per cent, Italian rates over six per cent and Greek rates, which are fictions given that nobody is trading the bonds, are at an incredible 42 per cent. The breakdown of European credit markets would be just a distant foreign problem were it not for the fact that the bonds are held by European banks in such huge amounts that default will wipe out their capital and drive them into bankruptcy.

European leaders have already arranged a default in all but name for Greece. Holders of Greek bonds denominated in Euros lost about 70 per cent of their money in what is called a “cramdown” in which the monetary authorities told holders to take the bad deal or get nothing. They took the deal and Europe avoided a formal default.

Greece represents three per cent of the European economy measured by its gross domestic product (GDP) divided by Europe’s GDP. If Spain, with 50 per cent unemployment of workers under age 25, were to be unable to pay its Euro-denominated national bonds, the monetary authorities would be hard pressed to pull off a Greek hat trick.

German voters have convinced chancellor Angela Merkel that it would be unfair for them to pay the bills of less productive, leisure-loving Spaniards, Italians, Portuguese and Greeks. Never mind that subsidizing those countries’ currencies makes it possible for German companies to export products that would otherwise be unaffordable in Madrid, Milan, Lisbon and Athens. Fairness is not the same thing as efficiency, but that is the fulcrum of the debate about what will happen to the Euro. If the Germans don’t support it, then the 17 nations using the Euro will have to go back to their own pesetas and lira, drachmas, francs and marks. A currency is only useful if people accept it. Just inflating money by running the printing presses would not work. That’s why it’s so hard to make this crisis go away.

European monetary authorities are labouring to pump up banks’ holdings of cash and credits with ever more elaborate systems of reserve lending by solvent countries to insolvent ones. Meanwhile, depositors, terrified that the Euro might be abandoned, have been rushing to swap Euros for bonds from Germany, the U.K., the U.S. and Canada. The result: as bond prices have risen, the yields on these bonds have fallen. U.S. 10-year Treasury bonds now pay 1.51 per cent, Canada 10s 1.68 per cent, and U.K. 10s 1.58 per cent. Meanwhile, inflation in the U.S. is running at 2.8 per cent, in Canada at 2.3 per cent, and 2.3 per cent in the U.K.

By parking money in good currencies and accepting returns less than the respective rates of inflation, investors are moving to the sidelines, ready to repurchase new lira and drachmas if they are ever issued. They will be bargain priced compared to dollars and deutsche marks. That the U.S. is massively in hock and really unable to pay its national debt is beside the point. In the psychology of the market, the U.S. Treasury is the best looking horse in the glue factory.

Holding money in marks and dollars is a short term loser, however. If the best deal you can get in a German, Canadian or American government bond is 1.75 per cent, then, after inflation running at 2.4 per cent or so in Canada and the U.S., a loss is certain. Yet there are many stocks with solid and rising dividend yields in the three to five per cent range — Canada’s chartered banks, BCE Inc. and other telcos and utilities and many more, but a couple of hard days on the market can drop stock prices by at least that much.

All eyes are on the Euro. Europe will only solve its problems when the alternative, not solving them, looks imminently catastrophic. The optimists in this scenario say that catastrophe is just around the corner. The pessimists say it will take months or years for the really bad news to force change.

Currency changes

If we apply a magnifying glass to the woebegone economies of Spain and Greece, Italy and Portugal, we see countries that can’t afford what amounts to monetary Amex gold cards. They do not sell enough goods to pay their bills. If they were not glued to the Euro, they could revert to national currencies. Those currencies would collapse in value and, presto, the prices of Spanish and other exports in U.S. dollars and the Euros of surviving prosperous nations would tumble. You could buy fancy Italian shoes for a fraction of the hundreds of dollars or Euros they cost today.

But — and there is a but — the massive loans and bonds issued by Spain and Italy might be repayable in collapsed currencies. Banks holding loans or expecting payment from Italian and Spanish borrowers would have to write off billions in loans and possibly trillions in derivatives. Banks that have not offset this risk could wind up with a sack of lira or heaps of pesetas would have to take charges against their capital.

European banks that have loaned 50 times their capital would be wiped out by a two per cent write-off of bad loans. (Canadian banks have much lower capital ratios — about 12 to one, allowing an eight per cent total loss on loans before they are insolvent.)

Now comes even more uncertainty. If a loan to a German bank were made to its London branch, would it be paid in pounds after the Euro collapses? What if the Euro loan were done through a London office of a Swiss bank operating in France? Lawyers could sort this out, though it might take months or years of litigation. In the meantime, what would bank assets be worth?

This situation has become so serious that the total value of all European bank common stock is now worth less than the value of the shares of Canada’s six major chartered banks. Switzerland’s central bank is pressuring Credit Suisse, one of the biggest banks in that country and a behemoth in world banking, to suspend its dividend in order to beef up capital. This is why European banks won’t lend to one another, won’t provide credits to businesses, and why European credit markets have frozen. Collapsing businesses and rising unemployment are the consequence.

What you can do

Markets dance to different drummers. Unless the world economy heads into a perfect storm in which all global commerce ends, an event not even the gloomiest forecasters predict, there are gains to be made in long bonds and oversold stocks. Buy bonds for insurance and stocks for gains. Nibble at bargains where they appear, but keep spare cash on the sidelines.

Finally, keep the faith. In the last 100 years, global capital markets have survived two world wars, the Great Depression, numerous flops in 1997 and 1998 in the global derivatives markets, the dot com meltdown in 2000, the Sept. 11, 2001 tragedy, and the 2008 liquidity crisis. The world will survive the collapse of the Euro, should it happen.

In the present financial crisis Olympics, there will be winners. Most likely, they will be the cautious investors who have neither sold at bad prices nor bought far from the bottom. In this crisis, patience is a profitable strategy. †

About the author


Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.



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