Commentary
Rioting in the (Wall) Streets
The Dow has now fallen for 12 of the last 13 days, a record not seen since the fall of 1974. The S&P is faring no better. The indices are off, respectively, 6.9% and 8.7% for the month, which has eaten into most of the gains of the year.
What happened to the rally window - the one that was supposed to make up for last year's poor showing and give us a leg up on this year's economic recovery? It's closed for now, although the US continues to chug along, offering up modest growth and improving labor and manufacturing markets. However, for the last few weeks, stability in the US has not been enough to overshadow concerns about the euro zone.
Two key fears are at play regarding a possible Greek exit (Grexit) from the EU. The worst case scenarios show a potential for contagious bank failures and a euro collapse. The European Central Bank (ECB), through its LTRO lending program, was supposed to have bought sufficient time for the euro zone to figure out how to handle its solvency issues in the peripheral nations and deal with the perennial problem child, Greece. But elections, markets and dithering politicians have gotten in the way. Time seems like an excuse in Europe to do little. Only riots - markets and citizens - seem to be able to inspire a response. And sporadic revolts, in the form of rising interest rates and civilian unrest, are what we have witnessed the last few weeks.
It began with recent elections in Greece and France which led to anti-austerity rhetoric and demonstrations. Greece wants to renegotiate the austerity terms of its bailout, which it says are too onerous. The far left party SYRIZA and other splinter groups believe they can threaten the EU with a chaotic exit and get the terms they want (no austerity measures). Other more moderate party members favor the bailout with varying degrees of compromise. At the same time, the stronger euro zone countries, most notably Germany, wouldn't mind making an example of Greece, to emphasize the severe consequences for countries who fail to meet their obligations. In other words the sides are entrenched until they are forced to compromise. Timing is crucial as to whether the crisis escalates or is averted.
Lenders and bank depositors, concerned over a possible Greek departure from the EU, are already selling Greek bonds and pulling their money out of Greek banks. If next month's elections don't yield a government committed to staying in the European Union, the country could run out of money in early July and be forced to leave. Once again, the issues are not so much about Greece, but the template it would create for contagion.
Here are the questions swirling around Wall Street and making investors nervous:
- Will the threat of a Greek exit force interest rates up (more) in Spain and create a need for a Spanish bailout?
- Will Italy become a target due to its bank ties with Spain?
- Will bank flight intensify as depositors flock to the US and other safer havens, causing selected banks in a number of countries to fail?
- Is there enough firepower (and will power) in the European rescue facilities to handle bailouts for Spain and Italy?
- And what does potential panic do to the euro? Anything other than an orderly decline, could cause economic and social chaos to erupt.
Without answers to fears, investors tended to believe the worst last week. For fast and frequent traders, hedge funds and institutions, stepping to the sidelines and being prepared to jump back in, was easier to rationalize than taking a measured approach to probability and reason. Sentiment, one of the key drivers of the markets (along with fundamental and technical analysis and monetary policy), can be fickle - especially in the age of electronic trading. It is one reason for the volatility that plagues the markets and a key impetus of the latest pullback.
What are needed are longer term reassurances of liquidity (monetization) - enough cash to bolster the banks through any crisis. The US, Japan and the UK all have serious debt problems, but markets aren't rioting in these countries because their central banks are following policies known as quantitative easing.
There are several ways that liquidity in Europe could be provided, although none of the options is popular with the leaders of the ECB or Germany, whose support is essential. The ECB's mandate is price, not government, stability, and the EBC is (so far) adamant about not creating a potentially unlimited supply of money to the euro zone.
- The ECB can re-establish its program to buy sovereign debt of the distressed countries.
- The European Stability Mechanism (ESM) can lend money directly to banks, bypassing the austerity measures that loans to governments require.
- The ECB can loan money to the ESM directly, thus providing the bailout fund with enough ammunition to support almost any bank crisis.
The G8 leaders met at an informal summit at Camp David this past weekend and began drawing up crisis-averting measures. Item #2 (ESM's ability to lend directly to banks) was proposed, putting pressure on Germany to change its stance. Perhaps there has been enough market rioting to force the euro zone leaders to act. However, investors should be mindful that change does not come easy in the European Union. There is likely to be a lot more pain for Greece before the crisis is over and perhaps some shared pain for Wall Street as well.
