Revising my 12-month strategy for stocks to include the stupid-politician factor
07/22/2011 8:30 am EST
I didn’t think they would be so stupid as to actually put the financial system of an entire continent—in the case of European politicians—or of the entire world—in the case of U.S. politicians—at risk.
My apologies. I forgot the teachings of that great investing guru P.T. Barnum, who said “Nobody ever lost a dollar by underestimating the intelligence of the average politician.” (That’s not an exact quote, mind you, but I think it captures the Barnum spirit.)
The repeated demonstration of the inability of politicians to solve either financial crisis has changed the likely timing and performance of the financial markets over the next few months. And it has left investors facing a very binary decision.
What do I mean? By dragging their feet on any solution, no matter how transparently inadequate, politicians have raised the odds of a short-term disaster striking the financial markets and your portfolio. But they’ve also raised the fear of such a disaster to a level that increases the size of the potential rally if they do cobble something together to skirt disaster. In other words, by raising the risk of a disaster, politicians have also raised the reward for investors who bet that the world can stumble through these crises—if the world does indeed stumble through these crises.
Which creates a rather unappealing dilemma for investors. Protect yourself against the short-term disaster and lose the rewards if disaster is averted. Bet on the financial markets avoiding disaster and get massacred if disaster isn’t averted.
To quote Pogo “We have met the enemy and he is us.” So how do we navigate this swamp? (And without a possum, too.)
Let’s start with the EuroZone part of this mess because the alternatives are fewer and the consequences easier to predict.
I never expected that the political and financial leaders of Europe would still be arguing over a rescue package for Greece as we head toward the end of July. But oddly enough, what looked like a French formula for an agreement that would bridge differences between Germany and the European Central Bank instead led each side to dig in. So we still have Germany insisting on bondholders sharing some of the costs of a new Greek rescue package and the European Central Bank insisting that even a program of voluntary participation by bondholders would amount to a default. The delay has raised fears that other countries, most recently Italy, would be dragged into the crisis and that Greece would be allowed to slide into default either intentionally or through inaction. On Wednesday the yield on Greek government two-year debt hit 40% for the first time on exactly those fears of default.
And now we’ve got what’s being billed as a “breakthrough” brokered by the French with the Germans Wednesday, July 20, on the eve of the emergency summit meeting that’s supposed to come up with a solution to the Greek debt crisis. But unless your standard for breakthrough is set so low that getting German Chancellor Angela Merkel to attend today’s European emergency summit meeting fits the bill, I’d call what emerged from the talks between Merkel and French President Nicolas Sarkozy more of a shopping list. From the few details that have emerged, the “breakthrough” between the two leaders seems like an agreement to put every proposed solution to the crisis on the table. As was true before the meeting, the tough work of throwing out some of these proposals, modifying others, and packaging enough together to gain the necessary approval still remains ahead.
The summit that began on Thursday is the most recent chance to change this game. But discussions could easily drag into August because the last $17 billion in rescue funds from last year’s package, delivered in June by the International Monetary Fund, the European Union, and the European Central Bank should be enough to fund Greece until the middle of that month. And because the newest French compromise, a tax on bank assets to pay for a buy down of Greek debt, would require months to get the necessary country by country approvals.
Any solution to the crisis will need two parts. First, a formula for a new rescue package for Greece that will get the country to 2014. And, second, a more powerful bailout facility in general that will give investors confidence that Portugal, Ireland, Italy, and/or Spain aren’t about to follow the path blazed by Greece.
The first part of the crisis involves coming up with a formula that will allow politicians in the countries that will bear the bulk of the financial burden—Germany, the Netherlands, and Finland—enough cover so that voters won’t immediate throw current governments out into the streets. It seems likely that the French will, eventually, be able to broker this deal.
But I don’t expect a near-term solution to the second part of the problem since it involves a fundamental restructuring of the European monetary union to create something like a EuroZone bond that would lower the punishing interest rates now paid by Greece, Portugal, and Ireland, and an enlarged financial backstop facility that would have the funding and the authority to buy government debt in order to prevent a crisis. Pushing those changes through will probably require another crisis.
The prognosis: More turmoil and then, sometime within days or a month a deal that will kick the Greek problem down the road into 2014. In other words exactly what we’ve been expecting all along but with more drama and pain.
Effect for investors: Continued decline in the euro and in European stocks until the deal gets down and then a strong relief rally that pushes up European equities, the euro (and therefore pushes down the dollar and pushes up commodities), and a related rally in emerging market equities with the decline in fears that this crisis will blow up.
Strategy for investors: If you believe as I do that this Greece problem will get solved, you can buy into the relief rally by buying shares of strong Spanish banks (Banco Bilbao Vizcaya (BBVA) and Banco Santander (STD) are my favorites) and if you want to move out the risk/reward curve shares of one of the big Italian banks such as Intesa Sanpaulo, Italy’s biggest bank (ISNPY in New York or ISP.IM in Milan.) To see what kind of pop you might get from a real solution to the crisis, shares of Intesa Sanpaulo were up 12.6% yesterday (July 21) on the breakthrough hopes.
Under other circumstances, I’d also advise you to buy with an eye to a commodity rally (for copper try Freeport McMoran Copper and Gold (FCX) and for iron Vale (Vale)), and to an emerging markets rally (shares of Japanese exporters have moved up strongly recently when Europe has seemed less risky so Komatsu (KMTUY) would be one pick and anything with momentum in China, such as Baidu (BIDU) would be another as would shares of U.S. exporters such as Johnson Controls (JCI)). Under other circumstances I’d advise you to buy now and then stick out as much as a month of volatility.
But those other circumstances have the potential to either short-circuit any Greek solution rally—or indeed to amplify its effects. (See how tough this market, right now? Are you nuts yet?)
What are those other circumstances? The U.S. debt ceiling crisis, of course. This crisis is much more complicated and harder to handicap than its European companion. It too has two parts.
First, there’s the debt ceiling itself: Will Congress raise the current $14.3 trillion debt ceiling by the Treasury’s August 2 deadline or will the United States have to go into financial triage with the executive branch deciding to cut this and spare that?
On Tuesday of this week, the financial markets decided that the odds for a deal that would avert a debt ceiling crisis were pretty good. Stocks climbed on news of a package of budget cuts and tax increases—linked to an increase in the debt ceiling—from the so-called Senate Gang of Six. The proposal was cheered as evidence of a bipartisan attempt to solve the problem and greeted approvingly by the White House as the basis for the kind of grand deal that President Barack Obama has been pushing for.
The next day the market revised its enthusiasm after noting the tepid—to be kind—response from the Republican-controlled House of Representatives to the package that their members in the Senate had embraced the night before. Commentators had apparently re-read their pocket guides to the U.S. Constitution over night and realized the raising the debt ceiling, requires the approval of both houses and any measure that involves revenue has to begin in the House. I’m not sure that any headcount is accurate in this volatile period, but estimates say that 60 Republican members of the House won’t vote to raise the debt ceiling under any circumstances. And Roll Call’s John Stanton reports that opposition to a debt ceiling increase under any circumstances has been rising among the most conservative Republicans.
In other words, the Gang of Six can propose anything they want, it seems unlikely to pass the House.
And on the other side, Democratic opposition in the House is increasing to a solution like that proposed by Republican Minority Leader in the Senate Mitch McConnell that would give Republicans the cover of a vote against raising the debt ceiling but allow President Obama to do it himself. Considering the number of House Republicans also opposed to this kind of slight of hand, it’s unlikely there are enough votes to pass this in the House either. And opposition to this plan seems to on the increase even in the Senate.
But this is only Part 1 of the U.S. debt crisis.
Second, there’s the threat of a credit rating downgrade from the current AAA rating for the United States from Standard & Poor’s and Moody’s. In putting the U.S. credit rating on CreditWatch Negative on July 14 S&P indicated that without some credible attempt to address the U.S. budget deficit the credit ratings company could down grade the U.S. credit rating sometime within the next 90 days.
Whatever the odds for some kind of maneuver to raise the debt ceiling are, the odds of a credible plan to reduce the U.S. budget deficit are even lower. The McConnell maneuver, for example, would raise the debt ceiling but it wouldn’t reduce the deficit. Hello, downgrade.
I know that the headlines keep saying that pressure for a big deal to raise the debt ceiling and cut the deficit is increasing, but the reported details below the headlines don’t back up the big type. Even the six proponents of the Gang of Six deal talk about how difficult it will be to get anything this complicated through Congress in the time there is left. (Write tax law in two weeks? You’ve got to be kidding. The lobbyists won’t even be finished with lunch by then.)
In other words, there’s every reason to expect that even if Congress does raise the debt ceiling, the threat of a credit downgrade will still hang over U.S. financial markets.
Let’s try to construct a calendar of how events might unfold.
If Congress doesn’t raise the debt ceiling, the first event will be a call from the Federal Reserve to the U.S. Treasury that says something like, “Projecting the inflows and outflows to the Treasury’s account, the account will be overdrawn by the end of the day. Do you want to deposit more funds or cancel some of the scheduled payments?”
The Treasury isn’t talking about what it might do in response to that phone call, partly at least because the last thing the Obama administration wants to do is tell Congress it might have more time to avert a disaster. (Sometimes I get the feeling that confronted with the end of the world tomorrow, Congress would say, You woke me up for that? What’s the hurry?) Speculation is that Treasury would prioritize payments so that the country wouldn’t default on interest on its Treasury debt. But Treasury could have other tricks up its collective sleeve such as borrowing from Fannie Mae and Freddie Mac.
But the crucial unknown is how the financial markets would react. From what I’ve heard and read about Wall Street contingency plans, most institutions are planning to treat any failure by the U.S. to pay its bills as a temporary event that would not require them to sell Treasury debt. As long as that’s the attitude, a failure to raise the debt ceiling on August 2 would be a non-event.
But it wouldn’t stay a non-event if the situation dragged on and on. With each day, it would be harder for money managers who are bound by their investing charters to put money into only top grade credits to avoid selling some Treasuries. With each day, it would be more likely that the repo market, which uses Treasuries as collateral, would require more Treasuries to back up existing debt, creating a kind of margin call that could freeze the markets for short-term cash. With each day, the pressure would increase on the credit rating companies to carry out their threats and downgrade the AAA-rating that the United States now enjoys.
And the real danger here is that rather than using these extra days to find a deal, Congress would move even further out of touch with reality. Many politicians who are now skeptical of Treasury’s August 2 deadline would wake up on August 3 and say, “What did I tell you, it was a hoax.”
Prognosis: I think pressure is rising for some kind of debt ceiling fix that Congress will pass by August 2 or so. This won’t do anything about the looming downgrade of U.S. debt. It will simply kick the crisis from August into the fall. Anybody think Congress will come up with a deficit reduction plans then, if it couldn’t in July? (Hint: Every month closer to the 2012 election increases the temptation to play politics with the budget.) I think the U.S. faces almost certain downgrade in the fall if there is no deficit reduction plan by August 2.
Effect for investors: In the short run I don’t think it pays to radically redesign your portfolio to avoid the effects of a failure to raise the debt ceiling by August 2. I would make sure I had enough cash at hand—and that means outside of a money market fund—to get me through any panicky reaction in the markets in the days after August 2. If the August 2 deadline passes and then the next week doesn’t bring the end of the world, you can expect to see some investors unwinding the end of the world hedges they put on. Gold, for example, might retreat. This would be the time to look for bargains to add to your portfolio in preparation for a potential downgrade in the U.S. credit rating in the fall. Expect to see worry start to ratchet up again in September.
Investment strategy: Participate in any “The euro crisis is over” rally in the ways that I’ve suggested above but get ready for a return of the market’s risk-on attitude in the September and October. In other words, don’t get over-extended in any rally and look to take profits when the rally starts to look like it’s getting tired.
In other words, what I’m advising now is that the risk/reward ratio is tilted toward reward over the next few weeks since the odds are that European politicians will hammer out some solution to the Greek crisis and that either Congress will raise the debt ceiling or that it won’t be financial Armageddon if it doesn’t.
And I’m advising that the risk/reward ratio will tilt back toward risk in the fall as the markets start to worry that they can’t quantify the effects of a downgrade from AAA for the United States. As I said in my July 19 column http://jubakpicks.com/2011/07/19/so-what-happens-to-you-and-me-if-congress-doesnt-raise-the-debt-ceiling-and-yes-it-could-really-produce-financial-armageddon-but-not-in-the-way-that-anyone-is-talking-about-now/ , I think financial Armageddon is a low odds possibility but the financial market for things like repo agreements is sufficiently opaque that I can’t guarantee that. Neither can Wall Street, which is what will make the markets so nervous in the fall if there is no August budget deal.
Full disclosure: I do not own shares of any stock mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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