Risks Rise as Debt Crises Drag On

07/22/2011 12:45 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

I thought US and European leaders could avert calamity. I may have been wrong. Here’s how investors should address the rising risks—and the higher potential rewards if these messes are resolved.

When I wrote way back on June 30 about what the next 12 months would bring for stocks, I was too optimistic about politicians in both the United States and Europe.

I figured that they would relatively quickly cut expedient, deceptive, don’t-fix-the-problem deals that would “solve” the euro debt crisis and the US debt ceiling crisis by kicking the problems down the road into 2014 and 2013, respectively.

I didn’t think they would be so stupid as to actually put at risk the financial system of an entire continent—in the case of European politicians—or of the entire world, in the case of US politicians.

My apologies. I forgot the teachings of that great investing guru, P.T. Barnum: 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 demonstrations of politicians’ inability to solve either financial crisis have changed the likely timing and performance of the financial markets over the next few months. And they have left investors facing a binary decision.

Upping the Ante
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 you’ll lose the rewards if disaster is averted. Bet on the financial markets avoiding disaster, and you’ll 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 the sage possum, to boot?)

NEXT: Greece Still Sinking

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Greece Still Sinking
Let’s start with the Eurozone part of this mess, because the alternatives there 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 further.

So we still have Germany insisting on bondholders sharing some of the costs of a new Greek rescue package, and the ECB 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, could 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. This means no one wants to buy Greek debt.

Also on Wednesday, we got what’s being billed as a “breakthrough” with the Germans, brokered by the French, on the eve of an emergency summit meeting that was supposed to come up with a solution to the Greek debt crisis.

Unless your standard for “breakthrough” is set so low that getting German Chancellor Angela Merkel to attend Thursday’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 of them together to gain the necessary approval still remain ahead.

The summit that began 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 next month.

Throw in that the newest French compromise, a tax on bank assets to pay for a buydown of Greek debt, would require months to get the necessary country-by-country approvals.

NEXT: 2 Problems for Europe to Solve

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2 Problems for Europe to Solve
Any solution to the crisis will need two parts:

  • First, a deal for a new rescue package for Greece that will get the country through to 2014.
  • Second, a more powerful general bailout facility 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 on 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, because that would involve a fundamental restructuring of the European monetary union.  

Namely, the powers would have to create something like a Eurozone bond that would lower the punishing interest rates now paid by Greece, Portugal, and Ireland. Then they’d need an enlarged financial backstop facility, which would have the funding and authority to buy government debt in order to prevent a crisis.

Pushing through those changes will probably require another crisis.

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 done, then a strong relief rally that pushes up European equities and the euro (and therefore pushes the dollar down and commodities up), and a related rally in emerging-market equities with the decline in fears that this crisis will blow up.

Investing Strategy
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.

If you want to move out the risk/reward curve, consider shares of one of the big Italian banks, such as Intesa Sanpaulo (ISNPY), Italy’s biggest bank (it trades as 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 10% on the morning of July 21, on hopes of a breakthrough.

Under other circumstances, I’d also advise you to buy with an eye toward a commodity rally. For copper, try Freeport McMoran Copper & Gold (FCX) and for iron, Vale (VALE).

Also, look for an emerging-markets rally. Shares of Japanese exporters recently moved up strongly 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. So would shares of US exporters, such as Johnson Controls (JCI).

I’d warn that if you buy now, you should be prepared to stick out about a month of volatility. But we’re facing unusual circumstances that have the potential to either short-circuit any Greek solution rally, or amplify its effects. (See how tough this market is right now? Are you nuts yet?)

NEXT: US Debt Mess Is the Wild Card

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US Debt Mess Is the Wild Card
What are those unusual circumstances? The US 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 what to cut and what to spare?

On Tuesday, the financial markets decided that the odds for a deal to raise the ceiling 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 Senate’s so-called “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 leaders of the House of Representatives to the package their party brethren in the Senate had embraced the night before.

Commentators had apparently re-read their pocket guides to the US Constitution, and realized that raising the debt ceiling requires the approval of both chambers, and that any measure that involves revenue has to begin in the House.

I’m not sure that any head count 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 has reported that opposition to any debt-ceiling increase under any circumstances has been rising among the most conservative Republicans.

In other words, the Gang of Six can propose anything it wants, but 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 the Republican minority’s leader in the Senate, Mitch McConnell, which would give Republicans the cover of a vote against raising the debt ceiling, but allow the president to do it himself.

Considering the number of House Republicans also opposed to this kind of sleight of hand, it’s unlikely there are enough votes to pass this measure in the House, either. And opposition to the plan seems on the increase even in the Senate.

But this is only Part One of the US debt crisis.

NEXT: The Downgrade Threat

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The Downgrade Threat
Second, there’s the threat from Standard & Poor’s and Moody’s credit-rating agencies of a downgrade to the US rating from its current AAA perch. In putting the US credit rating on CreditWatch Negative on July 14, S&P indicated that without some credible attempt to address the US budget deficit, the credit-rating company could downgrade the US credit rating sometime within the next 90 days.

Whatever the odds are for some kind of maneuver to raise the debt ceiling, the odds of a credible plan to reduce the US budget deficit are even lower. The McConnell measure, 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 members of the Gang of Six talk about how difficult it will be to get anything this complicated through Congress in the time they have 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 US financial markets.

With that in mind, 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 US Treasury that will go something like this: “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, at least partly 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 if it were confronted with the end of the world tomorrow, Congress would respond, "You woke me up for that? What’s the hurry?")

Speculation is that the Treasury would prioritize payments, so that the country wouldn’t default on its Treasury debt interest. But the 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 US 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 nonevent.

But it wouldn’t stay a nonevent if the situation dragged on. With each passing day, it would be harder for money managers—who are bound by their investing charters to put money into only top-grade debt—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 now skeptical of the Treasury’s August 2 deadline would wake up on August 3 and say, “What did I tell you? It was a hoax.”

NEXT: Prognosis

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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 US debt. It will simply kick the crisis from August into the fall.

Anybody think Congress will come up with a deficit-reduction plan 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 US faces an 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 on hand—and that means outside of a money-market fund—to get me through any panicky reaction in the markets.

If the August 2 deadline passes and the following week doesn’t bring catastrophe, you can expect to see some investors unwinding their end-of-the-world hedges. Gold, for example, might retreat.

Thus, this would be the time to look for bargains to add to your portfolio in preparation for a potential downgrade in the US credit rating in the fall. Expect to see worry start to ratchet up again then.

Investing Strategy
Participate in any “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 September and October. Don’t get overextended 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, because 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 failure to do so won’t be immediate financial Armageddon.

I’m also 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 18 column, 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 disaster won’t strike.

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 don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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