By LEWIS JOHNSON – Co-Chief Investment Officer | February 11, 2015We have been writing frequently about the unfolding problems in Greece since we highlighted the rising political risks there beginning in May of 2014, a full nine months ago. As so often happens, the tail risk we identified many months ago has now worked its way into a full blown crisis. We are writing about Greece again this week to dispel a misconception from which many market observers are suffering, namely that Greece owes its creditors “$100.” Greece actually owes “$100 million.” As J. Paul Getty would understand, Greece’s problems are not its own but rather those of its creditors as well! This week’s “Trends and Tail Risks” will summarize briefly why we have devoted so much time to writing about Greece for the last nine months. The key takeaway is that you should care about what happens in Greece, because it has already had a meaningful impact upon asset prices, and should also continue to impact asset prices from here.
How Greece Became so Important
We began to write about Greece in May of last year (Big Problems Start Small, 5/21/14) as we examined how the world of credit would change as we approached the inventory driven slowdown we expected. The inventory-destocking cycle that we first described on May 28th (Making Volatility our Friend: Trading the Kitchin Cycle, 5/28/14) kicked off last September with the collapse of the scrap steel market in Turkey. Steel prices in the U.S. had been far too high and were destined to collapse as inventory restocking suddenly reversed and turned into destocking, as we had predicted in the weeks that led into the peak (Unsustainable Steel Premiums, 9/3/14). Our experience has been that a trend change in steel prices, from up to down, often marks a cycle change for other markets as well. This cycle was no different.
Steel is not the only market that would suffer during this down-cycle. We had earlier noted in August that this “unexpected” deceleration would also stress the global credit system and could reveal the weak link in the credit system (Is Credit Quality Peaking?, 8/6/14). Our long study of cycles helped us to identify Greece as one of the weakest links in the global credit system. This link often breaks – or threatens to – when the stress of the destocking cycle strikes. We had been writing about the political changes underway in Greece since May and revisited Greece again in June to discuss the precedent of the English naval mutiny at Invergordon in 1931 as an example of the “austerity fatigue” with which Greece was suffering (Ghosts of Invergordon, 6/4/14). Once again we were well-served by the lessons of history. Our concerns have deepened that the Greek credit market could be a source of global contagion.
The Dangerous Game of Contagion
Potential contagion is very difficult to forecast. Contagion – forced selling and extreme price weakness – is a low probability but high expected value event. Simply put, contagion has only a small chance of taking place but should it do so the outcome would be extremely negative. One analogy might be the consequences of playing a game of Russian Roulette with only one bullet placed in a gun with 100 bullet chambers. Ninety-nine chambers of the gun are empty. There is “only” 1/100 chance that the bullet is in the “wrong” chamber, but should it be so the consequences are fatal! We fear that the game that Greece’s creditors are playing threatens not only Greece but also threatens themselves as well. What worries me is that Greece’s creditors do not seem to understand this.
These are important questions with which we must now wrestle: are the problems in Greece the beginning of a new phase in Europe’s long-running financial crisis? Or is it reasonable to expect that after months of “unexpected” weakness in many key markets, that the cycle may confound observers by changing direction yet again? The answer to these questions may hold the key for asset prices not just in Europe but also here as well.
Greece and Europe – a Dangerous Mix
Europe has remained a dangerous source of contagion for the world because its currency, the Euro, is structurally flawed. Sovereigns such as Greece borrow in Euros, which is a currency that the Greek government does not control. Greece is therefore borrowing in a currency to which Greece has made a policy decision to adopt. In this sense, Greece has “pegged” its currency value to that of the Euro by adopting policies prescribed by the Eurozone and playing by its rules. Until now.
The chart below of Greek three year sovereign bond prices shows that credit stress has re-entered the world and is most concentrated – for the moment – in Greece. Greek bond prices have fallen a stunning 30% in just a few months. As Greek bond prices fell, the interest rate cost for Greece to fund itself rose dramatically, from 3% just a few weeks ago to now more than 20 percent! Falling Greek bond prices creates all kinds of problems – and not just for Greece – but for Europe too, as we explain below.
Europe in many ways never really addressed its banking and financial problems. Our banking regulators in the U.S. forced our banks to recapitalize and de-lever by issuing equity. Many European banks never did so and remain much more highly leveraged than their American counterparts. For instance, most U.S. banks hold $1 in reserve for every $12-16 of assets that they own. In Europe it’s not unusual to see leverage ratios that are far higher, with $1 in reserve for perhaps $30-50 in assets. This higher leverage means that European banks are far more sensitive than their U.S. counterparts to falling asset prices. Furthermore, most European banks hold as reserves the bonds of their own sovereign nations; so Greek banks own a highly leveraged position in Greek bonds. This has become a serious problem as Greece’s sovereign bond market began to fail and its bond prices plummet.
Damage to the Greek government bond market has extended to other institutions in Greece as well. For instance, the publicly traded stocks of the largest Greek banks all trade for a dollar a share, or less. The bonds issued by these banks that mature in the next 3-5 years have yields of 25% or more. With a funding cost this high, it’s clear that the market is extremely worried about the solvency of Greek banks, which themselves are highly leveraged to ongoing events in the Greek sovereign bond market. The solvency of Greek banks is not only vitally important for Greek depositors who have money in the Greek banks but also critical for the European credit system at large. The banking systems in most European countries are many times larger relative to their economy than the size of U.S. banks to our own economy. Should these huge European banks have problems, are their host governments really big enough to save them? So Greece’s unstable credit and weak banks pose a threat not just to Greek depositors but also to the entire European banking system.
Our modern financial system is an extremely complex web of interlocking debts owed by many entities to a huge array of financial actors and counterparties. Each of these banks and counterparties themselves also in turn owe money to others. Most of the time, thankfully, this complexity does not impact our daily lives. In rare events, such as during the 2008 global financial crisis, we come face to face with how complex these markets are. I find this complexity even more disturbing when it comes to the European financial system and the role of Greece within it.
The ongoing Greek bailout secured funds from other European sovereigns and from the European Central Bank (ECB) to help keep a highly indebted Greece afloat. Part of this money goes to keep Greek banks funded, since the private sources of capital to Greek banks come at such a high price (25% as we outline above.) The newly elected Greek government is challenging the terms of its bailout, which raises many uncomfortable questions for the Greek financial system and everyone connected to it.
Will Greece reach a compromise with its creditors to keep itself funded? If so, what will that compromise look like? How patient will Greek bank depositors be as they watch the ongoing talks? What are the odds that a panic takes hold and fearful depositors scramble to withdraw their savings from Greece’s weakening banks? Surely the odds of such a policy accident rise the longer it takes Greece to compromise with its many lenders and counterparties. What about the counterparties of their counterparties? Might events take on a life of their own and take markets to a place that they would not otherwise go? We prefer to ponder these issues now in advance of these issues intensifying, and have been doing so in these pages since May of 2014. Remember that in 2007 it was the opinion of Fed Chairman Bernanke that the credit issues in the subprime mortgage market were “contained.” Will problems in the Greek credit market also be “contained?”
Investment Implications: The Endurance of Change
Many of the fears we expressed nine months ago have now come to pass. The protective steps we took in portfolios over the past year are paying off. For instance, our long-dated, high quality bond positions have appreciated in value as renewed European credit concerns have driven interest rates in Europe so low that in some cases yields there are even negative (Negative Interest Rates?, 2/4/15). Our own yields here in the U.S., while historically low, are still in comparison a lush oasis of positive returns. Our investment returns in the gold royalty companies have also benefited from this credit-driven trend of falling interest rates. Our steps in the Spring and Summer to pare back high yield exposure sidestepped the oil-driven carnage in that market since the Fall. Our negativity toward high cost U.S. steel equities has been rewarded as they have fallen more than 50% in value since last summer.
Where do events go from here? The financial markets are very forward looking and even now are attempting to discern – and price in – future fundamental developments. Now that I am well into my second decade of professional investing I have come to understand that Heraclitus was right: nothing endures but change. Many of the forces now at work in Greece and other markets kicked off with cyclical pressures that we identified months ago. Some of the trends I expect will endure for many years, such as lower long term interest rates and in time higher gold prices. Other trends, such as the ongoing inventory destocking cycle, may be nearing the exhaustion of their own trend and could soon reverse.
These different trends can interact in volatile and challenging ways over the short run. Events in Greece are just one of the cyclical forces at work in the world, although they are critically important right now. We must pay close attention to all of these forces if we are to shepherd capital safely through these volatile times. This is a goal to which we are committed.
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