Thursday, June 3, 2010

Good news from the service sector overshadowed by walls of worry

How bad can things be if over 60% of service sector businesses report seeing rising activity (the message of the above chart)? That was par for the course back in the go-go late 1990s, but today the market is plagued by concerns that the economy is about to slip into a double-dip recession, so good news apparently doesn't count, because bad news lurks around the corner. Once again the market is climbing a wall of worry.

Recessions, however, are pretty hard to trigger; they require big and largely unexpected changes in monetary and fiscal policy (mostly monetary policy), or (as was the case with the last recession) events which call into question the world's most deeply-held assumptions (e.g., the solvency of the world's banks). To be sure, many today worry about the solvency of the European banking system. This shows up as 2-yr Euro swap spreads that today reached 86 bps, and credit default swap rates of 250 bps on Spanish government debt and 740 bps on Greek government debt.

I have no reason to argue against the possibility that Greek debt will be significantly restructured (resulting in substantial losses), but I don't see the parallels between the potential for sovereign defaults in a handful of European countries and the massive panic triggered by subprime mortgage-related paper. Back then, it was a lack of transparency that sparked a panic. The value of trillions of dollars worth of mortgage-backed paper was suddenly called into question. Ultimately the value depended on the price of millions of homes—whose prices were in virtual free-fall—and things were further complicated by the way that thousands of securitized deals were structured, and by the fact that large institutional investors all over the world held substantial amounts of the paper.

Today the facts aren't too difficult to discern: only a handful of debtors are likely to default; in a worst-case scenario the losses will be a very small fraction of outstanding global debt; and those who are significantly exposed to the losses (mostly the larger European banks) are relatively few. Plus, today's concerns about sovereign debt defaults are taking place against a backdrop of a strengthening global economy and accommodative monetary policies, whereas the unravelling of subprime debt and residential real estate occurred against a backdrop of a weakening global economy and tightening monetary policies. I just don't see the ingredients here for a replay of the global panic recession of late '08.


Christian S. Herzeca, Esq. said...

"only a handful of debtors are likely to default; in a worst-case scenario the losses will be a very small fraction of outstanding global debt; and those who are significantly exposed to the losses (mostly the larger European banks) are relatively few."

while i agree, and therefore think now is a good time to increase equity exposure (somewhat), i think you underestimate the fear that investors may reasonably have that the ultimate outcome of this current mess is the disintegration of the EU/euro.

i can see france and germany coming out of this more interested in going back to the franc and mark than trying to continue to resuscitate the euro, especially if spain has trouble rolling over debt. that would be a very troubling development, even if one assigns a low probability of occurrence.

Unknown said...

Germany (if) reactivating DM is positive story for imbalances in EU.

South would regain its competitiveness, via weak New EUR (ex Germany), and Germany would again have export going on.
There is white paper on legal considerations of exit.

Scott Grannis said...

I believe that, as a practical matter, it would be extraordinarily difficult for the European monetary union, and the euro, to be dissolved. This is a decision that would take years to implement. It is far easier to find solutions to the problem of highly indebted countries (e.g., just cut spending!) than it is to walk away from the euro.

John said...

I believe Greece will have to restructure their debt at some point. Perhaps Portugal will also. Spain and Italy have more options and their respective situations will take considerably longer to play out. I remain convinced the European debt issues are manageable, although there will be losses in many sovereign bond portfolios. None of this is new. Governments have restructured debts many times over the years and markets have adjusted and thrived. Our markets are temporarily governed by fear. Soon the weight of good economic news and low prices of high quality companies will overcome the fear merchants' ability to influence market participants and prices will more accurately reflect a growing global economy.

As of now, I think it is highly, highly improbable ANYONE leaves the EU. Debt restructuring, yes. Highly likely. EU breakup, ain't happenin'. Not for a long time.

Just my cheap opinion.