5/20/2010

Greece - A Market Update

By Martin Gremm

Introduction

As Europe's debt crisis is infusing the world markets with uncertainty, it is worth reviewing how it may affect the US economy. We will begin with a brief review of the current state of the US economy and then discuss the implications of the European response to the credit problems.

US Economy

In the US, most companies are continuing to report better than expected earnings, but it looks like the pent-up demand from all the purchases that were deferred in 2008 and 2009 may be slowing a little. We continue to see signs of a manufacturing-driven recovery coupled with slow job growth.

Traditionally, consumer spending and the housing market have been major contributors to the recovery after economic crises. However, for the last few quarters, consumer credit has been holding steady at a level about 5% lower than the peak value reached in 2008. This supports the notion that consumer credit purchases will play a secondary role in this recovery.

Housing is also unlikely to contribute significantly to the recovery. The swelling number of foreclosures and the expiration of the tax credit that artificially supported the housing market will most likely keep prices and housing starts low for the foreseeable future. Of course, the continuing trouble in the housing market also means that qualified buyers should be able to find attractively priced properties at near-record low mortgage rates.

Euro Bailout

It is virtually guaranteed that there won't be a quick resolution to the problems in Europe because the underlying cause, excessive public debt, cannot be addressed easily and painlessly.

The markets are worried about a sovereign default and the half-hearted response by the various European governments has done nothing to alleviate this fear. Sovereign defaults in the past, e.g. Russia in 1998, have caused significant disruptions in the credit markets. There is some doubt that the European national governments can work together well enough to deploy the massive $1 trillion bailout package they recently put together to prevent such defaults.

Even if the bailout could be deployed, it would only be a short-term fix. The bailout essentially requires the countries with better credit to borrow money on behalf of their less responsible neighbors. This fixes the immediate liquidity crisis of the weaker countries, but it also drives up the debt load the stronger ones have to carry. Most of these countries are already dangerously over-extended and cannot really afford to bail out their neighbors. If they do, they run the risk of becoming the next Greece a few years down the road.

Finally, there is a possibility that the bailout may be derailed and the Euro region may fall apart if the voters in the stronger countries get tired of supporting their less responsible neighbors.

These considerations explain why the bailout plan has not done very much to calm down the markets.

The current national governments are committed to the Euro and the EU. To drop the Euro now would mean reversing fundamental positions that all mainstream parties have held for decades. As the pressure to act in concert mounts, their response will become more cohesive and convincing. Nevertheless it is conceivable that the current governments will eventually be voted out of office or that they will bend to public opinion if the voter discontent grows.

Over the next few months we should see some stability return to the markets as the crisis management of the European governments takes shape and becomes predictable.

US Impact

The uncertainty from the European crisis is making markets volatile and credit harder to obtain. However, these effects generally abate fairly quickly once the acute crisis is past. There are two main problems that may have a long-term effect on the US economy.

The most lasting impact on the US economy may very well be the drastic decline of the Euro against the dollar. At $1.23, the Euro currently trades about 20% lower than its recent peak value of $1.51. If current levels persist, this may affect the main driver of recovery in the US: manufacturing.

The European Union is one of the largest trading partners of the United States. In 2009, exports from the US to the EU totaled $221 billion. Imports from the EU were $281 billion. Thanks to the Euro’s decline, imports from Europe are now about 20% cheaper than they were last November. Conversely, exports from the US are now 20% more expensive for Europeans.

It is likely that this will cool European demand for US exports, which will slow down the recovery in the manufacturing sector and add to the trade imbalance with the EU.

The second risk is currently more remote, but it has potentially much more serious consequences. The European Union as a whole is in much better financial shape than the US. At the end of 2009 its debt to Gross Domestic Product (GDP measures the size of the economy) was 79% and its budget deficit was 6.3%. The corresponding numbers for the US are 86% and 9.9% respectively.

It would not take much to get the world markets worried about the US’s creditworthiness. A change in credit ratings would do it; a costly bailout of a large bankrupt state like California would do it. Just about anything that makes people take a cold hard look at the US’s ability to repay the ballooning national debt would do it.

We have seen how quickly the public opinion o f Greece changed. Last October Greek 10-year bond yields were around 4.7%. Now they are about 7.5%. The actual economic situation of Greece has not changed much since last October, but the market has woken up to the reality that Greece is unlikely to repay its debts.

Many countries have sustained very high debt loads for decades without encountering a blow up, but eventually an event will trigger a meltdown such as we are seeing in Greece. Hopefully the events in Greece won’t be the trigger for the US, so we have time to put our financial house in order before events force us to take drastic and painful action.