Its All Greek To Me

The European view is from a major trading desk morning comment, where the author cannot be cited:

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I’ll dispense with the usual prose today and break this thing down as logically as I can (source for all data below is Bloomberg):

A) We’re witnessing a mild retreat from risk this morning.

B) Another way of saying this is that risk premiums, the gaps between expected values and values at which investors are indifferent to the risk of owning the asset, are widening out.

C) They’re widening out because of perceived instability. That perception began with Dubai’s inability to service its debt (and Abu Dhabi’s unwillingness to backstop Dubai) which was announced on November 25th, two weeks ago.

D) The perception of instability was never totally extinguished, in part because global financial markets are complex and tightly coupled.

i) In retrospect it seems obvious that the Street was too quick to dismiss the Dubai story as “non-systemic.” Even the Shanghai Surprise back in early 2007 – which I think is more reminiscent of Dubai than the collapses of Bear Stearns, Freddie/Fannie, or Lehman/AIG/Merrill – took a month and a half to digest before the S&P 500 recovered its pre-Shanghai levels.

ii) Dubai’s stock market seemed to stabilize on Sunday, December 6th, rising by +1.2% after falling by -7.3% and -5.6% in the two previous sessions. Maybe the better than expected U.S. jobs report played a role, but whatever the reason, it subsequently fell -5.8% and -6.1% on Monday morning and this morning, respectively.

iii) Meanwhile, Greek bond yields have been widening out against German bunds, and Greek sovereign CDS had been rising throughout the month of November. The CDS spiked during the Dubai episode, fell back, and are spiking again. The Greek stock market’s rebound from its Thanksgiving week lows has been reversed and fresh lows are being made. Greece cannot “run the printing presses” to pay off its debt because it is on the euro, so if it cannot service its debt it will either default or will have to be bailed out.
iv) Euro weakness, a natural result of Greece’s problems, means a stronger dollar. A stronger dollar/euro cross spills into other dollar crosses (which are also aided by a knee jerk bid in times of uncertainty) and the dollar carry trade – real or imagined – is unwound, causing selling in risk assets everywhere.

E) The perception of instability was never totally extinguished, in part because there is no underlying confidence in the sufficiency of private sector cash flows to service existing private sector debt.

i) Notice I said private sector cash flows. The public sector can create all the cash flows it wants because we have a global fiat money system. Abu Dhabi’s and the United Arab Emirates’ decisions to withhold a public guarantee on Dubai World’s private debt burden introduced doubt into the marketplace that governments would reliably and consistently guarantee private sector debt.

ii) The Greece situation is another reminder that there are other political hurdles out there (in this case, the peculiarities of the euro zone) which may prevent public sector guarantees on private sector debt.

iii) Without such guarantees, there is no confidence that gruesome debt deflationary dynamics will not resume. This lack of confidence is rational because the global economy shrunk throughout the credit crisis and has not yet grown to a size sufficient to generate private sector cash flows capable of servicing the private sector debt burden.

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To make matters worse, I don’t feel comfortable saying that the global economy is going to continue growing as it has in the second and third and (probably) fourth quarters.

Look at this morning’s NFIB Small Business Optimism survey for November, which has stagnated now in a range between 86 and 89 (below the average levels seen during the 2001 and 1990-1 recessions) since April. Look at the drop off in retail sales as reported by both the International Council of Shopping Centers and Johnson Redbook Research in the week following the Thanksgiving weekend.

Here is the ICSC’s seasonally adjusted index going back to June of 2008. It shows the Lehman-related drop off, a recovery, and now it looks to be rolling over again:

(source: ICSC and Bloomberg)

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I’m not trying to be alarmist, although it may come off that way. I’m trying to explain the dynamics at work here and why we are still walking in a minefield.