The Greek Cockroach

Warren Buffet’s adage “you never see just one cockroach” is going to be tested in Greek. We are about to find out if this is true as the ongoing “Odyssey” of Greece’s finances continues to unfold.

The holiday weekend revelations about Greece and the use of swaps that were arranged through Goldman Sachs is just one more chapter in the Greek tragedy. Detailed reports are now available in Der Speigel, Bloomberg, Wall Street Journal, FT and elsewhere.

It appears that Greece clandestinely attempted to use currency swaps as a deferral technique to project their payment obligations into the future and to hide them. Greek officials claim to the contrary; they say the transactions were reported. But an initial scan of the reports that were used in the early part of this decade does not find them. Hmmmm?

Let’s make this clearer for readers: the use of this type of swap accomplishes the movement of debt off the balance sheet and into the currency balances. There can be legitimate economic reasons for this type of transaction as an offset to trade flows. And the same transaction can be used for outright deception if the user wants to hide a rising debt ratio.

Now an investigation is underway by Europe’s statistical office, Eurostat. News reports have also been confirmed that Greece has a history of using this allegedly deceptive technique in the past. We now know it was done in 2001 and was contemporaneous with other actions that Greece was taking so it could become the twelfth member of the Eurozone.

It also appears that these transactions were arranged through Goldman Sachs and that subsequently GS hedged its position to a neutral one by shorting or constructively shorting Greek debt. Did Goldman act improperly? That now also is a subject of debate. Investigations are certainly coming. Witch-hunting about Goldman Sachs and their book of derivatives is very popular these days. We expect to see more of it on both sides of the Atlantic Ocean.

There will be much EU political outcry about this transaction which currently is measured at 1 billion euro. The key question for markets revolves around whether or not this is a single event or if there are more such transactions that will be revealed in the books of Greece or other EU member states.

Markets now have to contend with speculation about whether or not there are other transactions. Markets will ask if they are limited to Greece. Were the disclosure rules violated and if so, what lies ahead in more damaging revelations? Within Greece there are issues of legality and they redound to the governments that were in power at the time.

And this also adds to the firestorm that detractors are using to claim that the EU, the ECB and the euro as a currency are all doomed. Our email and telephone messages are running heavily against the euro. Europhiles are rare and Europhobes seem to be in abundance.

Let’s add some fuel to the detractors’ fire. We expect the rocky period in the evolution of the euro and the Eurozone to continue for several more months. The euro could weaken more. Some estimates are as low as 1.15-1.18. We do not expect the euro per dollar spot exchange rate to get that low but anything is possible in an emotionally driven market.

We do not expect the euro to fail as a currency and we do not expect the ECB or the EU to dismember. This is true even if Greece defaults. Would the United States dismember if Rhode Island defaulted on its municipal bonds? We think not. Did the revelations about Robert Citron and the Orange County California pool and bankruptcy dismember the entire US Muni market? No. But it did create a terrific buying opportunity when the market swooned and all Munis sold off for a few weeks.

We believe that the weakening of the Euro will make the companies in many European countries much more competitive on the world scene. Machine tool makers in Germany which compete against those in Pennsylvania now have a 10 percent price advantage when selling to China. The didn’t have it a few months ago. The same is true for French winemakers or French nuclear reactor technology sellers. The weaker the euro becomes the more competitive European exporters will be in the world markets. And the weakening of the euro will not add to inflationary pressures in the Eurozone because the negative output gap is huge. That means the ECB will maintain its present very low interest rate policy throughout the crisis with Greece and likely for the rest of this year.

Also, note that the crisis is strengthening the dollar since it is now the default currency choice in the world. A stronger dollar means any inflation pressures that the US economy may experience are diminishing. The Fed knows this which is why it will remain on a low interest rate program for the rest of this year.

At Cumberland we see this as a developing opportunity to reposition in Europe with a higher allocation and more selectivity. Not today but the time to trade gets nearer every day as the crisis unfolds.

For the moment we continue in the strong dollar mode. Our US ETF accounts are fully invested and we expect the US stock market to go higher. Our target of 1250 to 1300 on the S&P 500 index remains. We expect full closure of the “Lehman gap.”

That is consistent with our present international position; we have over weighted other places in the world. My colleague Bill Witherell summed it up at the end of the piece he wrote about why Portugal is NOT another Greece. His concluding paragraph is below.

“In Cumberland’s Global Multi-Asset Class and International ETF portfolios all Eurozone positions except for the Netherlands are now underweight. Our current strategy anticipates overweighting the stronger Eurozone countries when market conditions become less turbulent. Among the weaker Eurozone economies, we intend to remain underweight for Italy and Spain. No country ETFs are available for Greece or Portugal. Ireland is on a strong recovery track and a new ETF for Ireland announced by iShares will soon open that opportunity for ETF investors.”

David R. Kotok, Chairman and Chief Investment Officer
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