Sovereign Debt Crisis: Born in Greece?

Good Evening: U.S. stocks tried to extend yesterday’s rally on Wednesday, but another late sell off prevented the major averages from posting only their second back to back up days in six weeks. Equities had been up as much as 1.5% before they slipped back into the red, but I find the market action a little strange since last Friday. Coming into last week’s unemployment data, the S&P 500 was at a perfect spot (1100 or so, just below its 200 day moving average) to either decisively resume its fall from the April peak or attempt a decent rally. Friday’s down move was indeed decisive, and yet every day this week has anything but, since the S&P has only flirted with the May lows around 1040.

I sense a resolution coming soon (up or down), one that could carry the indexes 10% away from these levels in fairly short order. Market participants are acting like a herd of Antelope that has seen a lion in the brush. They are fidgeting and pawing the ground anxiously, wondering which direction to bolt without being ambushed by the lions they can’t see. Governments are nervous, too, since their debt levels leave them little Keynesian room in which to combat any economic fallout from the sovereign debt crisis. Debt burdens have been accumulating in developed nations since long before the Greeks found out they couldn’t spend far more than they produced, but what started in Athens earlier this year is still anything but contained.

After yesterday’s minor comeback on Wall Street, stocks in both Asia and Europe were higher overnight. Markets in China were given a boost via an unsubstantiated report that its exports were growing strongly in spite of the recent issues in Europe. The official data, including May CPI figures for the People’s Republic, will be out later this week, but Chinese equities were up 2% in response (see below). What will be more interesting than the economic statistics, however, will be how the Chinese government responds to worker unrest over demands for wage increases. It’s not just Honda’s workers in China who want a better return on their labor, and rising wages in China will eventually impact the global cost structure for a whole range of goods.

Equities opened higher in the U.S. and then rallied further into lunchtime. The averages then developed a slow leak that not even a positive Beige Book release nor testimony from Ben Bernanke were able to prevent (see below). Banks led the ensuing down move, and many energy names followed when the residue from the Gulf oil spill weighed down the shares of BP and others. Volumes picked up during the final hour, as did the pace of the decline. The Dow, S&P, and NASDAQ were all down by 0.5% or so, while the Dow Transports and Russell 2000 held on finish with fractional gains. Treasurys were weak until both a solid 10 year note auction and slippery equity prices enabled them to finish flat. The dollar fell 0.5%, but the real action was in the cross-rates. The euro-yen relationship once again hovers just above a nine year low. Ex some weakness in precious metals, commodity prices were able to shake off their recent doldrums. Lower than expected crude oil inventories and moves higher in both soybeans and copper lifted the CRB index to a gain of 1.2% on Wednesday.

Fitch Says Cameron Faces ‘Formidable’ U.K. Debt Task
IMF Says Risks to Economy Have Risen
Pimco’s Crescenzi Sees ‘Keynesian Endpoint’ in Devaluations
Stimulus Talk Yields to Calls to Cut Deficits

Tonight I wish to briefly explore how the four stories above all touch upon a theme that is quite familiar to readers of these commentaries. Iceland may have been the first sovereign debt victim during the financial crisis of 2007-2009, but media types and others who are financially memory-challenged tend to date the beginning of the sovereign debt crisis to Greece’s blow up earlier this year. Since structural deficit spending has been a hallmark of Western Civilization for decades, the only respect in which the sovereign debt crisis can be considered of Greek origin is due its role as the cradle of democracy more than 2500 years ago.

Also worthy of a smirk or two have been official statements along the way that the problems would be “contained”. First it was Greece’s borrowing problems themselves that would be contained. After Greece had to pay double digit yields to borrow this spring, EU heavyweights intoned that the problems in Greece would stay contained and not taint others in the EU. Now that Spain, Hungary, and other PHIIGS face trouble, G-20 leaders tell us all that what is happening in Europe will stay contained on the Continent. As to whether the contagion of red ink will halt before it crosses either the English Channel or the Atlantic Ocean, count me as being from Missouri.

Unless David Cameron’s new coalition government in London can stitch together a new budget soon, Great Britain might become the next sovereign debt target over the intermediate term, at least according to Fitch (see above). The newest resident of #10 Downing Street has promised austerity, but market participants are less enthralled by words these days. Both they and Fitch would like to see actions taken. A sensible budget would also suit the IMF, if the warning they issued in the article above is to be believed. What worries the IMF is that governments have “limited room to act” with all the debt they now have on the books, a worry shared by PIMCO’s Tony Crescenzi.

Mr. Crescenzi is concerned that sovereign nations are approaching a “Keynesian Endpoint”, the terminus where a marginal dollar/euro/yen/pound borrowed from the future to be spent now to give an economy a boost becomes harmful rather than helpful to said economy. This insight about when the marginal utility of governmental stimulus turns negative (through higher interest rates, a lower credit rating, or both) is important for voters and policy makers to understand. I hope to elaborate on it further when I can get my hands on Mr. Crescenzi’s original article.

Where the sovereign debt crisis strikes next only Mr. Market knows, but if we go back a few years and substitute “subprime mortgages” for “Greek debt” then you will know why I have my doubts whenever I hear the word “contained” during financial tumult. The lip service given to deficit reduction in the New York Times article doesn’t square with the actual policies implemented to date (and contemplated for the fall election season — see above). Until policy makers in London, Tokyo, and Washington feel some of the pain we’re seeing now in Athens Dublin, and Madrid, I have little faith that the sovereign debt crisis has breathed its last.

— Jack McHugh

U.S. Stocks Decline as Energy Shares Tumble on BP Concern
China Stocks Rise Most in Two Weeks on Report of Higher Exports
Bernanke Says Fed Prepared to Counter Effects of Europe Crisis

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