Thinking the Unthinkable

Thinking the Unthinkable
David R. Kotok
May 16, 2012


Chapter two of our old book on Europe outlined the benefits of convergence. Charts and data displayed the boost to growth that occurs when interest rates coalesce at a lower level and when credit spreads narrow. The multiplier effect is huge. Europe experienced it during the formative stages in the last decade. Those were the good times.


All that has changed. The unthinkable has occurred.


We now have DIvergence instead of CONvergence. We now have DISintegration instead of Integration. The Eurozone is coming apart.

The book that Vincenzo Sciarretta and I wrote is out-of- date. Its value is to read it in reverse. By doing so, one can estimate the pain that still lies ahead for the countries of Europe which are still engaged in extending public debt burdens, high taxation, failure to rein back spending and deferral of confrontation with the reality of the situation. They are ignoring the old adage: “If you find you are in a hole and if it is getting deeper, stop digging.”

Greece is no longer the issue. It is already dead. Its banks are bleeding. Liquidity to keep them from a collapse is provided through the mechanism of the Emergency Liquidity Assistance (ELA) funding. It allows the central bank of Greece to lend euro to its member banks against pledges of questionable value. Without ELA the Greek banking system would collapse.

In Greece, we have reached the “Endgame” as John Mauldin calls it in his book. Greece is doomed.

The issue for other Eurozone members is played out in Spain, Portugal and now, Italy. Portugal has experienced repudiation in the credit markets. Spain is getting it, too.

Italy is the one to watch. It is the 800-pound gorilla and it is sick. Its economy is shrinking, not growing. It has failed to rein back the public expenditures. Its demographic composition is impossible to balance with a debt-to-GDP ratio above 120%. Italy is the world’s third largest debtor. The test of “too big to fail” will come with Italy.

Credit spreads with Italy are widening. I recall that the difference between the ten-year German bond yield and the ten-year Italian bond yield once reached nine basis points. That is correct 9 basis points. The charts start on page 27 of my old book and depict the good old days. That was only 7 years ago. Look at today’s pricing vs. the old pricing and play the movie backwards and one can see where this is headed. Things are going to get worse.

Investors are running from Europe. That is why the world’s credit spreads are widening between the “good guys” and the “bad guys.” We update them weekly on our website, The hits on the charts there are rising each week as global investors want to see these comparisons. Visitors are welcome.

We are very underweighted in Europe and believe it is too soon to “bottom fish”. We believe the US economy and financial system has already discounted much of the turmoil.

The US has become the world’s safer haven among the OECD mature economies. We remain overweighted in the US stock market. We remain invested in US dollar denominated bonds and favor the spread sectors over the US Treasury bonds and notes. We are using hedges where practical to dampen strategic interest rate risk.


David R. Kotok, Chairman and Chief Investment Officer

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