November 28, 2011
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Key Points
- News flow on the eurozone debt crisis is speedy, and the latest news of a fiscal pact brings cheers by stock investors… for now.
- There are many similarities between the 2011 and 2008 crises—but even more differences.
- The end of the "Debt Supercycle" has ushered in a period of heightened risk and shortened economic/market cycles.
Before we get to a compare-and-contrast between the eurozone debt crisis of today versus the subprime crisis of 2008, let's first summarize (no easy feat) where we are today with the former.
Single currency experiment goes awry
At its most basic, the problems in the eurozone are nothing new: too much debt, from eurozone member countries to over-leveraged European financial institutions. Adding to the woes is the lack of global competitiveness among many of the zone's members, thanks to the tying of 17 vastly different economies and policies to one (too-strong) currency. The lack of a single fiscal authority within the eurozone that's capable of enforcement or supervision has allowed the problems to fester and the can to be continually kicked down the road.
Exacerbating the crisis recently has been spiking yields on sovereign debt of the most heavily indebted counties (Portugal, Ireland, Italy, Greece and Spain, commonly referred to as PIIGS). The fiscal austerity now being demanded is adding to economic woes, making a eurozone recession all but inevitable. Greece remains the most beleaguered of the eurozone nations, but Italy and Spain have come into the crosshairs more recently.
Turmoil in the European banking sector is raising fears of bank runs and/or failures. Thanks to the "haircuts" placed on Greek debts that didn't trigger credit default swaps (CDS), concerns have elevated about further contagion among global banks. If similar haircuts are applied to other countries in the zone, the problem grows. All of this has greatly raised fears of rating-agency downgrades and further spikes in yields, suggesting a vicious cycle of debt, instability and uncertainty.
Germany plays chicken
This is unsustainable longer-term, and policy makers know this. Many believe (as we do) that Germany is presently playing a game of brinkmanship: saying publicly it's against European Central Bank (ECB) initiating quantitative easing (QE) and balking at the issuance of common eurozone bonds. Both are seen as the only viable solutions to stem the crisis longer-term.
Germany's reluctance is understandable: If it rescues its most profligate eurozone neighbors, its own credit standing gets hit. If Germany does not come to the rescue, a eurozone collapse becomes likely. But a groundbreaking fiscal pact may be in the works, whick helps to explain today's market rally.
As reported in the November 28
Wall Street Journal, the fiscal pact aims to prevent the euro currency block from fracturing by tethering its members more closely together. Although not yet agreed to, the pact would make budget discipline legally binding and enforceable by European authorities, and would "mark a seminal shift in the governance of the 17-nation eurozone," according to the
WSJ.
One of Germany's biggest concerns regarding QE by the ECB was that it didn't have the ability to control the finances of any country. This pact may be the "out" Germany needs to eventually support QE or eurobonds. QE and/or eurobonds would likely represent the "bazooka" needed to stem the crisis, akin to what the Troubled Asset Relief Program (TARP) was to the US crisis in 2008.
2011 versus 2008
This brings me to the comparisons between today's crisis and 2008's. I enlisted the aid of several colleagues on Schwab's Investment Strategy Council for this section, so thanks go to Kathy Jones, Brad Sorensen, Michelle Gibley, Rob Williams, David Kastner and Tatjana Michel. In fact, many of our discussion occurred on Thanksgiving Day (though it didn't spoil my appetite!)
The eurozone debt crisis is not distinct from 2008's, because what we're really dealing with is the finale of the global "Debt Supercycle" that took decades to brew. A breaking point was reached in the United States in 2008, and more recently in Europe.
The top five list of similarities between the two phases:
- Perception: When Greece's troubles erupted, policymakers and investors downplayed it because of its size—similar to the initial perspective about Lehman Brothers' problems.
- Liquidity: Eurozone policymakers initially assumed Greece's problems were about liquidity, not solvency, and blamed them on "speculators." This was similar to the initial reaction to the subprime crisis in late 2007; ultimately investors demanded a more comprehensive solution.
- Reality: Investors are now faced with the reality that assets previously considered risk-free now carry much more credit risk. Financial engineering then and now had magically and falsely transformed the most-dodgy loans and bonds into highly rated securities. Banks holding eurozone sovereign debt can no longer be sure that the CDS contracts they used to hedge against defaults will be honored, so they've been selling bonds, causing yields to spike.
- Contagion: Consistent over the period is a complex web of interconnections among global banks and limited transparency on credit-derivative exposure. Short-term funding risks today also mirror those in 2008, though so far to a lesser degree. The structure of the eurozone system has encouraged its financial institutions to become heavily reliant on short-term funding. The 90 banks covered by the recent European Banking Authority stress tests need to refinance debt in the next two years equivalent to 45% of EU gross domestic product.
- Moral hazard: If there are policy options available, how far do you take them to ensure that the parties involved solve their fundamental problems? Bond markets and the cost of short-term borrowing, and/or the evaporation of short-term liquidity in both cases, were factors that exacerbated the crises.
A top-10 list of differences between the two phases:
- Origins: The crises had different origins, with the 2008 US crisis spreading from the bottom up: starting with home buyers, through Wall Street's mortgage securitization and asleep-at-the wheel credit rating agencies, to the global economy. The global recession was triggered by the breakdown of the financial sector.
Europe's crisis today started from the top: fiscally profligate governments and weak economic growth led to a loss of faith by the financial and business communities, which crushed private-sector spending and investment. In this case, one could argue that markets and financial institutions were not the criminals, but the victims.
- Direction: The US private and financial sectors gorged on debt prior to 2008, and the subsequent (and forced) deleveraging caused a massive economic shock. Europe's crisis began with weak eurozone peripheral economies, prompting the private sector to hoard cash.
- Solutions: The solution(s) to the 2008 crisis required government and central-bank interventions to provide liquidity via record-low interest rates and bank bailouts. The response was swift and coordinated, with the really big gun coming via TARP, which essentially took a massive chunk of private debt and made it public.
Today, that response is hoped for in Europe, but it's been slow in coming (if it ever does). The primary problem today is a virtual absence of confidence among financial players of every variety in eurozone governments' and policy-makers' ability to stem the tide and stimulate growth. In addition, the bad debt at the heart of the eurozone crisis is already public.
- Geography: In 2008, the epicenter of the crisis was the United States, a single nation. Today's the crisis is spread among 17 countries, with surplus economies pitted against deficit economies.
- Speed: The crisis in 2008 hit quickly and fiercely with the collapse of Lehman Brothers, even though there had been previous warning signs. The eurozone crisis is moving much more slowly. Although kick-the-can effects are in play, they do give leaders and financial institutions time to make adjustments.
- Bullets: Global central banks had more bullets in their guns in 2008 than they do today. Monetary policy in the United States is as close to loose as it can get. Both the Federal Reserve and the ECB have injected massive liquidity into their financial systems, but there are limits to these strategies' effectiveness. This means stimulus is more likely to come from politicians today as compared to central bankers in 2008.
- Stress tests: Unlike in the United States, where regulators built a credit stress test for the systemically important financial institutions, European regulators used much less rigor. No write-downs were taken on sovereign debt in held-to-maturity accounts and funding pressure has become more acute. With no credible plan, European banks are forced to sell non-core assets, which will exacerbate the global deleveraging cycle.
- Health and liquidity: US Banks are far better capitalized, with much lower leverage than in 2008. Regulation is likely to keep leverage ratios lower going forward, which, although bad for earnings, is good for bondholders and the stability of the financial system. You can see this below in key charts of the Tier 1 Capital Ratio of US banks, US banks' earnings, the Bloomberg Financial Conditions Index and the TED Spread.
- Inflation: Commodity inflation was on a tear in 2008, putting significant pressure on emerging-economy central banks to adopt tight monetary policies, which fed into the negative global growth loop. Today, inflation pressures have eased and many global central banks (including the ECB) have moved toward looser policies.
- The US economy: Unlike in 2008, when the economy and jobs were imploding, the US economy is much healthier today (if not healthy in an absolute sense). Corporate earnings are on a tear whereas they were pummeled in 2008. Pent-up demand among the household and business sectors should support growth over the next few years.
Tier 1 Capital (as Percent of Risk-Weighted Assets) Much Improved Since 2008
Source: FactSet, Federal Deposit Insurance Corporation, as of September 30, 2011. Tier 1 Capital is primarily common equity and certain perpetual preferred stock for FDIC-insured institutions. Chart represents ratio of capital to risk-weighted assets.
Banks' Operating Income Has Surged Since 2008
Source: FactSet, FDIC, as of September 30, 2011.
Key Measure of Financial Conditions Much Healthier Than 2008
Source: Bloomberg, FactSet, as of November 25, 2011. The Bloomberg Financial Conditions Index combines yield spreads and indices from the short-term debt markets, stock markets and bond markets into a single normalized index.
Key Measure of Banking System Stress Well Off 2008's Crisis Level
Source: FactSet, as of November 25, 2011. The TED spread is the difference in yields between three-month London InterBank Offered Rate loans and three-month US Treasury bills.
Conclusion … if there is any to glean
There's no shortage of worries for investors, and when it seems like the negatives begin piling up, the market takes a hit and moves into risk-off mode. But, as we're seeing today, with any sign of good news, the market can shift to risk-on and stage an impressive rally. It's frustrating for investors, but is illustrative of why taking an all-or-nothing approach to being invested in stocks can be dangerous.
These are difficult and somewhat dangerous times. Rolling crises are likely inevitable, leading to shortened economic and market cycles. We're in a period of history with challenges that are new and more powerful than what have been dealt with in the past. But it's also helpful to remember what Warren Buffet once wrote in a shareholder letter: "…we have usually made our best purchases when apprehensions about some macro event were at a peak."
