On Strategy

Déjà Vu? Eurozone Crisis Today vs. 2008 Subprime Crisis

November 28, 2011

Liz Ann Sonders
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:

1. Perception: When Greece's troubles erupted, policymakers and investors downplayed it because of its size—similar to the initial perspective about Lehman Brothers' problems.
2. 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.
3. 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.
4. 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.
5. 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:

1. 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.
   
2. 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.
3. 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.
   
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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."

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Schwab Market Perspective: Missing the Forest for the Trees?

October 28, 2011

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research

Key Points

• Earnings season was good and economic data in the United States has shown signs of improvement. Although we don't believe we'll see robust growth in the near future, we do believe the economy is improving. But investors appear to be unconvinced that the picture may be brightening.
• Headline inflation continues to run higher than we'd like to see but we don't believe sustainable price gains are likely.  The Fed continues to be extremely accommodating, seemingly more concerned about the potential for deflation.
• Although Greece has garnered the headlines, Italy has the potential to be a much bigger problem. There are positive signs of progress in Europe and a tentative agreement has been reached, but hopes for a true long-term solution remain thin. Conversely, Chinese growth, while slowing, is likely to suffer no worse than a soft landing.

In investing, a danger is getting caught up in day-to-day, hour-to-hour developments. And typically, it's the negative news that gets the majority of the attention from the media.  Looking at the bigger picture is important for investors that have longer-term horizons.
The market continues to be at the mercy of developments out of Europe, with much of the recent focus on Greece. Discussed in more detail below, Greece itself is a relatively small country in terms of economic size and importance, but is getting the lion's share of media and market attention. Its importance is heightened due to it's interconnectedness with other European nations, but overemphasizing its problems can obscure the bigger picture solutions that are being formatted. But even the broader European focus has largely seemed to overshadow developments in the United States, which remains the world's largest economy.

US growth improving and recession risk is ebbing

We are seeing signs of better growth that we believe is supporting an upside breakout of the recent range-bound equity market. But despite a nice rally in the markets since the beginning of October low from just under 1100 on the S&P 500, investor sentiment remains quite dour. The Ned Davis Research Crowd Sentiment poll does show improving confidence, but it remains in the "extreme pessimism" zone, which contrarily bodes well for the potential of a continued move higher in equities.

Investors appear unconvinced despite recent rally

Source: FactSet, Standard & Poor's. As of Oct. 20, 2011.

We are now well into third quarter earnings season and it has been better than anticipated. The vast majority of companies reported both bottom- and top-line results that met or beat expectations, while outlooks were mildly optimistic. Demand has held up relatively well, and companies continue to hold their costs down and maintain solid balance sheets. After factoring in the latest results and guidance, valuations are attractive, especially relative to bonds.
Economic data also supports a modestly improving picture. Although the NY Empire Manufacturing Index remained in negative territory, important subcomponents including orders, employment and shipments all moved from territory depicting contraction to expansion. Another regional manufacturing survey, the Philly Fed Index, surged from -17.5 (which shocked markets two months ago) to 8.7, a six-month high; while new orders, shipments, capital expenditures, and employment all either remained in or moved into positive territory. Additionally, industrial production moved higher by 0.2%; durable goods order ex-transportation surprised significantly on the upside; and the Index of Leading Economic Indicators moved higher by 0.2%, the fifth-straight monthly increase. Finally, third quarter real gross domestic product (GDP) came in at 2.5%  growth, up from 0.4% in the first quarter and 1.3% in the second quarter, further helping to dispel fears of a renewed recession. While encouraging, we continue to believe business confidence needs to strengthen in order to really get the economy moving in a sustainable way.

Small business confidence better, but still too low

Source:  FactSet, Nat'l Federation of Independent Business. As of Oct. 20, 2011.

Murky jobs picture, but maybe better than portrayed

Improving employment growth continues to be the focus of both the Federal Reserve and the government, and we are seeing nascent signs of improvement. Initial jobless claims continue to hover around the 400,000 level; various surveys, as mentioned above, indicate improving employment conditions; and the often-ignored JOLTS (Job Openings and Labor Turnover Survey) report showed that at the end of August there were 3.1 million job openings, up 200,000 from a year ago and 944,000 greater than the trough seen in July 2009. While the long-term unemployment rate is far too high at over 6 million, that number has remained relatively stagnant over the past year.

Fed continues to swing away

The Federal Reserve continues to be concerned with the over 9% unemployment rate and the still moribund housing market that appears to be, at best, bouncing along the bottom. Although new home starts jumped by 15%, permits were down 5% and both of those number were greatly affected by the volatile multi-family component. Additionally, existing home sales fell.
In response to these concerns, the Fed adopted "Operation Twist" at its most recent meeting, attempting to bring down longer-term mortgage and Treasury rates. So far, the impact hasn’t been felt as mortgage applications actually fell by close to 15% a week ago and are now at a 15-year low; and longer-term interest rates are now higher than when the program was announced. But, although there appears to be increasing dissention within the ranks of the Federal Open Market Committee (FOMC), the majority still seems ready to attempt to do more if they deem it necessary. The Fed appears unconcerned about stoking inflation, despite the headline Consumer Price Index (CPI) rising by 3.9% year-over-year, and the core rate at the upper end of their implied preferred range of 2.0%. Despite these readings, we too remain relatively unconcerned about inflation in the near term. We've seen commodity prices move lower recently, which should alleviate pressure on the headline rate, while continued high unemployment, minimal wage gains, and capacity utilization of 77.4% (still 3% below its 1972-2010 average) should keep inflation relative low.

Washington continues to underwhelm

Focus will likely return to Washington over the next month as the debt Super Committee's deadline for coming up with a deal approaches. Early reports are that there’s little positive movement toward a deal that both sides can agree on. But in addition to the fact that most deals like this get done at the last minute and we are hearing rumblings that a "grand bargain"-type deal is not out of the question.
Although a recent University of Michigan survey reminded us that the government is doing little to help confidence, as the ratio of those thinking the US government was doing a good job versus a bad job fell to a record low -53%, we do believe they will manage to cobble together some sort of agreement that avoids some of the more draconian outcomes currently predicted. However, any chance of a long-lasting, credible, plan that stimulates growth, cuts spending, and lowers debt before the 2012 elections seems slim at best.

Is Italy or Greece Europe’s weak link?

Across the pond, however, some progress was made on finding at least a temporary solution to the Greek debt problem. Although still short on critical details that could derail any feasible agreement, it appears that participants have started to realize the reality of the situation. The recent summit ended with private Greek debt-holders agreeing to a "voluntary" 50% haircut in the value of their bonds, while also announcing the bolstering of the European Financial Stability Facility (EFSF) and increased capital to the continent's financial institutions. However, where that money is coming from is unclear at this time—a major question still looming. Despite the vagaries, it is a glimmer of hope. Although global risks have intensified in recent months, a meltdown of the global banking system has significantly moderated in our view; with the mere acknowledgement and progress toward actions to fight the eurozone debt crisis. That said, the fallout from the crisis will likely continue, in three significant areas: Italy, the European banking system, and the overall eurozone economy.
Italy is in focus due to its large debt load. At 1.9 trillion euros ($2.6 trillion) Italy has the world's third largest bond market; behind the United States and Japan. It represents nearly 120% of Italy's GDP. Italy needs to continually raise vast sums of money to roll over maturing debt. If they are unable to find investors willing lend at reasonable interest rates, its debt would likely be too big to bail out. Lastly, with growth nearly stagnant, Italy needs changes to the status quo to put its financial future on a sustainable path.
Reforms in Italy needed to both reduce spending and spur growth are similar to changes needed in many of the "Club Med" countries: overhaul the pension system, reduce the protection from new entrants in certain "closed" professions, and reduce red tape. The World Bank ranks Italy 87th globally in its latest ease-of-doing business survey and 158th in terms of enforcing contracts. Markets question Italy's resolve to adhere to an austerity plan and implement reforms. Infighting within Prime Minister Berlusconi's fragile coalition government, allegations of corruption and scandals, and reversals of prior promises undermine confidence as well.
Italy's situation is not entirely dire though—it should not be considered the next Greece. Italy suffers from liquidity concerns due to low confidence; not from questions about solvency. Unlike Greece, Italy has a primary budget surplus; a surplus before debt payments; as well as high percentage of domestic, long-term holders of its debt, and long debt maturities. This suggests that any crisis should be slow to develop. We believe that Italy, like governments of other peripheral nations, will likely eventually come to grips with tough decisions. If the current government doesn’t make good on its promises, markets and constituents could force a change in leadership.
Another victim of the prolonged debt crisis is the eurozone economy broadly, as European banks could limp along. To achieve the higher capital ratios mandated as a part of the "recapitalization plan," European banks could sell assets or reduce dividends, diluting equity holders. And there is potential for increased demand for claims on collateral (bank assets).

Eurozone banks likely to rein in lending

Source: FactSet, European Central Bank. As of Oct. 25, 2011.

A weakened eurozone banking system is likely to reduce lending, the lifeblood of economic growth. Over the summer, eurozone banks started to tighten lending standards at the fastest pace since 2009, and indicated they expect tightening to worsen. In response, businesses could begin to protect cash by freezing or cutting employment, capital investment and discretionary spending, reducing production or reducing inventory.
In addition to economic headwinds, we've kept our neutral intermediate-term view on European stocks believing that there may be more downside risk to eurozone earnings estimates than elsewhere globally. Third quarter earnings season may bear this out, as only 52% of European companies reporting through Oct. 26 beat earnings estimates, well short of the 72% rate in the United States, per Bloomberg.

Longer-term investment implications from the eurozone debt crisis

Investors likely have whiplash from month-to-month swings in sentiment regarding the eurozone debt crisis, but there are longer-term implications. In our opinion, the euro "experiment" of a common currency for countries with different cultures, economic make-up and growth, without fiscal union, is flawed. What may be needed is fiscal coordination on budgets, tax rates and collection; debt issuance; and enforcement of budget discipline. The adjustment to supra-national oversight is likely to be unpopular with constituents who may see this is as "taxation without representation." Social unrest and discord could continue to be a staple in the eurozone.
Big picture implications from the eurozone debt crisis could shape investment philosophy for several years. In an era of painful debt reduction realities in many developed economies, there is the potential for uncertainty to result in more frequent and shorter business cycles, while pressuring economic and earnings growth.
Alternatively, emerging markets could grow in relative investment attractiveness. Emerging market economies tend to have lower debt levels. Additionally, generally younger demographics create a lighter burden on public finances and potential for more output. Meanwhile, expectations for emerging markets are low, with valuations at the lowest levels since 2009. Emerging market stocks came under pressure earlier this year amid monetary tightening headwinds; and further intensified with market volatility and concerns over a hard landing in China.

Are China fears justified?

Growth in China slowed to 9.1% in the third quarter from the 9.5% rate in the second quarter, hardly qualifying as a hard landing. However, due to lack of transparency and mistrust of government statics, it is useful to look at other proxies of economic growth. The HSBC survey of purchasing manager intentions of over 400 companies—a broader version than the government’s as it includes smaller companies—increased to 51.1 in September.

Soft landing in China looks likely

Source: FactSet, Bloomberg. As of Oct. 25, 2011. Seasonal average over a six-year period excluding a one-year period from May 2008—June 2009. October data is preliminary.

Despite low 2011 figures, HBSC notes that a PMI reading as low as 48 is consistent with annual growth of 12-13% in industrial output and a 9% rate of increase in GDP. Other positive proxies of growth include healthy freight volumes and an acceleration of electricity output in September to 12.2% from 9.1% in August.
We believe a hard landing in China would probably need a US and global recession to occur, and policymakers have many levers to arrest a slowdown. While Chinese officials have yet to decisively move away from inflation vigilance, they have started to sound a more conciliatory tone. They are talking about support for small businesses; adding jobs as an explicit priority for the first time in recent history; reduce fuel prices; and making bank stock purchases.
A shift in policy bias in China could be nearing and fulfill the last condition needed for emerging market stock outperformance, as cited in Emerging Markets: A Bright Spot?
Visit http://www.schwab.com/public/schwab/resource_center/expert_insight/investing_strategies/international for more international perspective.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

The following is analysis from outside sources. I have included WBFG views on some of the comments. RGW

What IS THE IMPACT OF A GREEK DEFAULT?

Many economists think a Greek default is inevitable. As we enter 4Q 2011, Greece has a debt-to-GDP ratio of about 160% (and that percentage is rising). While Greece accounts for less than 3% of Eurozone GDP, ripples from a Greek default could strain the European banking sector and global financial markets.

Struggling for the best worst-case scenario. Greece is redoing its financial system, but it is still facing one of five potential (and painful) outcomes.

1. Greece renegotiates its debts & forces its lenders into write-offs. Many Greek banks are nationalized; Greece endures a long recession.
2. Greece can’t renegotiate its debts. It sinks into a multi-year depression exacerbated by additional austerity measures.
3. Greece rejects further austerity cuts recommended by the EU. A standoff with the International Monetary Fund and European Central Bank results; the ECB and IMF blink and continue bailout payments to Greece; Italy and Spain see the way Greece made the ECB and IMF cave in and later wrestle the ECB and IMF into submission in the same way; Germany gets frustrated with all this and ditches the euro.
4. Greece rejects more austerity cuts & the EU stops bailout payments. Civil unrest jeopardizes the country. Its banks close; its public services halt. The CIA has advised that a coup may occur in Greece in such a scenario.
5. Greece lapses into a banking/cash flow crisis & leaves the euro. This is the “doomsday” scenario. Assume #4 occurs with Greece also electing to go back to the drachma. That could mean a run on Greek banks, and then Spanish and Italian banks. A return to the drachma could mean frozen borrowing for Italy and Spain and possibly lead to insolvency for major banks in Europe. Picture 17 nations trying to agree on and quickly implement an EU version of TARP. Havoc could result for stocks and the global economy.
   

This all sounds very gloomy, but prospects may emerge from the gloom.

A(nother) golden opportunity? In the event Greece defaults, the search for safe havens could mean a quick flight to gold. If a Greek bailout succeeds, there may still be fiscal instability among EU members, and presumably an easy monetary policy fostering loose credit. If Greece defaults, then you could see big drops in the spot prices of currencies plus some competitive devaluation. All of this could make gold look very, very good.

On the other hand, if true systemic risk hits global markets, investment banks and hedge funds might need capital fast – and gold is easily liquidated. So a gold selloff could also possibly occur if the situation becomes dire.

WBFG View

WBFG holds a negative view of gold and does not recommend it has a long term investment for clients. Its current role in the market appears to be as a speculative tool. This view has appeared to push gold into bubble territory with the possibility of rapid price deprecation (as seen last week when gold dropped around 10% in two days.

What about Treasuries & the dollar? Treasuries remain popular, and demand for them could jump after a Greek default. What other choices do central banks have if they want to shop around for a stable, readily available, reasonably liquid investment? The euro is hardly a rival to the greenback right now.

WBFG View

WBFG believes it is appropriate to hold short term, high quality, multi currency fixed income holdings in this environment. This view is reflected in the fixed income positioning that the Investment Committee has recommended.

How about emerging markets? Here is another option. The BRICs and some of the other emerging-market nations have managed to ride out the recent volatility fairly well – there has been some “decoupling”, if you will.⁸ No one is saying these markets would be immune from a continental banking crisis or a flight from stocks, but you have to concede that emerging markets have the capability for independent behavior.

WBFG View

WBFG believes a position in emerging markets is still appropriate and provides diversification.

Would it still be worthwhile to own blue chips (stocks)? Keep in mind that the Dow did not fall to 4,000 after the Lehman Bros. and Washington Mutual failures and the initial rejection of TARP by Congress. Stocks did pull out of that plunge, and spectacularly so; bargains abounded, for that matter. So it might certainly be worthwhile to hold onto stocks in the coming months, especially as some European governments have hinted at possible capital injections for banks if the need arises. On September 13, German chancellor Angela Merkel noted that the EU would not let Greece fall into “uncontrolled insolvency” and reports surfaced of China getting ready to purchase Greek debt. Treasury Secretary Timothy Geithner even got involved in the search for solutions in mid-September.

Europe’s biggest private lenders may be deemed “too big to fail” by the EU and ECB, and if unwinding of any financial institutions is needed, the authorities should do everything within their reach to try and make it gradual.

It could be that Wall Street has already priced in a Greek default and will just wince, not stumble, at its confirmation – assuming the news arrives with more inevitability than frenzy.

WBFG View

From a fundamental standpoint, stocks appear to provide relative valuation advantages to bonds and cash. Accordingly, the equity positioning that is consistent with our clients’ long term plan is appropriate even in this period of uncertainty.

The biggest fear of all: contagion. Italy and Spain may be “too big to fail” in the eyes of the EU and IMF, but they also face big debt problems. Standard & Poor’s cut Italy’s credit rating to ‘A’ in September; Moody’s Investors Service is weighing downgrades for Italy and Spain before November.

                                                                                                                  

WBFG View

As with risks in the past, the market provides the appropriate pricing for contagion risk as well as other risks. As long as we have the appropriate long term position and appropriate diversification, we have the right portfolio positioning for our clients.

Schwab posted the following commentary this week on the Eurozone Crisis. RGW

On Strategy

The End of the Line: Eurozone Crisis Hits Tipping Point

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., and
Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research
September 12, 2011

Key points

• The growing likelihood of debt default by Greece rocks markets and sentiment.
• Although the banking system is healthier today than it was in 2008, contagion risks are elevated.
• The grand experiment of a unified currency in Europe is facing its greatest test yet.

The inevitability of the eurozone crisis was foreshadowed by the late, great economist Milton Friedman. At the time of the euro's debut in early 1999, Friedman expressed concern that it would not survive the first major European economic recession or crisis. Prescient thinking.

Euro 101 The primary motivation for the creation of the euro was less economic than political. The goal was an integrated Europe that could more effectively compete with (and/or rival) the United States. The hope was that a single currency would also force economic restructuring in the more-wayward peripheral countries, requiring them to abide by the Maastricht Treaty rules that govern member countries' budget policies.

Things didn't work out as planned. Blatant disregard for budget policies among the "PIIGS" nations (Portugal, Ireland, Italy, Greece and Spain) brought on wage and price inflation greatly exceeding the eurozone average. In addition to the resultant diminished competitiveness of these peripheral members was the effect of burgeoning budget deficits as a percentage of their gross domestic products (GDP).

Fast-forward to today, and there's legitimate risk that these countries don't have the wherewithal to honor their debt obligations. The major problem is that European leaders don't appear (at least publicly) to understand either the gravity of the crisis or the impact that confidence has on the financial system. The very recent decision by Germany to begin contingency planning and shore up its banking system suggests perhaps they are just getting to this point of awareness.

Not contained to Europe … The pressures emanating from the overhang of government debt in the eurozone continue to negatively impact trading in Europe, but why have US stocks also been taking their cues from the eurozone? Why does Greece matter so much?

Because the crisis is about more than just Greece. The problems in the eurozone are more about the health of the banking system in Europe, the long-term viability of the euro, Europe's contribution to global growth and the indirect impact on the US dollar.

… but Greece is unique in severity
Greece's deficit and debt levels (15% and 140% of GDP, respectively), lack of economic growth and commitment to austerity put it in a class of its own, and Greece is the most likely member to default on its debt. Greece's quarterly review for funding conducted by the troika of the International Monetary Fund, European Commission and the European Central Bank (ECB) broke down in early September. The breakdown was due to lack of progress on achieving fiscal targets, implementing structural reforms, selling off public assets (privatization) and a public debt-swap plan rumored to be short of the 90% participation goal.

In an illustration of Greece's struggle, the ability for Greece to generate the revenues targeted under the bailout is severely hampered: the economy contracted 7.3% in the second quarter and Greek officials have confirmed that they have cash for only a few more weeks. If this sounds familiar, it is: Greece was in the same position in mid-July of this year when cash was running low because the deficit was higher than expected.

This was partly due to lack of progress on austerity and reforms, leading to the second Greek bailout to cover higher-than-expected cash needs. Since then, yields on Greek two-year debt have skyrocketed relative to the other peripheral nations.

Greek Two-Year Bond Yields Go Parabolic
Source: FactSet, as of September 9, 2011.
So is forcing more austerity on a country already suffering from a lack of economic growth the solution, or will this just exacerbate the problem? It's clear to most observers that this is an unsustainable situation, with a restructuring of debt obligations ultimately needed.

Contagion from Greece is infecting the European banking system
Policymakers have been hoping to postpone a Greek debt restructuring until growth recovers, reforms have been put in place and banks have had a chance to better capitalize to cover potential losses. However, the lack of agreement and ability to act in a coordinated way by eurozone policymakers has allowed a crisis of confidence to develop, resulting in contagion to other countries and a banking-system infection. As a result, banks are less willing to lend to each other, as highlighted in the chart below by the widening in the three-month Euribor/EONIA spread, indicating a growing credit crunch.

European Bank Stress Up, But Below 2008

Source: FactSet, as of September 9, 2011. Europe Bank Stress=three-month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate.

There's a question of which came first, the chicken or the egg here, but the interaction between banks and governments appears to be reinforcing this negative feedback loop. Reasons include:

• Banks have large holdings of sovereign debt which they may need to write down.
• Governments tend to be the backstop for banks.
• Yields on government debt are often the basis for loan rates.
• Banks themselves can have funding issues if they're using government debt as collateral for loans.

As a result, we believe European banks need more capital. Reasons include:

• Eurozone banks have low levels of capital. European banks remain highly leveraged, not having recapitalized or deleveraged to the same degree as those in the United States. According to Michael Cembalest, head of JP Morgan's private bank, European banking-sector liabilities are three-to-four times the size of European GDP, versus the one-to-one ratio in the United States.
• It's likely that sovereign debt (Greek in particular) will have to be written down further at many banks. While the proposed second bailout for Greece forced a 21% write-down of some Greek debt, markets are pricing in more than a 50% discount, in line with the haircut many believe is sustainable for Greece to support.
• There's a need to bolster confidence that banks can absorb losses. Banks' overreliance on short-term funding has exacerbated uncertainty and volatility, and investors need comfort before providing capital.
• Banks must have the strength to lend—the lifeblood of economic growth.

Why not let Greece default and stop the contagion?
Some believe that separating Greece's solvency issues from liquidity issues elsewhere by drawing a line in the sand and recognizing that Greece needs restructuring may ultimately be a positive action. While this could be destabilizing in the near term, it's possible that by sizing asset values and removing uncertainty, markets could form a base from which to build.

The problem for markets is that we just don't know the broader implications of a Greek default on European banks or contagion to the other PIIGS. Banks across the eurozone own Greek debt, and Greece is only one of the three countries currently under bailout (Portugal and Ireland being the others), while the debt of the other two PIIGS (Spain and Italy) is currently being propped up by ECB purchases. An immediate default without a longer-term plan to "ringfence" banks and other sovereigns (like Italy) would be quite risky.

The question is whether the value of the debt of these other countries will also be marked down and whether Portugal and Ireland will decide to either default or ask for new conditions. Lastly, the lack of transparency in the credit default swaps (CDS) market means we don't know where all the liabilities exist.

Ultimately, it's unknown how much additional capital eurozone banks would require if contagion spreads, but it's believed that even including CDS exposures, US banks would feel little impact. The chart below shows the direct exposure of US banks to PIIGS' sovereign debt, relative to the European banks.

US Exposure to PIIGS Limited

Source: BCA Research and Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.). Debt as of December 31, 2010, and includes public and private. GDP as of June 30, 2011, and expressed in nominal terms.

US banks' capital ratios are about double those of the average European bank. In addition, many banks claim that their "net" (including CDS) exposure is limited. But as we learned through the Lehman Brothers debacle in 2008, if you have "insurance" via CDS, but the party on the other side (AIG at the time of the Lehman failure) can't pay the claim, a can of worms is opened. (You can see a chart of Greece's CDS further below.)

Meanwhile, the ECB's ability to purchase debt, which has helped ease pressure in Spain and Italy, is limited by its need to sterilize (offset) injections of money into the financial system with withdrawals of liquidity elsewhere. Discouragingly, even the ability of the ECB to stabilize the situation has been hampered.

Greek default may force decision between euro breakup or fiscal union
A potentially bigger-picture implication of a Greek default is whether it would come in conjunction with a decision to leave the euro, either voluntarily or involuntary. In the near term, Greece leaving the euro and returning to the drachma could result in debt defaults for businesses and households, require banking system recapitalization and disrupt international trade. There would need to be strong coordinated action in the eurozone to stabilize the situation and keep things orderly—something that's been lacking thus far in the crisis. This may ultimately require coordinated global central-bank intervention.

Any country opting (or forced) to leave the euro would find the process a lengthy one. An exiting country would have to negotiate with the entire European Union (EU), not just the eurozone authorities. All treaties and legislation governing the euro are EU treaties. In fact, several of the 27 countries encompassing the EU require referenda to be held on changes to treaties.

On the other side, a full eurozone fiscal union may be desired but politicians must convince their citizens of the advantages. Additionally, many new laws and treaties would be required—which would not be an easy or quick process. To date, more-austere nations have been unwilling to consider measures toward fiscal union (such as issuing common eurobond debt) until bailout nations make more progress on austerity and reform.

One outcome of the German court decision this week (that ruled the European Financial Stability Facility constitutional) is that it rules out open-ended, longer-term fiscal responsibility for other nations, thwarting the possibility of eurobonds. The flaw exposed during this crisis is that a currency and monetary union without fiscal union may not be sustainable.

Greek CDS surge
The choice will be between kicking the can down the road again or removing the band-aids and taking the short-term pain. Over the weekend, Greek officials indicated further measures to close the deficit gap for this year and renewed their commitment to meeting obligations rather than default. Additionally, despite continued resistance to assist in bailouts and strong language that austerity and reforms agreed to must be adhered to, the German finance minster has rejected speculation of a Greek default. Markets remain unconvinced, as the CDS market is indicating a 92% probability of a Greek default.

Greek CDS Go Parabolic
Source: Bloomberg and FactSet, as of September 9, 2011.
It's also important to note that both Italy and France five-year CDS have increased sharply, indicating that contagion has begun. We don't know when a Greek default will happen, and it is possible the can will be kicked down the road again before a restructuring ultimately occurs. Additionally, while the current negative sentiment may end up presenting the possibility of a short-term bounce for stocks, we await better visibility on a resolution to the eurozone crisis before changing our cautious outlook on the eurozone.

2008 redux?
Whether we're heading on a path to repeating the 2008 crisis is a question we often receive. There are many indications that the global banking system is in far better shape today than it was back then and that the crisis is likely to be relatively contained to the eurozone. But we don't take pictures like the one below lightly either.

Foreign Banks Shovel Money to Fed
Source: FactSet and Federal Reserve Bank of St. Louis, as of September 9, 2011.
Foreign official and international accounts have deposited nearly $103 billion at the US Federal Reserve, up from less than $58 billion at the beginning of 2011 and well above the prior crisis high of less than $89 billion in January 2009. This indicates a loss of trust in the European banking system.

Lars Tranberg from Danske Bank said European banks have been reduced to borrowing dollar funds for "a week at a time," as opposed to the typical six-to-12 months. "This closely resembles what happened in late 2008, though the difference this time is that the major central banks have dollar swap lines in place. If the dollar funding market completely freezes up, the ECB can act as a backstop."

Growth under attack in the eurozone, pressuring the global economy
The eurozone is an important part of the global economy, as it accounts for nearly 20% of global GDP. While the eurozone has not recently been a big driver of growth, a breakdown in economic growth or the banking system would be felt globally. With growth already slowing globally, a recession in Europe would hurt. While we think a recession in several European countries is very likely, we believe a broader global recession akin to that experienced in 2008 can be avoided.

As a result of falling confidence in the longer-term viability of the euro and the potential that the ECB may need to pursue its version of quantitative easing by making unsterilized purchases of either sovereign or bank debt, the value of the euro has fallen. There's also pressure (rightly so) on the ECB to lower short-term interest rates.

This has resulted in a corresponding increase in the US dollar, as you can see in the chart below. History is mixed as to whether a stronger dollar (which we expect) would necessarily be negative for the stock market. Recently, the two have moved inversely, but over long-term history, a stronger dollar has more often been met with a stronger stock market. Regardless, a stronger dollar would mean weaker profits for multi-national companies, but less inflation.

US Dollar Breaks Out on Upside

Source: FactSet, as of September 9, 2011.

What's next?
The situation in the eurozone remains fluid, with key events still ahead, including final approval of the new Italian austerity package, French banks bracing for a potential downgrade by Moody's and the European Commission pushing for a global agreement on a potential financial transaction tax later this month.

Importantly, the second Greek bailout and expanded European Financial Stability Facility has yet to be ratified by the parliaments of all 17 nations that comprise the euro, which is expected to occur in September and October. Additionally, Finland's demand for a collateral guarantee in exchange for its bailout contribution is expected to be resolved in mid-September.

What's an investor to do?
This all begs the question about how an investor should be thinking about portfolio positioning. From a stock perspective, we continue to think that the US market will remain a decent relative performer (though not necessarily a decent absolute performer). In fact, on a year-to-date basis, the US stock market is ranked seventh among the 33 largest stock markets globally. And we know readers will be shocked, just shocked, that Greece's stock-market performance is dead last.

While we've been negative on Europe, we don't believe in completely avoiding the continent, but instead supplementing diversified European exposure with an allocation to Switzerland's defensive market. Elsewhere, we're favorably disposed to Japan, where we believe there's an improving environment in which companies can operate more competitively globally. In combination with low expectations and declines in valuations, it could bring about the long-awaited revival of Japanese stocks.

Lastly, we believe the global economic slowdown and strength in the dollar may provide emerging markets with inflation relief. That would enable a pause in monetary tightening to the potential benefit of stock-market performance, once the uncertainty and high correlations (degree to which asset classes move in tandem) eases.


Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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