July 2011

“Greece is not another Lehman moment – it is far worse than that….”

This was the provocative headline in a recent edition of Money Week. Obviously with the austerity measures passed last week by the Greek government, all is now well and happy…or so we would be led to believe by the European authorities. But the truth is actually very different; there are still fundamental problems in the global economy and the issue will be when, not if, Greece defaults.

A quick recap: Greece was bailed out a year ago to the tune of €110bn. The government promised to slash the budget deficit – the annual shortfall of state spending minus the tax take. Yet lenders still didn’t believe the country could service its existing borrowings. And yet it now needs a further €110bn. The debt pile Greece had already built up was just too great. So they slashed the value of Greek government bonds, driving up the yield. If Greece tried to borrow last month, it would have to pay up to 30% a year. That indicates just how little faith investors have in the country’s ability to repay any loans. And small wonder. By the end of this year, the Greek government will owe over 150% of the country’s annual output, reckons the International Monetary Fund (IMF). By 2016, even with huge state spending cuts, that figure will only have fallen to 146%. History shows that once a country’s debt/GDP ratio rises above 150%, a default is just a matter of time. In other words, Greece is about as bust as can be.

The pressure on the Greek government has built steadily over the last few weeks. The Germans have been wrangling with the European Central Bank over the terms of a fresh bail out, whilst protesters have been marching in the streets of Athens, fighting more austerity. There were certainly reasons to fear that Greece might be forced into a sudden default – and that would pose huge risks for the European banking system. Greek debt is hidden on balance sheets right across the financial system. No one really knows where the losses will come out. Even so, it is nothing like Lehman Brothers.

When the Wall Street investment bank collapsed in 2008, the US Treasury and the Federal Reserve had no real idea it would pose a systemic risk to the financial system. If they had, they wouldn’t have let it go down; they would have stepped in to rescue it instead. The crisis it provoked was largely unexpected. That isn’t true of Greece. Germany’s chancellor, Angela Merkel, and France’s president, Nicolas Sarkozy, are well aware of the threat a Greek collapse poses to the financial system. They aren’t going to let their financial system blow up until their experts have reassured them their banks can survive. If they have to find a few more tens of billions of euros to prop up their wayward southern neighbour for another year, they will, as it is better than the alternative. So there isn’t going to be a sudden collapse. The risks are all flagged up, and everyone will work hard to avoid them. The trouble is, Greece is just the tip of a much larger iceberg.

At the end of 2010, according to data from the Bank of International Settlements (BIS), Italian banks held $2.3bn of Greek debt, and UK lenders were in for $3.4bn. They should be able to cope with those losses. But then the numbers get much scarier. French lenders held $15bn of Greek sovereign bonds, while German banks were exposed to more than $23bn. The total for European banks was $52bn. This doesn’t include the ECB, which itself has bought €47bn of Greek bonds in a failed attempt to boost confidence in the country.

And then there’s the question of what happens to all the credit default swaps (CDS) written as insurance against Greece going bust. If Greece defaults, would the banks who wrote this insurance be able to pay out? Markets are looking at a scenario of a Greek debt default becoming disorderly. The big worry is that, as happened with the Lehman collapse in 2008, banks will stop trusting one another as fears over exposure to the country’s debt contaminate the eurozone. ‘Counterparty risk’ will become an issue once again, as banks that once looked OK have their capital eaten up by Greece-related debts going bad. So banks will stop dealing with each other – which is key to a functioning economy – in case they don’t get their money back.

Meanwhile, the Greeks have been running massive budget deficits for years. So have most of the other peripheral countries, such as Portugal, Ireland and Spain. France shows very little sign of getting its deficit under control. Neither does the US. The UK is making some progress, but lower than expected growth means we are unlikely to meet our targets. The sovereign debt crisis is not just a Greek issue. It is hitting most of the developed world and will affect the markets in three ways.

Firstly, it is going to depress economic growth. There is only one real way to bring deficits under control, and that is to make deep and painful cuts in government spending. But as governments everywhere scale back on their expenditure, growth is going to be hit. Over the medium term, a smaller state allows the private sector to grow faster. Cuts allow the economy to grow faster – eventually. But it takes time for that to happen. And in the medium term, the economy will be more sluggish than it otherwise would be.

Next, the debt crisis is going to deter investment. Who would want to build a new factory or sales office in any of the peripheral eurozone countries right now? You have no idea what the economies will look like, or even what currencies they might be using in three or four years’ time. You are likely to face years of grinding austerity programmes as governments struggle to stay in the euro. And yet investment is the lifeblood of economic growth. If companies don’t invest, then economies are not going to be able to grow.

Finally, it is going to depress asset prices. For all the reasons outlined above, the debt crisis is going to slow global growth. That is bad for just about every class of asset, from equities, to bonds, to commodities. Obviously, that is going to depress the markets as well. But it also means that investors are going to be very cautious. The constant threat of defaults, the worries that it will lead to a fresh banking crisis, and the nervousness over which country is likely to be targeted next, will all make any kind of bull market very hard to sustain. And the lower asset prices are, the lower growth will be as well.

In many ways, therefore, we’d all be better off with a Lehman moment. A quick, sharp crisis that would end with Greece defaulting on its debt, re-establishing its own currency, and one or two overexposed banks being bailed out would be better than a saga that drags on for years with no clear resolution. But it isn’t going to happen at least in the short term. The global economy suffered from the Lehman collapse – but was able to start recovering the following year. Unfortunately, this crisis will take far longer to resolve.

A Final Word on…Gold

The financial press are starting to question if gold is a bubble waiting to happen? We disagree and believe whilst there may be some volatility, there is a long way yet for the price to move up. Gold’s ascent has actually been quite gradual. Between 2000 and 2010, the average annual appreciation of gold lies anywhere between 11% and 18%, depending on which currency it is measured against. That is a very respectable return– especially compares to the stock markets and it vindicates the buy-and-hold strategy employed by so many in this bull market. But it’s still a steady, gradual increase. It’s nothing stellar or exponential. Compared to the last gold bull market in the 1970s, the story was rather different. Over the last ten years, of all the major currencies, gold’s biggest gain was 43.7% rise against the pound in 2008. Incidentally that year it only rose 5.8% in US$ terms. Looking at the US dollar alone gold rose against it by 49.7% in 1972. In 1973 it rose by 73.5%, and in 1974 by 60.1%. In 1979, as the bull market reached its final phase, gold moved 140% higher. Gold’s moves in this bull market so far have been much more measured and restrained. Still many experts can see the price rising from its current $1500 per ounce to $2500 per oz. Indeed, some have predicted a level of $5000+

But what of gold mining shares which have endured a frustrating 2011 to date? Indeed whilst gold bullion is up 7% year to date, the gold equity index is down some 14%. This relative underperformance is, according to Ian Williams of Charteris, is a buying opportunity. In a conference call with TWP, Ian cited the example of a South American silver mining company, in which he had invested. Twelve months ago, it cost the company $7 to mine an ounce of silver, which they sold for $17. Today the cost of production hasn’t changed at $7 per oz, whereas they are receiving $35 per oz; an increase in bottom line profit of $18 per oz. Gold and silver mining companies are currently sitting on huge levels of cash; and something needs to happen to that cash.

Either the companies will increase their dividends, they will undertake share buy backs, or they will look to buy other companies. In each case the share price should appreciate strongly. It is for these reasons, we at TWP, are still firmly committed to holding part of our portfolios in gold and gold equities. Oh and they should offer some protection against global economic crises…but we have already covered our thoughts on that topic.