Tuesday, June 15, 2010

TEOTWAWKI— The End Of The World As We Know It— Part III

¹²TEOTWAWKI— The End Of The World As We Know It— Part III

By Normxxx | 15 June 2010

I believe that "the 'Little' States of Europe" matter. Hungary matters, Greece matters. And Portugal and Spain. And Ireland and Iceland and Belgium (the latter having earned the nickname, "the Greece of the North"). And especially Italy.

It was expected that the $125 billion EU-IMF-Fed-orchestrated bailout of Greece would be "the end" of Europe's sovereign debt worries. These "small" economies "hardly matter"— do they[!?!] But perhaps the 1997 Asian market crash proved otherwise.

The 'Greek crisis' (and the other European debt crises yet to come) is merely another step in the prolog to the "real world" debt crisis of 2010-2012. A crisis among these developed nations (and those they drag along into the pit, eg, the UK, France, Germany— and the U.S.[!?!]) will dwarf the "Asian emerging-market" debt default cycle of the late 1990s.) Likewise, both the emerging-market crises of the last decade, the Internet bubble that followed, and the real estate bubble after that were all merely stepping stones along the path to the ultimate collapse of the greatest bubble of all— the world's untenable, "unlimited", paper-backed credit bubble, which has heretofore been reinflated after each of these previous mini-crises.

So while the economic world as we know it might be ending there's no reason you can't enjoy the fireworks from the safety of your well-protected portfolio. And while I fear the terrible suffering that's likely to be caused by a collapse of the world's developed economies (yes, really), I can still get excited about the opportunities that will likely crop up along the way.

Let's begin with a review of where we stand now in the mid stages of this unfolding crisis— which you can date from the turn of the millenia. By now you should be intimately familiar with how sovereign credit crises spread from one over-indebted nation to the next— starting with the 'emerging-market credit debacle' of the late 1990s, which culminated in the Russian default. This crisis began with a tiny country (Thailand) that most pundits said "hardly mattered," and ended with a wave of poverty and bankruptcy for many tens of millions of people around the world.

It also set up one of the great trades of the last several decades. This is a central, unpleasant fact of global finance: A horrible crisis is perhaps the single best way to make (or lose) an enormous amount of money quickly.

Argentina was using a somewhat novel currency scheme. In order to reassure its citizens, who were used to runaway inflation, and its creditors, who were used to chronic defaults, Argentina's government had adopted a "currency board regime". The government matched each domestically circulating peso with a U.S. dollar in reserve. As a result, the amount of pesos circulating depended on Argentina's trade balance with the rest of the world (since international trade is conducted largely in dollars)— particularly the U.S. So when Argentina's trade deficit went negative (when the dollar suddenly appreciated in value— a problem Chindia is facing today), so did the pressure on the domestic economy. Only foreign borrowing could relieve the pressure.

Argentina's relentless borrowing to fund its currency board system led a lot of folks to spend a lot of effort trying to guess how long the scheme could last. Nor was Argentina alone; almost every "hot" emerging market around the world was funding some form of 'pegged-currency' scheme with enormous quantities of foreign borrowing. It was easy to see that these debts (and their growth rates) were not sustainable. All you had to do was look at the numbers.

Thus, when Thailand collapsed in the fall of 1998, it was certain that ALL of the other heavily indebted emerging markets would follow— and they did. A recommendation to buy puts on Telebras just after the Thai baht was allowed to float (it sank about 90%) soared more than 500% in about six weeks as the crisis intensified. (Telebras was the telecom monopoly of Brazil and the most widely held emerging-market stock in the world.) As a rule, investors moving out of emerging-market stocks sell their most liquid stocks— like Telebras— first.

Argentina managed to maintain its peg to the U.S. dollar throughout the Thai baht crisis and the Russian default of the following year. It survived because it was willing to pay high interest rates and borrow enormous additional sums. It wasn't until December 2001 that Argentina was forced to close its banks and "pesofy" all of the dollars held in its banking system, robbing its citizens of their life savings.

The current 'sovereign debt' crisis is merely another phase in the "credit bubble market's" ongoing collapse— which began with the late 1990s 'emerging-market debt' crisis. Only this time it's happening in some of the world's richest nations, i.e. the "real world". In economic terms, there's almost no difference between the "PIIGS" of Europe and the world's emerging economies in the 1990s. And, indeed, thanks to the results of the 'emerging-market debt crisis' of the late 1990's, Asian and other emerging market economies are today in far better shape than those of the "richest" nations.

Rather than pegging their currencies to the U.S. dollar, Portugal, Italy, Ireland, Greece, and Spain have simply chosen to peg their currencies to a French/German basket and have been using vast amounts of foreign debt to keep the scheme alive. It simply cannot last for several reasons. The first reason is easiest to understand.

Just as Argentina's economy couldn't compete with the much larger U.S. economy, Greece and the others can't compete against the vastly larger German economy on a playing field that's denominated in what's really the German mark. The euro isn't viable because it never was in the first place. And it's certainly not sustainable with those weaker economies now paying enormous amounts of interest to maintain debt loads that approach (or exceed) 100% of gross domestic product (GDP).

The second reason the PIIGS must soon decouple from the euro is competitive. The other nations the PIIGS can compete with— such as Hungary and Poland— have the benefit of a flexible exchange rate. As these countries devalue their currencies to protect their economies, the pressure on the PIIGS will greatly increase to devalue as well. But, as part of the common currency scheme, that is now impossible while they remain part of the EU.

So, Hungary matters just as Thailand and Indonesia mattered to much larger economies such as Chile, Brazil, and Russia back in 1998. Last week, the Hungarian forint lost about 5% against the value of the euro and about 7% against the Swiss franc. About 45% of Hungary's foreign debt is denominated in foreign currencies (mostly French and German), so the forint's collapse impairs the Hungarian government's ability to service its debts.

It costs the Hungarians significantly more forint to pay the same debts they were paying just weeks ago. A weak economy is undermining a weak currency, which further weakens the economy. In a rare moment of clarity and honesty, Peter Szijjarto, the Hungarian president's spokesman, told reporters, "I don't think it's an exaggeration at all to talk about a default…"

It shouldn't be a surprise that one of the largest lenders in Hungary is Italy's UniCredit! The stock fell 5% on the day of Szijjarto's comments. Like dominoes, all of the weaker economies in Europe are going to tumble for the simple reason that creditors will be unwilling to extend more credit given the increased risk of default. And, when debts cannot be rolled over or extended, a country's fiscal situation can simply and suddenly collapse because confidence is lost.

Why does this matter to you? Well, consider this fact. A considerable amount of the large international companies' assets (including those of U.S. banks) are invested in European debt. If Europe's financial situation continues to deteriorate and the euro finally does collapse, more than half of these loans will likely end up in de facto or de jure default. That would create a significant new international financial problem for all to to deal with. The growing crisis in Europe will almost certainly result in many international companies being forced to raise new equity at unattractive prices, dampening international trade still further.

Many of the world's developed economies have been fueling growth with foreign debts. This growth and the asset values created under the euro standard are unsustainable for the simple reason that debt service cannot be made in a severely recessionary world and creditors are unwilling (or themselves unable) to extend these debts on reasonable terms. Moreover, a world in which everyone is indebted to everyone else is not sustainable on its face: international debt is a zero sum game— it is simply not possible for everyone to end up being a debtor— someone has to be the (net) creditor.

In the past, it was the U.S. that filled that role: but no more! Even while the U.S. had to go into net debt(!) against all of the other currencies of the world to do so. Today the world is expecting China to fulfill that role; but China's "reserves" of about $1 trillion are already committed for internal purposes and in any case is a mere pittance in a world where international indebtedness is of the order of half a quadrillion dollars.

These problems have no simple answers. They will spread from 'creditor' to 'creditor' and intensify as the market realizes these defaults are unstoppable— in effect, everyone will enter into a 'damage control', 'musical chairs' scenerio. The next major country likely to experience a credit crisis is Italy or Austria, which haves enormous exposure through their banks to Eastern Europe and the rest of Europe's weak economies (as is also true of the stronger economies of France and Germany, which now face the unpalatable prospect of letting one or more of their major banks go under or of 'rescuing' these failing economies).

Italy's public debt totals 1.7 trillion euros— seven times the size of Greece. Italy is the world's third-largest sovereign borrower. It cannot be bailed out— it is simply too big. Meanwhile, it cannot possibly hope to pay back its debts as long as it remains in the euro. In fact, Italy has been in recession almost since the day it adopted the euro: Its economy has grown by a total of 0.54% over the last decade.

Italy's total public debt to GDP will soon surpass 120%. At that point, it will become progressively more difficult for Italy to extend its foreign debts because all of the foreign creditors will know these debts will never be repaid. A default and devaluation will be the only way to restart Italy's economy.

One recommendation is that you sell Italy short. It's simple to do, using the Italy exchange-traded fund called the iShares MSCI Italy Index (EWI). But, the ETF has been crushed lately— falling to $14 from $19 in just the last three months; so the entry price for such a short is hardly attractive right now. Yet here's the important thing to understand: Italy simly cannot afford its debts. Its economy cannot grow— at all— because it's stuck in a currency regime it can't truly afford. Thus, it is only a matter of time before Italy abandons the euro and defaults on its foreign debts.

I believe the crisis in Europe will continue until Italy fails and the euro collapses. Shorting Italy is a good way to hedge your portfolio against the risks of sovereign defaults, as it is the largest country that's most likely to default. It's the Argentina of the "real world" crisis. I'd look to establish a short position here on any rebound in EWI to more than $16. As always, limit your risk in this position by using a 25% trailing stop loss and don't allocate more than 5% of your portfolio to the position.

The other smart way to hedge your bets against the continuation of the "real world" debt crisis is to buy high-quality bonds at a big discount. Huge profits were scored by buying distressed debts at a discount during 2008 and early 2009— but in the current case, by buying Italian or other European bonds not likely to suffer default (eg, the bonds of major international European and Italian companies with products not likely to be severely affected by the financial storms ahead).

Buying individual bonds, however potentially profitable, can be extremely difficult and dangerous for folks who aren't used to buying bonds or don't have a good relationship with a broker who deals in them. In that case, look for a discounted bond fund holding solid, well rated European company bonds. Avoid any that are also holding sovereign debt.


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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