As I watch US & international stock and bond markets move over the past few days and weeks, it is clear that markets are schizophrenic. The only news that propels stock markets is further bailouts. Case in point, this article is about whether and when Greece will be bailed out. So this is what it has come to:bail outs of western democracies. We are likely to learn more about a Greece bailout on Tuesday or Wednesday next week. Global stock, bond, and commodity markets will continue to be supremely volatile in the interim.

 Easy Button Version:

• Greece has a huge annual fiscal deficit of 12-13% of GDP (OK, the Greeks claim more like 9%, but given their propensity to be creative with economic statistics when they joined the EU, I’ll go with 12-13%.).
• It is attempting to roll-over / re-issue new federal government debt to fund its spending spree.
• Europe’s equivalent of the Fed (the ECB) has given Greece a deadline of March 16th to present a formal plan to right their fiscal ship.
• Bond markets are pricing-in the chances that Greece and now several other profligate European democracies will default.
• Greece is the proverbial tip of the iceberg. The rest of the PIGIS are seeing their bonds sell-off out of concern of default.
• All eyes are on the ECB to bail out Greece (and the rest of the PIGIS next).
• Feb 9th: rumors of an ECB bail out of Greece caused global stock & bonds markets to rally.
• International bond, stock, commodity markets are going to be under downward pressure unless the ECB announces a bail out in the next 1-3 months.

Portfolio Impacts: Sorry bloggers. Clients get this part…

Detailed Version:

The proverbial pig in the python in economic and investment circles is whether Greece will default or be bailed out. But Greece is not alone in its poor balance sheet. It shares space with the rest of the PIGIS (Portugal, Italy, Greece, Ireland, and Spain). Hence whether Greece is bailed out by the EU matters more than anything else right now. Greece is the tip of the iceberg. It is certainly small enough to let default, and small enough to be bailed out by the EU. But Spain is sure to follow, and with a $1T GDP and 11.4% 2010 deficit, you see the pattern and risk.

A few weeks ago we saw a bond auction for Greece go very badly. Greece now has enough money to meet its needs until April (+/-) as a result of the bond sale. But it has been spending far beyond its means for decades, and is expected to see a 12-13% of GDP fiscal deficit this year. (sounds like Argentina, doesn’t it?) For the first time ever, the European Central Bank (ECB. Their version of the Fed.) has given Greece a deadline of March 16th to unveil a plan to rein-in their spending and lower their deficit to 3% by 2012. This is unlikely to happen. If Greece were to do this, it would cause a depression.

For years, I’ve written that the bond markets will “figure it out first”, and signal that change is coming. The bond markets are now signaling bright red regarding Greece. Unless you’ve not been reading my emails for the past few years, you know that Europe has some sickly members (the PIGIS) that threaten the EU economic bloc solidarity. The scale of the risk is very significant — much larger than the fallout from the Russian debt default in 1998. (when the S&P500 lost 18% in roughly a month)

As a counter-point, it is interesting to note that Europe’s situation when taken as a whole is actually less dire than the US -from the point of view of fiscal deficits alone. Taken in the aggregate, the EU has 6% deficits, and the US has 10% deficits. The trouble is there are elements of the EU that are time bombs just waiting to default with 10%+ deficits (the PIGIS). There is concern that the PIGIS will collectively default and cause the cost of capital (issuing bonds) to raise to the point it will choke off a nascent recovery, and cause a depression across Europe.

The ECB announced that on Tuesday Feb 9th, they would implement some kind of support package for Greece. But we also had a report a few hours later refuting the support. We do not yet know whether there will be support for Greece.

The most likely support scenarios and their ramifications:

1. The ECB provides limited guarantees and liquidity measures to lessen the chances of an outright default by Greece in the coming weeks/months. The solution will be a band-aid to what is in reality a gaping headwound. With planned national strikes next week to protest government newly imposed austerity measures as they shrink government spending, it is a virtual certainty that Greece will default at some point in 2010 or 2011. It is also a certainty that Greece and the rest of the PIGIS will see no economic growth for years. This will slow the European economy and slow global growth. Short term, a limited bail out / support package would cause markets to rally from their recent depths, but ultimately those gains will be fleeting because the solution to this problem involves wholesale spending cuts in Greece (& the rest of the PIGIS). Lower economic growth rates mean lower P/E multiples. Yup, stock market corrections.

2. The ECB provides a comprehensive rescue package for Greece. This is less likely because:

• it would necessitate a lot of hard-earned German money transferring to profligate Greece. Germany has been bearing an unfair share of economic support for the rest of Euroland since long before the economic union. Sooner or later, the Germans are going to say enough is enough, and let those living off its high credit rating coat-tails fail on their own.
• The Maastricht Treaty (Economic Treaty from 1993 that laid the groundwork for the EU to be born in 1999) forbids member countries from economic bailouts. Whereupon I say — so what! The rules of membership in the EU club dictate that 3% of GDP is the speed limit of profligacy / budget deficits. Yet, look at where they are (far beyond 3% deficits).
• consider the lesson being sent. Spain, Portugal, Ireland, and to a lesser extent Italy would all be watching and interpret that they too will be bailed out. Moral Hazard. My bet is the Germans will not have the stomach for a full bail out of their EU compatriots that have been living beyond their means for years.

3. No bailout. This is the prudent choice, and thus it is least likely to be selected. No bailout would cause Greece to default in the 2nd quarter this year as they fail to raise the funds they need to sustain their binge. This would dramatically increase the cost of issuing new debt. This in turn would push the rest of the PIGIS into default later in 2010 and 2011 as they see their debt servicing costs rise. This is the end game. A default by the PIGIS will crush several large European banks since they’re the ones that will take the losses on sovereign defaults. Last time I checked, many /most of the large European banks were as unhealthy as the large US banks.

You may be wondering how this volatility impacts us – especially since we have gone out of our way to avoid any European equity or debt.

We’re seeing a flight to the USD. This is the opposite to what the US needs if we are to export our way out of this recession. (Export to whom? the EU is 20% of our exports.)

• the flight to the USD is hurting commodities since they are priced in USD. This has put downward pressure on gold and all other commodities. There is only so long this will continue in the case of gold before it reverses course and climbs as fear and uncertainty build. Natural gas prices are hurt less by a strong dollar than many other commodities since both the dollar and natural gas are home-grown.
• the flight to the USD is hurting our int’l equity positions. Even though the countries we’re invested in have far better long term fundamental economic prospects (and balance sheets) than both Europe and the US, their currency is losing value vs the USD because every non-US currency is being painted with the same brush. This is a short term phenomenon. We need the USD to lose value so we can export our way to health. It will happen because we need it do. It will be manufactured via continued low interest rates and a deficit spending.

If the ECB does not provide a comprehensive bail out to Greece in the coming days/weeks, it is not the end of the world. It means most equity investments take large losses — say 40-60% from here. Treasuries rally -unless one of our weekly & never ending bond auctions goes badly (not an impossibility. we actually had a pretty weak reception for our Treasuries on Tues Feb 9th). But it does mean that big European banks take a pile of losses. This means several fail. This in turn causes several large US banks to fail. Not the end of the world, but no fun. A good time to be well-hedged and hold very high quality, liquid investments. And a good time to hold non-traditional assets that largely ignore whatever the stock and bond markets are doing.