Current Crisis

In the last week global markets have suffered a severe reaction to a number of macro-economic shocks. Most main markets are down by nearly 20%, with many emerging markets in a bear market with drops of more than 20%. The main questions to ask is whether this reaction is justified or are markets currently over sold.

The three main areas of concern at present are the spreading of the European Debt crisis, the economic slowdown in the US economy and the downgrade of US sovereign debt by S&P.

Euro Debt Crisis

The Euro debt crisis has continued to spread away from the small peripheral economies of Greece and Ireland and towards the large economies of Italy and Spain. Both Italy and Spain have seen their yields rise close to 6%. This yield effectively is the interest rate the government has to pay to borrow money from the markets. The concern is that when a country like Italy owes 120% of its GDP, a small change in the interest rate can make a big change in the amount of money the government has to pay in interest payments. This can lead to a debt spiral as happened with Greece. While Greece is a relatively small country with a population of just 16 million, Italy and Spain are much larger with a combined population and GDP close to the size of Japan.  Indeed after Japan and the USA, Italy is the biggest borrower in the world. Any potential threat of default from these nations would cause a significant threat to the global financial system.

However, there is an end in sight to this crisis. The Eurozone represents the largest economy on Earth. It has the ability to fix the problem; what it lacks is the political will. There is currently a proposal on the table which should solve the entire problem: the concept of red and blue bonds. Under this system, the European Central Bank will guarantee government bonds up to the value of 60% of a country’s GDP; beyond that countries can issue their own red bonds which will not be backed by the ECB.

At present Germany pays around 2.5% to borrow money whereas Spain and Italy pay nearly 6%. Spain’s debt to GDP is still relatively low at around 60%. If the new blue bonds had a yield close to German yields then Spain could cut the interest it pays in half saving the Spanish government billions of Euros every year in interest payments.

Even Italy, which has a debt to GDP of 120%, could cut around 25% of the Interest costs it pays at the moment. This corresponding drop in interest payments made on the blue bonds would have a corresponding impact on Italy’s red bonds as the Italian government becomes more solvent. This would mean investors would require less of an interest payment to hold Italian debts.

At present European leaders lack the will to introduce this system. Germany, the Netherlands and other core countries would have to accept paying a slightly higher yield on their Blue Bonds. However, if it means preventing a major default and saving the existence of the Euro then leaders will act. The likes of Germany benefit too much from the Euro. They would suffer more than anyone from the collapse of the currency.

US Economic Slow Down

It seems certain now that the US economy has slowed down. It may also be headed for a period of recession lasting anything from 1 to 2 quarters. This slowdown has been caused by a number of factors; the principal trigger seems to have been the supply shock caused by the Japanese Tsunami and the Oil price shock caused by the Arab spring. With manufacturers like Toyota, Sony and Panasonic unable to source high end components from their Japanese factories that were damaged by the Tsunami they shut down US production. This temporary shutdown was sufficient to slow job creation in the US. July figures were also weak largely based on a shut down in the state government of Minnesota.

Unrest in the Middle East has pushed up the price of gas hitting US consumers hard. This lead to a reduction in US consumer spending of 0.2%. The combination of a reduction in consumer spending as well as slower than expected job creation has led many to speculate the US economy is heading towards recession.

Given the relatively weak pace of US growth in 2011 it is entirely possible that the US will go into recession for at least one quarter.

While the world has become increasingly concerned by the strength of the US economy, we have also had the almost comical performance of the US congress to deal with and the state of US public finances. While Democrats and Republicans did in the end agree on a deficit reduction plan and an increase in the debt ceiling, the size of the reduction was seen as insufficient by S&P. The ratings agency had been looking for a program to reduce the US deficit by $4 trillion. However, with the Republicans vehemently opposed to tax increases the size of the package was just $2 trillion. This has led to S&P cutting the US long term credit rating to AA-.

While S&P’s rating cut is a shot across the bow of congress to come up with a more sustainable fiscal position the effect on bond markets is relatively limited. US yields have been largely unaffected. There is still a strong market for US treasuries. The major concern is that transactions and companies which rely on holding AAA securities could be adversely affected. However, with only one of three agencies cutting the US rating long term, US treasuries are still technically AAA rated. S&P has not cut the US short term outlook. This means that T bills and other money market instruments are still AAA rated.  At present the current market turmoil is being caused by investors trying to figure out the actual impact of the cut. More and more seem to be coming to terms with the fact that there is no change.

With or without S&P’s AAA rating the world still needs to hold US treasuries. Currently they represent 60% of all AAA rated assets. For example, China and Japan are currently holding some $5 trillion in foreign reserves and really have no alternative to holding US government bonds.

Japan, the world’s second largest industrialized economy, has a rating of just AA-. Its current yield is 1.05%. This despite the fact that Japan has 200% debt to GDP which is nearly 3 times the level of the US.  The US will be able to continue to borrow. While the US economy is weak and may head towards recession, current stock market drops of nearly 20% probably reflect this reality. It is likely that during October and November of this year markets will move higher after bottoming out sometime in August.