Wednesday, January 25, 2012

Is Europe Throwing Us Into A 1930s Moment?

The market has been watching Europe (NYSEArca:VGK), particularly the fact that (as of this writing) a deal still hasn’t been struck between the Greek government, the Troika (the ECB, IMF, and euro-zone leaders), and private holders of Greek debt (bankers, hedge funds, and sovereign wealth funds).
In order for Greece to avoid a default on €14.4 billion, which comes due on March 20, these groups must agree to reduce the value of Greece’s debt. Basically, they are negotiating to see how much money lenders will lose — in other words, accept a massive “haircut.”
Negotiations have been ongoing for a while, and a deal is expected to be reached. But the original agreement was supposed to have been struck months ago. So it’s interesting to see why this is taking so long.
The reason is because the Troika wants to get Greece’s debt/GDP ratio down to a manageable 120 percent from the current 200 percent. The problem is that every time they look at the Greek economy, they see that it’s slowing.
Consequently they have to re-do the growth forecasts, which then requires more of a haircut on the bonds to reach the 120 percent target debt/GDP ratio.
Think of it this way: Suppose you go to buy a house, and the bank wants to make sure that the mortgage isn’t more than 120 percent of your annual income. Let’s say you make $100k a year. The bank would be willing to loan you up to $120k. But, if your income decreases to $80k, the bank will only loan you $96k.
“It is about avoiding a 1930s moment … a moment, ultimately, leading to a downward spiral that could engulf the entire world.” — Christine Lagarde, chief of the IMF
The point of this is that every time the parties think they have an agreement, the private bondholders are told they need to take a bigger loss. Originally they were told it would be 50 percent, now the figure is 70 – 80 percent, so they’re taking a hard line approach.
In all likelihood, the negotiations will get done and a deal struck. But given the slowing of the Greek economy due to austerity the Greek government will have to impose to receive a bailout, the probability of the deal having to be re-negotiated at some point is high.
Longer-term Problem
Looking further down the road, the question comes up: How are the PIIGS countries supposed to pay back all this bailout money, when they are simultaneously being forced to implement austerity measures that will slow their economies, and in return tax receipts?
The answer isn’t at all clear. But it is a stark reminder that this whole European crisis is one that will take years to figure out — something to keep in mind the next time we get a furious rally in the European markets (NYSEArca:IEV), like we’ve seen lately.
Remember that in the short term, the market focuses on the rate of change in a trend, not the direction (i.e. are things getting worse than they were last week), not “are they getting better?” The rate of change in the euro zone is positive, and markets are reacting accordingly, but fixing the problems will take years.
So when the talking heads start saying the situation is fixed, you might consider the ProShares Ultra Short Euro ETF (NYSEArca:EUO) and Ultra Short MSCI Europe ETF (NYSEArca:EPV).
Both could potentially profit from overly short-term optimistic traders. Just keep in mind, though, that these are leveraged ETFs, and as such are good trading vehicles, but not meant to be buy-and-hold investments.

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