Cruising Toward Resolution

Does it ever feel like this… to be a stock market investor these days? Two weeks ago, the markets were rocked by the Standard & Poors ratings downgrade of longer-term U.S. Treasury securities.  This past week, it was problems with European debt.

It’s not immediately obvious, even for financial professionals, why U.S. and U.K. stocks should suffer because Greece or Italy have trouble paying their debt obligations.  But in a recent posting, Mohamed El-Erian, who serves as co-CEO of the world’s largest bond management company, made an interesting analogy that helps to make the situation a bit clearer.

His analogy suggests that we think of the European Central Bank as a Coast Guard in the Mediterranean, who receives a warning that a relatively small cruise ship called Greece is in trouble.  The ship passed through a significant storm called 2008, and now, through poor planning, has run out of food and fuel and is in danger of sinking.  True to its mission, the Coast Guard sets out to tow the battered ship back to shore.

But then the rescuer receives another message.  A somewhat larger cruise ship is also in trouble, as a result of the same storm.  Another call comes in, another ship is foundering.  And then one of the larger vessels, called Italy, announces that it is in trouble as well.

What to do?  Nobody prepared for the possibility that more than one ship would be in danger at once, much less four or five.  The Coast Guard can think of only one thing to do; it radios the two largest cruise ships in the Mediterranean, called Germany and France, and asks them to participate in the rescue operation, by cutting short their trips, sharing the food and fuel that was set aside for their passengers, and basically rescue the cruise ship business before too many future passengers become disenchanted and cancel their tickets.

The captains of cruise ships France and Germany are willing to help out, but their passengers are extremely restless. Why should their trip be sacrificed?  Why should the food they paid for be shared with the passengers of less stable or thrifty cruise liners?  The captains of the France and Germany cruise ships are afraid their passengers will mutiny if they execute a rescue, and afraid of the consequences if there is no rescue and one of the smaller cruise ships goes down with passengers and crew.

The world, of course, is watching.  The overwhelming hope is that the larger ships will come and save the day.  The fear is that they may not.  Meanwhile, El-Erian says, the crew of the struggling rescue vessel is struggling with a once-unthinkable decision: should they throw somebody overboard to lighten the vessel and save the rest of the passengers?

This, El-Erian says, is the European Central Bank’s situation today.  And if we have learned anything since 2008, it is that in such a highly-connected global economy, if one major entity is allowed to go under the waves (think Lehman Brothers), the entire global system will be negatively affected.  Hence, investors sell stocks in fear of another 2008.

How likely is that? Putting my chess-playing hat on there are three possible endgames to the European Sovereign debt crisis.  One is a disorderly breakup of the eurozone, which would mean temporary economic chaos.  This could happen if the countries with the most debt problems–Greece, Ireland, Portugal, Iceland, Spain and Italy–fail to address their fiscal balance sheets due to pressure from their voters.  To return to the cruise ship analogy, the people aboard the vessel named Greece believed that they paid for an appropriate ticket, and now the captain is telling them that they will have to sacrifice their holiday and pay back the Coast Guard and the other cruise ships.  The response, for some, has been rioting.

A second possibility is a tighter fiscal union among the European countries, which basically means that Germany (and, to a lesser extent, France) reaches into its pocket and bails out the debtor nations to the south.  In return, Germany gets more control over over the economic governance of the other members of the European Union.  The slogan of this approach: never again will we float unsafe vessels.

And the third?  Several economists, have floated the idea that two or three “peripheral economies” (Greece and Italy) would take a sabbatical from the euro.  They would go back to their own currencies, which would allow them to devalue immediately, making their exports more competitive and their debt less costly.  Meanwhile, the euro becomes stronger.  The motto: fix your own vessels, and then come back to see us when you’re finished.

As one of these scenarios plays out, it might become obvious that many American and European stocks are currently being affected more by anxiety and uncertainty than by any direct connection with the Euro’s woes.


Duncan R Glassey
Senior Partner – Wealthflow LLP

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