With the riots in Athens this past week, the potential for problems associated with Greece’s possible default on their sovereign debt seems to finally be sinking in. Our financial markets have corrected down a bit this week, although on a percentage basis, the dip we have seen thus far is a tiny fraction of the bull market rally we have experienced over the past fourteen months, which saw U.S. stocks gain almost 100%. In this week’s column, I will discuss the underlying problems Greece is experiencing, the potential for a contagion effect spreading across Europe, and why local investors should pay attention.
Greece is a very small country with a narrow economic base, primarily focused on tourism. Their annual GDP (Gross Domestic Product—the value of all goods and services produced in a country within one year) is only $356 billion (about 278 billion Euros). Their national debt is roughly 113 percent of GDP, or about $400 billion (315 billion Euros). Their annual budget deficit is around 12 percent of GDP, or about $43 billion (33 billion Euros). These are estimates, of course, and I would say that it is highly likely that both their national debt and budget deficit will be substantially higher this year, due to their quickly deteriorating economic situation, and the political and social unrest occurring right now (tourists are a lot less likely to go to Greece when the citizens are firebombing banks).
One might conclude that, since Greece is such a small country with such a small GDP, that it really shouldn’t be a threat to our economy or financial markets, even if it does default. The problem is that Greece is not operating in a vacuum, and is not the only country in trouble in Europe. In fact Portugal, Spain, Ireland, and others have similar problems, and are much larger countries, so their problems are larger as well. The strongest countries in the E.U. (European Union) are Germany, France, and the UK. Germany seems to be doing the best out of these three, but all three still have high unemployment, and the UK has a projected budget deficit larger than that of Greece for 2010! Worse yet, should any of the troubled countries default, the vast majority of the money they owe and will not be paying back in the event of a default is owed to banks in these “stronger” countries. So, if Greece defaults, Germany France and the UK will be the countries hit hardest in terms of the impact on their banking systems.
Some may have taken the recently proposed bailout package from the IMF (International Monetary Fund; read the U.S. – we are the single largest contributor) and the E.U. as a sign that the crisis has been averted and we can go back to our bull market and rosy expectations for a robust economic recovery. The problem with the bailout is that it requires each member country in the E.U., which includes Portugal, Spain, Ireland, and all the other countries struggling with their own financial problems, to kick-in a proportionate amount of the bailout package, as a percentage of each country’s GDP. So, for example, Spain will have to pay $4 billion Euros to Greece as part of the $140 billion (and growing) proposed bailout.
If we assume that the bailout receives a positive vote, and that all countries participate as required, and that this is enough money to prevent Greece from defaulting—long-term, not just this month, we then have to ask; What happens when Portugal comes knocking for its bailout package next week or next month? What about Spain? What about Ireland?
The point is that, even if Greece is saved temporarily, this does not address the bigger picture issue, which is that the accumulation of debt across Europe is so massive, and so pervasive, that the only country large enough and strong enough to bail Europe out is the United States. Even if a good year, when our economy was at its strongest, this would be a tall order. Today, it is an impossibility. We simply do not have the money, period.
If I step back for a minute, and assume that Greece receives this bailout, and that as a result they are able to avoid default over the long-run, and I assume that no other countries default, there are still extremely negative implications for the global economy and for U.S. companies. Keep in mind that most large U.S. companies generate a significant portion of their total sales from outside the U.S. and that Europe is a key component of those outside sales.
Even if no countries default, the money that will be required to bailout all of these struggling countries will have to come from these same countries; even the troubled ones, but more significantly the stronger ones, such as Germany, France, and the UK. The capital drain that will take place across Europe will be unprecedented, and will result in a contraction of their credit markets that will make what happened in the U.S. after Lehman Brothers failed look like granny bouncing a check at Ralphs. European banks will not have the available capital to make loans, and without access to capital, the economies of Europe will be massively constrained.
A continuing deep recession across Europe will mean that U.S. companies that depend on sales in these markets will be weak and will not meet analysts’ expectations, which in my opinion are far too rich. This would mean that current stock prices are also far too rich and must correct down to more accurately reflect what future earnings will be. The United States could very well experience a double-dip recession as a result.
The wealth effect of the current rally in stocks has helped to reduce the negative impact of the recession and has given investors and others hope that things are improving. Unfortunately we have not seen consumer sentiment picking up, unemployment is still very high, and corporate spending is weak as well. The reality is that, aside from government spending, which has been funded entirely through debt, the stock market’s positive performance is really the only other positive for our economy. If the stock market were to correct substantially, consumer spending, which has only recently started to tick up, could falter. Since consumer spending represents 70 percent of our total economic activity, we absolutely must have strong consumer spending to have a strong recovery. Without it, we will not have a recovery.
The scenario I laid-out above assumed that Greece and the other troubled countries did not default. If one or more does default, you can place a pretty high exponent on everything bad that I outlined above that could happen. Worse, if one defaults, it is highly likely that several will follow shortly after. This would cause a contagion effect that would spread, not just across all of Europe, but across the entire world, including the United States, and would even impact us right here in Santa Barbara.
I heard a well-respected “expert” on CNBC this week, when asked where people should invest say that Taiwan would be a good place to look. I have nothing against Taiwan, but I don’t think I want the risk of having my money invested in a tiny Asian country with a developing (not yet developed) economy with the potential for a catastrophic financial disaster looming in Europe.
The current mentality of investors here in the U.S. reminds me of the Isolationist Movement before we were attacked by the Japanese and entered World War II. It may be easier to assume that what happens outside the U.S. isn’t important, but we live in a global economy, and we need to understand the risks and implications when other countries face serious problems. In my opinion, the European debt crisis is a rapidly deteriorating situation, that has the potential for severe consequences for all of us.