The snow season thus far in Colorado has been a bit of a mixed bag. The start of the season was horrendous and conditions did not start to improve until about three weeks ago. But even when there was fresh powder, it was skied off the mountain quickly unless you knew where to find the “hidden powder” stashes in the China bowl known only to hearty locals and the ski patrol. I had endured conditions like this in the past, but generally always end up with an upside down smile and a yearning for more fresh runs. A few years ago my friends and I decided to say screw-it and booked our trip out West despite what we knew would be dismal conditions; after taking a few turns with the masses, my buddies and I would typically head off to those aforementioned elusive powder chutes to grab the last bit of fresh tracks for the day. But once this powder stash was “skied off”, you were back to conditions that were less than ideal given the lack of snow-pack. Having been through this tale before, I decided to wise-up and make the heart-wrenching decision to opt out of a trip to Colorado this season (Lake Tahoe here I come!). The market went through a very rough patch last Fall but has since been on a tear with continual amounts of “fresh powder” being pumped into the market in the form of monetary easing both here and over in Europe combined with yet another short-term fix to the Greek debt crises. But just like a powder day in Colorado, investors should be wary and vigilant to the fact that this recent “powder” could be skied off at some point in the future and we will be left with the same underlying structural issues that have haunted the market over the past year.
A Greek Solution…At Least For Now
It’s been over two years since the market was initially rattled by the potential ramifications of a Greek default, and despite bailout packages, haircuts and promised austerity measures, the situation seems far from truly resolved. Although the second bailout package was finally approved over the weekend, one has to wonder how long this will last with the Greek economy contracting at roughly 7% a year! Thus, the haircuts bondholders took to get Debt to GDP down to 120% look to be fleeting in my view. Given the longevity of the Eurozone crisis, the lack of an ultimate solution (namely one that really deals with the solvency risk adequately) and persistence of negative headlines, it is my belief that investors have become less reactive to these headlines However, the bond markets continue to punish longer-dated Greek securities knowing that more “haircuts” will likely be needed in the future as austerity programs are rejected and the Greek economy continues to contract at a pace well-above economist predictions. For example, the near-term March maturity is trading at 35.6 (on a dollar price) this morning while Greek Aug. 13’s are trading at 23.5 and Greek Jul. 18’s are trading at 21.0. The bottom-line is this drama will continue to play out over the course of the year and more likely than not more action will be required on the part of the EU to keep Greece solvent and avoid a disorderly default.
Take Me Out to the Ball Game
Ever since the ECB lent 489 billion euros ($648 billion) to eurozone banks, global equity markets have been on a bit of a tear. Couple that announcement with some bright spots in the form of improving domestic economic data, and the end result is a solidly performing U.S. equity market as well. Whereas the financial crisis of 2008 greatly curtailed the bid for risk assets globally, you could argue that the bid for U.S. based risk assets was hit the hardest. It is of my opinion that the European debt crisis is having the same effect, only it is the bid for European based risk assets that is evaporating faster than that of U.S. based assets. Overtime as the crises has unfolded, new policies have been written which have required fund and money managers to limit their exposure to the region while a fall in overall yields in so-called “safe-haven” markets has only intensified a grab for yield. The negative market moving and “risk-off” waves the market had been experiencing quite frequently in late 2011 have resulted in a much stronger bid for U.S. risk based assets. Whereas in 2010 when aggregate market European (iTraxx Europe) and U.S. (CDX.NA.IG) based indices were trading right on top of each other, the sizeable increase in bid for U.S. based assets coupled with net selling of Euro based assets, has allowed said U.S. indices to tighten in spread considerably relative to their European equivalent. Further, given the derivation of what has historically been offshore demand, one should suspect an even further shift in allocation from European based assets to U.S. based assets should follow. Those regions (UK / Europe) who have largely been net sellers of U.S. based paper in the last few years will likely switch their strategy which would result in them becoming a net seller of European paper and a net buyer of U.S. paper. Moreover with Asia historically being a stalwart buyer of U.S. Agency and Treasury paper and the thought that their allocation strategy will continue into the future thus keeping “safe-haven” market yields depressed for the foreseeable future, it will likely case a waterfall effect and cause those investors who have the ability to reach for yield in the credit/equity markets to do just that.
What Could Cause this Powder to get Skied Off?
With the exuberance currently at work in the marketplace, what are the outside factors that could cause a unexpected downdraft and a flight from risky assets? The first risk is that the Euro area goes into a recession that is both more severe and more prolonged than many market pundits expect. As highlighted before, a mild recession could actually be good for US risk assets, but a severe recession and the resultant funding pressures on the European banking system would certainly drive up volatility and result in a diminished appetite for all risk assets. Another risk to the marketplace would be an oil price shock induced by unrest in the Middle East – i.e. Israel/Iran, Libya, Egypt and Syria. We have already witnessed a spike in gasoline prices and some are expecting prices could reach $5.00 a gallon by Memorial day. With GDP growth in the U.S. limping along at 2% and consumer balance sheets still strained, a rapid increase in oil prices could lead to a dramatic slowdown in the real economy. These two “fat tail” risks combined could easily lead to a new and pronounced round of volatility that, in my view, will result in much less safe marketplace for you to place your hard-earned cash.