..Hello? Is anyone paying attention?!

As time has marched on since the debt ceiling debate we are left wondering where is the sense of urgency from Capitol Hill?  Former Federal Reserve Chairman Alan Greenspan recently said as much when he told a subcommittee of the Senate Finance panel “if we presume that we have a year or two before starting serious long-term restraint, and we turn out to be wrong in that optimism, the impact on financial markets could be devastating.” Not only have politicians glossed over the longer term implications of current financial issues the country faces, by their inaction they seemingly have little understanding of the importance of taking corrective measures in 2011 or the stomach to communicate to the electorate what will be unpopular solutions.

Indecision and/or ineffective actions now set the stage for higher deficits and a more difficult economy going forward.  The projected $1.4 Trillion deficit is the largest (nominally) in US history but more importantly without a change to the fiscal direction the total US debt owned by other countries could move to nearly 100% of GDP, leaving America in the worst financial situation since WWII.  Think about it-  if all of the money generated from all of the US’ output equals the debt this will hamper growth and prolong the current financial pain we feel.  Democrats and Republicans would likely agree that the current US fiscal issues need to be corrected but agreement on the big picture problem has never been - well - the problem. Both parties seem reticent to make the tough decisions to get America out of harm’s way and the ideas proffered are unrealistic and ineffective.

 The White House’s Budget forecasts that the current deficit will be reduced to $900+ Billion by the end of 2012 and decidedly smaller in subsequent years.  While we would welcome a lower deficit in the near future, the devil is in the details. The $500 Billion question is - where is the money coming from?  The Administration’s Budget shows that the decrease is primarily based on an increase in (tax) revenues from individuals and corporations to the tune of $580 Billion over the next two years. We believe that to achieve that magnitude of tax revenue increase requires GDP growth well above the anemic .4% and 1% growth seen in the 1st and 2nd quarters of 2011 respectively; additionally there has to be significant reduction in the (current 9.1%) unemployment rate for this math to work. In an economic recessionary environment having substantial GDP growth with a considerable decrease in unemployment without some catalyst is unrealistic.  Some believe that Fed action will be that catalyst for growth but the methods proposed thus far i.e., a third round of Quantitative Easing or a “TWIST” – the recent process whereby the Fed sold short term treasury securities and bought longer term treasuries - do not address the underlying problem;  reviving a recessionary economy requires individuals and companies to spend and invest with banks lending the necessary funds. We believe the Fed's actions so far have not and do not encourage spending, investment or lending. Essentially we are out of the traditional bullets used to get the country growing to fix the fiscal problem.

Given the need to address the problem sooner than later and ineffective Fed action-  now what? Simple-- to reduce the fiscal deficit on a go forward basis US politicians must realize both unpopular decisions must be made- Democrats must accept deeper spending cuts and Republicans must accept higher tax increases.  Proposing and implementing significant reductions in entitlement programs and requiring others to dig much deeper in their pockets is both uncomfortable and difficult - particularly in an election cycle - but that is the professional politician’s job.  Politicians on both sides of the aisle must show the political will to put the US economy first and not their own agendas. 

It’s the (Global) Economy, Stupid

Miguel de Cervantes wrote what is considered by many to be the most influential literary work from the Spanish Golden Age - Don Quixote.   The story of Don Quixote tells of a gentleman nearing fifty, with a distorted perception and wavering mental faculties, who enlists the help of his dimwitted friend, Sancho, to help Quixote sneak away from their tiny village and search for grand adventure.  From this story we get the term quixotic, foolishly pursuing certain ideals or beliefs. 

As we assess, then re-assess and then (re)re-assess our analyses on the state of the global capital markets we are left wondering - are we being quixotic.  Long before the political brinksmanship of the debt ceiling debate or the US downgrade by S&P or civil unrest in places like Greece, Portugal and Spain we have stated a number of times that global capital markets are teetering precariously.  Still without any meaningful improvement in the fiscal and/or economic landscape since summer 2011 we continue to watch US capital markets trade irrationally higher on rumor, speculation and emotion.  

Even though emotionality is dictating the direction of market moves, we believe it is paramount that rationality and logic be used when trying to understand what is happening in the world around us.   In previous commentaries we have discussed the challenging situations in Greece (“Rebirth of the Drachma”) and the US (“Sword of Damocles”), as well as the possibility of global financial contagion (“It’s a Small World”); and beyond choreographed press conferences and financial summits, we have seen little action or information that changes our belief that things are likely to get worse before they get better.  Simply, we do not believe we are channeling our inner Don Quixote and fighting windmills in our minds.

If the aforementioned commentaries haven’t sufficiently alerted investors to current global economic frailty - let’s talk about Italy.  With the focus so squarely on Greece, Italy has gone comparatively under the media’s radar.  Much like Greece (and the US) Italy has been piling up debt to unsustainable levels given their low growth economy (Italy’s 2010 GDP was 0.9%).   But compared to Greece’s €350 billion (approximately $480 billion) outstanding sovereign debt that continues to give investors heartburn, Italy’s €1.9+ trillion (approximately $2.6 trillion) is heart stopping.  Recently S&P downgraded 24 Italian banks and financial institutions reasoning, “Renewed market tensions in the euro zone's periphery, particularly in Italy, and dimming growth prospects have led to further deterioration in the operating environment for Italian banks”.  Also noteworthy is that the European Central Bank (ECB), much like the US’ Federal Reserve Bank, has been artificially holding interest rates down below market equilibrium.  The ECB has been the primary purchaser of Italian debt in secondary markets. At September month-end yields on Italian debt stood at 5.14% and as of October 18^th debt yields increased 72 basis points to 5.86% which includes the ECB buying program.  Increasing yields indicate that investors want higher returns/greater compensation for taking increased risk when buying certain debt.  Greece’s outstanding debt, which is speculated to be worth only 30 – 50% of original value and is prompting concerns about how to recapitalize affected European banks, is analogous to the potential risk inherent in Italian debt.

Even if the European leadership does manage to solve or ring-fence the current Greek crisis, we believe that Italy’s debt situation shows that sizeable downside risks to capital markets around the world still remain.  At the conclusion of Cervantes’ Don Quixote, Quixote returns to his small village and a short while later wakes up having fully recovered his sanity – As sanity and rationality return to the global financial markets, investors will wake up to the undeniable realization that significant debt overhangs and low growth economies mean lower equity prices .       

The Sword of Damocles

The Roman politician/philosopher Cicero tells a famous parable of the tyrant Dionysius and his servant Damocles in which Damocles desires the wealth and power of his master. Seeing this desire, Dionysius instructs his men to bring to Damocles the best wines and foods; then they were to present him with gold and treasure beyond imagination. As Damocles expresses thanks, the tyrant Dionysius then orders his men to hang a sword by a single horse hair from the ceiling directly above Damocles’ head. Much like the sword above Damocles’ head, we believe the debt that hovers over Uncle Sam’s head is perilous.

As we watch the interplay between the capital markets and US politics we believe the current fiscal problem could be disastrous if not handled quickly. Former Federal Reserve Chairman Greenspan recently said as much when he told a subcommittee of the Senate Finance panel “if we presume that we have a year or two before starting serious long-term restraint, and we turn out to be wrong in that optimism, the impact on financial markets could be devastating.” Not only have pundits and politicians glossed over the long term implications of not resolving the current problem, they seemingly have little understanding of the importance of making those decisions in 2011.

Why 2011?  The US budget deficit is expected to be approximately $1.4 Trillion in 2011. The White House’s Budget estimates the deficit at $900 Billion by the end of 2012 and decidedly smaller in subsequent year ends. But the devil is in the details, so the question is where is the money coming from to reduce the deficit? The Administration’s Budget shows that the decrease is primarily based on an increase in (tax) revenues from individuals and corporations equaling $580+ Billion of additional money coming into governmental coffers over the next two years. Problem: achieving that magnitude of revenue increase requires real GDP growth well above the anemic .4% and 1% growth seen in the 1st and 2nd quarters of 2011 respectively and there also has to be significant reduction in the (current 9.1%) unemployment rate. In a recessionary environment having substantial GDP growth with a considerable decrease in unemployment without some catalyst is unrealistic. While the prospect of an increasing or unchanged deficit should be more than enough get politicians' attention, they should be further incented because in 2012 the U.S. will need to make decisions regarding approximately $4 Trillion in short term debt that is coming due. Both parties would agree that the current situation is untenable and corrective action is necessary. However, it is clear that both parties are unwilling to repair Washington's largely broken system because of the deeper spending cuts and more substantial tax hikes that are required.

But won’t the Federal Reserve help revive the economy- that would be the catalyst for economic growth, right? Chairman Bernanke has indicated that the Fed will act to help revive the US economy. Problem: the two methods proposed thus far i.e., a third round of Quantitative Easing or a “TWIST” - a process whereby the Fed sells short term treasury securities and buys longer term treasuries - does not address the underlying problem. We submit that in order to revive this economy individuals and companies need to SPEND/INVEST money AND banks need to LEND/INVEST money. The ideas put forth will keep rates artificially low and keep money available in the system but neither idea encourages spending, investment or lending.

So the question - where is the money going to come from to reduce the deficit - remains unanswered. Historically we would look to the international community to finance any shortfall but given the still developing situation in Eurozone because of Greece, Italy et al, no one country has the financial wherewithal to provide assistance.

From our vantage point the logical solution is to embrace the difficult decision to cut spending AND raise taxes. We agree with many that state cutting entitlements would be the "easier” solution. Problem: while this is true mathematically, politically we think it inconceivable that entitlement programs like Social Security, Medicaid and Medicare will receive the substantial cuts that are needed. After all the name “entitlements” describes how people receiving these governmental benefits feel - entitled to receive them. Add in the fact that 2012 is an election year and we would be hard pressed to believe that decreasing benefits in any great measure to senior citizens would happen. According to the U.S. Census Bureau during the last presidential election more then 79% of people 65 and older voted. This is meaningful when compared to an overall voter turnout of 52%.

Clearly there is a confluence of events globally which make previous actions and other ideas in a recessionary environment either ineffective or near impossible to implement. The uniqueness of the current situation notwithstanding, the time is NOW for politicians to address the United States fiscal problems. Observers need only to look at the meteoric rise in gold prices which proxies investor fear to see that many believe the global economic situation is precarious and the US economy is very much part of that. We believe this was certainly validated when S&P downgraded the U.S. credit rating. There are a growing number of economic indicators that clearly tell us the canary in the fiscal coal mine may quickly lose consciousness.

Much like the sword dangling precariously above Damocles, we can see the dangers of our debt and deficit perilously hanging there. In the end Damocles chose to remove himself from the deadly situation before the horse hair suspending the sword breaks. U.S. politicians need to remove America from the perilous economic situation we find ourselves in; one can only hope that they do so before the hair breaks—in this case timing is everything.

The Rebirth of the Drachma?

Some two millenniums before William Shakespeare was born, theatre was alive and well in ancient Greece.  The ancient Athenians created plays that are still considered among the world’s greatest works of artistic expression.  From tragedies to comedies to satires which made fun of political and cultural leaders, Greek theater captivated audiences and served as a means of expressing political thought and ideology in the ancient world.  The most well-known and prodigious playwright of the time was Sophocles, whose play Oedipus the King was popular with his audiences.  The story of Oedipus begins with his arrival to Thebes, a stranger to this small town; Oedipus finds that the town is under the curse of the Sphinx who will not free the city unless her riddle is answered.
Today the financial world waits and wonders if the riddle of the Greek debt crisis will be answered. Greece’s current tragedy has been well chronicled but what has been less talked about and debated are the options currently available to Greece to solve its problems.  From our vantage point Greece’s voluntary exit from the European Union, while suboptimal in the short term, appears to be the most logical solution.
With the creation of the European Union members believed that the benefits and economies of scale of creating a single currency would be a boon to member-states’ GDP.  In reality many of the Eurozone members have benefitted mightily since the introduction of the euro.  All seemed reasonably well with the euro as it became the second most transacted currency only behind the US dollar.  But upon closer retrospection Greece’s inclusion in the Eurozone probably made little sense; after all the Greek economy is largely sustained by tourism and the export of olive oil.  Neither of which can significantly reap the benefits of international trade like say the German auto makers.
But we are where we are - so what is next for Greece? It is important to remember that Greece IS part of the European Union so the “what’s next” options are finite.  They can decide to either remain a member or they can decide to leave.  What makes the “what does Greece do” question critical and complex for investors/decision makers is the interconnection of the fiscal health and well-being of the 17 euro-using Eurozone members and the potential cascading impact.  Simply put, the outstanding Greek debt at €350+ billion is in and of itself not the problem; the problem is the potential European domino effect.  In all likelihood this is a primary topic of discussion at the G7/G20 meetings now happening.
Since the introduction of the euro Greece has run-up unfathomable debt levels and a corresponding mind blowing (for them) interest expense that has contributed to the approximately 170% debt-to-GDP ratio. Many financial economists calculate that a debt-to-GDP ratio above 90% is a recipe for disaster, and ideally the ratio should be closer to 50% to ensure sustainability.    Further, a condition of the prior Greek bailout was that Greece implements an austerity program to cut their expenses in order to pay back the outstanding debt and make interest payments. Notably Greece has yet to implement the agreed upon austerity program.  In a country where unemployment is approximately 16%, and salaries have been slashed and individuals’ tax burdens have been increasing, it is understandable that the last thing the Greek populous wants is more pain from further cuts.  We believe that all of the austerity that has happened will be all that will happen.
But that gets to the crux of the situation — if you are Greece you know that remaining a member of the EU means interest expense payment, debt repayment and austerity.  So Greece’s leadership must ask themselves is the benefit from being in the EU greater than the costs of voluntarily exiting.  We would submit that the only real way for Greece to get control of their economy over the long term is to rid itself of the debt/interest expense and devalue their currency. The effect of getting rid of the debt is clear- better debt to GDP ratios and greater ability to raise cheaper debt; and the devaluation of their currency would make Greece more competitive on the world stage a la Argentina in 2001.  The most direct effect from a devalued currency is the likely increase in tourism dollars.  No outstanding debt, increase in revenues, decreased interest expense—Ouzo for everyone!
The problem is that the only way to do the aforementioned is to NOT be part of the European Union.  Staying in the EU categorically means that an individual member-state cannot simply rid itself of accumulated debt and there is only a single currency so a member-state cannot simply devalue the currency [as part of inclusion into the Eurozone country specific currency - e.g. Greek drachma - disappeared and some monetary sovereignty was relinquished by member-states to the European Central Bank].  
So if Greece is problematic then the other EU members should encourage or allow them to leave, right? No. if Greece leaves and essentially gets a do-over then there is potentially that other problematic member-states would follow that same path – recall that Italy has €2 Trillion of debt outstanding.   Ok, so if the debt is the underlying problem why doesn’t the IMF or ECB or Germany just buy out the debt to resolve the situation? Certainly the monies exist to buy up the Greek debt but what happens when another member-state wants forgiveness or buyout of their debt (e.g. Italy, Portugal, Spain etc.)? What if all problematic member-states wanted debt relief? There is not enough euros in the coffers to satisfy all of the outstanding debt (let’s say it again, recall that Italy has €2 Trillion by itself). In either case there exist the real potential of a contagion or domino effect to other sovereign European nations who are ALL incented to do what is in their countries’ best interest.
We believe that the euro and the EU have largely been beneficial for the global capital markets; it is just in this specific case Greece was probably not a good choice for inclusion; that poor decision, however, could have calamitous effects. No one can say for certain when this current drama will unfold but if the capital markets are a good indicator – and we believe that they are- the current rates on credit default swaps indicate that whatever happens to Greece it will be sooner than later.  
In the final act of Oedipus the King Oedipus solves the riddle of the Sphinx.  Since the king had recently been murdered, he becomes the king and marries the queen.  But this was in no way a happily ever after ending because in time, Oedipus comes to learn that he is actually the king’s son, who was cast out of Thebes as a baby; thus he had killed his father and married his mother.
“The horror of darkness, like a shroud. Wraps me and bears me on through mist and cloud.” – Sophocles, Oedipus
The ancient Greeks certainly had a flair for the dramatic as do our contemporaries; but when all is said and done we hope the current Greek tragedy playing out on the world stage will not end so painfully. 

It’s a small small world

The concept of quantum entanglement suggests that two objects that should be too far apart to affect one another – in fact, due to quantum mechanics – causes one to (instantly) change when the other is affected.   Investors and politicians alike would be wise to be aware of this concept.  Many investors continue to narrowly analyze the US economy without considering many possible worldwide issues and challenges that ultimately could affect the United States. 

For instance, GROUPe des Assurances Mutuelles Agricoles aka Groupama is an international insurance company based in Paris, France.  Groupama’s solvency ratio is extremely weak due to its equity holdings and the state of the global equity markets is in all likelihood not helping.  During a conference call Groupama indicated that that solvency “probably dropped to 117 percent by Aug. 4 from 130 percent at the end of June due to falls in equity markets”.  Global equities have only continued to soften since that conference call.  It is estimated that Groupama will need approximately €2 billion Euro ($1.5 billion USD) of new capital to meet upcoming changes in European capital requirements. 

It is notable that Groupama holds approximately 4 percent (34 million shares) of Societe Generale - France’s second biggest bank, making it the second-biggest shareholder behind employees of the bank.   The share price of Societe Generale (ticker: GLE) has fallen dramatically to $20.87 (Aug 19, 2011) from $41.84(Jan 3, 2011) as there has been persistent speculation that GLE is insolvent; the likely reason why we believe that Groupama has been unsuccessful at selling the bank shares to raise capital to meet the aforementioned new requirements. We estimate that GLE should be valued at less than 40 cents to the dollar of stated book which makes GLE, and by extension the shares, effectively worthless.  What investor would buy an asset that is worth less than its fundamental value?  

If Groupama has solvency issues and GLE is worthless why should US investors care? Or said another way-  aren’t the French financial institutions irrelevant to us? (two objects that should be too far apart to affect one another?).  The answer is not found in quantum mechanics but rather in the global interdependence of financial markets.

In our opinion investors should care because Societe Generale has significant derivative exposure globally and we believe that to avoid some form of systemic financial collapse GLE will likely need to be pulled from the jaws of (financial) death - think AIG in the US.  IF the French government chooses to save Soc Gen, an injection of monies into bank reserves would be needed.  This requires the European Central Bank (ECB) to do what they heretofore have deemed undesirable – print money.  Economics 101 teaches us that adding MORE money to an economy is inflationary and also tends to devalue the currency.  Without getting to far in the weeds, a devalued Euro makes US goods more expensive to Euro denominated consumers.  More expensive goods from a European perspective lead to less purchasing – unless of course you absolutely HAVE to have a Range Rover to drive along the autobahn.  Decreases in US exports will widen the US Trade Deficit. Additionally, after adding to the coffers of GLE maybe the ECB is called on to infuse capital to other troubled sovereign banks – turn on the printing presses! With much more money in circulation the law of supply and demand tells us that the Euro depreciates, but with a number of troubled banking concerns that devaluation could be significant.      

In either case what is the likely US market response? One possible reaction could come from the rating agencies. On August 8^th Moody’s stated in their Weekly Credit Outlook “…a [US] rating downgrade could be triggered before 2013 by … (2) a significant deterioration in economic outlook resulting in adverse fiscal implications that are not offset”.  We submit that a significant widening trade deficit or becoming the recipient of exported inflation is each individually an adverse economic event likely not to be offset, which could trigger a second rating agency downgrade. While this is only one possible scenario that could lead to an increase in rates, we believe that having a second major rating agency downgrade the US would lead to higher interest rates.

You may be wondering what does “significant” actually mean – i.e. how much does the ECB have to crank up the Euro printing press?  What magnitude of bailout funds are we talking about? The Bank of International Settlements estimates that European lenders held approximately $136.3 Billion in loans to Greece at the end of 2010 and nearly $2 Trillion to Portugal, Ireland, Spain and Italy.  We agree with many analysts that put the total sovereign debt in Europe at approximately $6 Trillion—printing and apportioning approximately one-third of total sovereign debt to European financial institutions is clearly significant.

Whatever the breadth and depth of insolvency within the European banking sector turns out to be, one thing is certain - much like physics’ concepts that affect our lives, it would behoove all investors and politicians to remember that there is interdependence among global markets which affects our economic lives daily.  It is a small small world after all. 

The Good, the Bad and the Ugly

In 1966 Jeremy Thomson wrote the classic western “The Good, the Bad and the Ugly” which starred Clint Eastwood.  The story goes that two cowboys learn of a buried stash of gold in a cemetery. The problem is that each one only has a piece of the critical location information - one finds out the name of the cemetery, while the other finds out the name on the grave. So the two must work together in order to find the gold.

During the summer of 2011 Washington politics can be characterized as The Good, the Bad and the Ugly as Democrats and Republicans argued, pontificated and blamed each other for the seemingly never ending impasse to get a comprehensive solution to the debt ceiling problem.  Much like the movie each side talked about working together but showed distrust of the other’s motives. 

Before the political pundits barraged airways with the drama playing out in DC, recall that Saddle Peak had, after extensive research, meaningfully repositioned the portfolio to reflect a more defensive posture. The substantial change in asset allocation was based on our (continuing) belief that Washington is broken and interest rates are too low.  

The Good: After much politicking an agreement was reached that averted the possibility of a US government debt default.  Highlights of the agreement follows:

•         Allows a debt ceiling increase by as much as $2.4 trillion dollars in total. A further increase of at least $1.5 trillion would be available only after a special bipartisan committee identifies matching levels of spending cuts.

•         Calls for cuts of more than $900 billion over a ten year period in spending from programs, agencies and day-to-day spending.

•         Calls for the formation of a 12-person bipartisan special committee to identify further spending cuts. Note that this committee must complete its work by Thanksgiving 2011 and Congress must hold a vote on the committee’s recommendations by December 23, 2011. Importantly Congress cannot modify the committee's recommendation.

•         If the special committee is deadlocked or Congress rejects its recommendations, then automatic spending cuts of at least $1.2 trillion will go into effect.

•         Requires that the House and the Senate vote on a Balanced Budget Amendment to the Constitution, although its passage is not guaranteed.

The Bad: Even with the 11^th hour deal one of the three major rating agencies - S&P- still issued the first ever downgrade to the United States, going from AAA to AA+ with negative watch.  It has been noted that the downgrade was based in part on the ongoing uncertainty regarding Washington’s ability to solve the United States longer term debt problem4.  After the downgrade, we saw well known investors (Gross vs. Buffet) disagree about the correctness of the downgrade; other major rating agencies reaffirm their ratings but indicated things could change5; and substantial pressure in the global markets.  Our view was that the downgrade was a less than surprising event given (our analyses indicating) that any non-comprehensive agreement could potentially lead to default or downgrade. This deal felt more akin to a game of kick- the-can which gave Washington additional time to come up with a more definitive plan. Admittedly the agreement did stave off default potential but it seemed to us more smoke and mirrors rather than a substantial solution.  Looking ahead the bipartisan committee will again debate the issues of tax increases versus spending cuts.  In our view this committee is fundamentally designed to fail, given the extremist views creeping in from both sides of the aisle. 

The ultimate success or failure is an unknown but what is clear to many like us is that the only way to put the US economy back on the right path is through a combination of spending and tax measures.

The Ugly: Throughout much of the year the most fitting word to describe the United States economic environment is ugly.  Certainly there have been positive signs in the business and financial sectors which have seen increases in both orders and profitability, BUT these positives have been more than offset by dour news in total economic output (i.e. GDP) and employment. 

In the near term we believe that more ugliness can rear its head in any number of different ways, e.g. continued sell off in the markets, sudden and significant rise in interest rates, etc; where ever the ugliness may come from it is predicated on our belief that Washington is still slumbering, possibly unaware or unwilling to do what is ultimately required.

A Hollywood Ending? During the final portion of the classic western there were numerous gun battles to decide who will ultimately get the gold.  In the final scene, after one last twist, both men shared the gold equally but not without some remaining animosity.

When all is said and done will Washington have a similar Hollywood ending? Only time will tell…