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 .