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Lighten up on stocks..

April 27th, 2010 · No Comments

We advice to lighten up on positions. The Greek situation isn’t going to go away anytime soon, even if there comes a major IMF/EU bailout package, and this has the potential to derail the economic recovery and the health of financial institutions. The rally in stocks has also been a bit long in the tooth so we think the risks are increasing.

Alternatively, one could protect positions with puts.

Why do we think the situation is getting more risky?

After having it’s debt downgraded to junk status, the credit markets are effectively closed to Greece. That means that for the financing of its ballooning public sector deficit, it’s entirely dependent on the European Union and IMF. This is an extremely uncomfortable situation, to say the least.

The best possible outcome is that there will be a large EU/IMF rescue package for Greece. It has to be large, considering the size of the problems. According to The Guardian, Greece might very well need more than three times the package now discussed.

It remains to be seen whether that 150B euro(!) or so now needed for the coming three years according to the FT will be forthcoming anytime soon.

If a substantial package will come forward, the rot could be stopped, at least temporary. There might even be something of a relief rally. But the problems will not go away..

Greece’s debt has been downgraded to junk status. It’s public sector deficit is 13.6% of GDP, it’s outstanding debt 110% of GDP. These numbers will increase further, as the Greek economy hasn’t recovered at all, accumulated inflation differential has made it deeply uncompetitive and deep spending cuts and tax hikes will only worsen the short-term economic situation.

To give you some idea, Ireland has already embarked on draconian public sector cuts and tax hikes, to the tune of 5% of GDP last year, involving things like 20% wage cuts for many public sector workers. However:

  • The deficit was just over 11% of GDP last year, and even after all those cuts, it’s going to be just over 11% of GDP in 2010 as well [BBC]

When situations get as dire as those in Ireland and Greece (and Greece’s situation is actually far worse than that of Ireland), one has to run just to stand still.

One could argue that even in the worst case, a Greek debt default and leaving the euro, things will not be dramatic as Greece is a small economy on the periphery. One could not be more mistaken. There will be numerous ripple effects:

  1. A contagion effect to larger countries with similar problems. Already today, Portugal’s debt was downgraded as well. Countries like Spain and Italy, and even the UK are experiencing large public sector deficits as well..
  2. A European banking crisis, as they hold the larger part of European public sector debt. The numbers are such that they could rival those of the US housing bust, with banks in far worse shape now
  3. A full-blown currency crisis if Greece defaults and leaves the euro.

Until now, we were not overly worried about Greece because in our assessment:

  1. The problem was of manageable proportions (or at least it seemed that way).
  2. It was in the interest of everybody involved to arrive at a solution.

Now we’re not at all sure this still holds:

  1. If Greece really needs some 150B euro over the next three years, the problem is not within manageable proportions.
  2. With such magnitude, keeping Greece afloat might no longer be in all the parties best interest.

On the latter point, we ask. Until when will the Greece population (already on the streets) and its politicians tolerate having to slash-burn its economy? When will a debt default and leaving the euro become irresistible? For the EU, when will the burden of the Greek bail-out become so large that one is beginning to contemplate the hitherto unthinkable, kicking Greece out of the euro?

We think we must be close to those ‘pain’ points already.

There is only one chance to salvage this situation, and time is starting to run out. The EU/IMF package has to be overwhelming, and so have to be the Greek spending cuts and reforms. There is a chance that the rot will stop at that. But there are no guarantees, which is why we argue to lighten up on stocks after a good rally.

The most likely outcome, we fear, is that there will be a substantial aid package, this will salvage the situation for some time, but soon Greece will be back for more as it’s deficit, debt, competitiveness and general economic situation really are enormous. And we’re not even mentioning possible other European countries with similar problems..

This won’t go away any-time soon, and it could easily get worse. A lot worse.

Tags: Sovereign debt crisis