This note was originally published July 19, 2011 at 08:31 in
“Nothing is more obstinate than a fashionable consensus.”
Most stock market operators, particularly those trained in the dark art of short selling, have an understanding of the concept of herd mentality. The expression “herd mentality” describes how people are influenced by their peers to adopt certain behaviors. Herding around perceived fundamentals has led to some of the most spectacular bubbles of the last fifteen years – the internet, real estate, uranium, and so on. Interestingly, we may be at the beginning of the end of the most spectacular financial bubble of our lifetimes: sovereign debt.
Just over two years ago, on April 8th, 2009, Keith and I attended a guest lecture at the Yale Law School by former Treasury Secretary Robert Rubin. For better or worse, Keith and I have never worshipped at the Church of Rubin, though many current and former U.S. policy makers are considered his protégées - including the venerable Timothy Geithner and Larry Summers - so his philosophy certainly influences current U.S. policy. At that time two years ago, the Hedgeye team was digging deep into sovereign debt issues and were naturally struck by one specific quote from Rubin’s lecture:
“There is no risk of any defaults on sovereign debt globally."
In hindsight, Rubin pretty near top ticked the global sovereign debt markets with his Fashionable Consensus.
Last week, we introduced Policy Pong as one of our three Q3 2011 investment themes. On a global level, Policy Pong refers to the batting back and forth of Keynesian monetary and fiscal policies between Europe and the United States. Our view on the world’s two key reserve currencies, the Euro and the U.S. Dollar respectively, is directly influenced by the intermediate outlook for policy from each region.
In the U.S., the policy debate over the debt ceiling is critical to watch, but the U.S. Treasury market is telling us emphatically that no default is imminent. In fact, yields on 10-year treasuries are near year-to-date lows at 2.92%, while credit default swaps for 10-year treasuries are trading at 64 basis points versus 59 basis points on December 31, 2010. Despite heightened rhetoric, it is likely that the Republicans and Democrats will reach a Fashionable Consensus, which in the intermediate term is positive for the U.S. dollar versus the Euro.
There is no doubt that the herd is negative on European sovereign debt. In fact, with Greek 5-year CDS currently trading at 2,568 basis points and recent media reports suggesting that Greek debt could be written down by 80%, the case could be made that investors are too bearish on Greece. As it relates to the outlook for Europe more broadly though, Greece, at less than 2% of European Union GDP, is not the best indicator for contemplating the next move in the Euro currency or the Eurozone economy. So, the question remains, is the herd bearish enough on the Euro and European sovereign debt issues?
We are currently short of the Euro / USD via the etf FXE in the Virtual Portfolio. The key component of this thesis is that we believe that the ECB will be forced to shift its monetary policy stance due to both slowing growth in Europe and accelerating sovereign debt issues, primarily in Italy. Currently, credit default swaps on 5-year Italian bonds are trading just north of 300 basis points, which is slightly better than Lebanon at 358 basis points and Vietnam at 344 basis points.
This acceleration in the price of Italian credit default swaps has been underscored by the rapid increase in yields on Italian government debt. As an example, the yields on Italian 10-year bonds are currently at 5.79%, an increase of almost 100 basis points from the start of July. Rapidly accelerating interest costs are an issue for Italy because it has debt-to-GDP of north and 110% and interest-payments-as-percentage-of-GDP are north of 4.8%, according to recent ECB reports, which is second only to Greece at 6.7%.
Rather than viewing the European Union holistically, sovereign debt investors are rightfully evaluating each sovereign issuer on its own merits. Conversely, the ECB is seemingly evaluating the next interest rate move on what is best for the healthy economies in Europe, in particular Germany. Unfortunately for the one size fits all policy makers at the ECB, the GIPSIs (Greece, Ireland, Portugal, Spain, and Italy and so named for their wandering fiscal policies) are collectively more than 25% of Eurozone GDP and have credit default swaps government debt yields that are saying “No Más” to Trichet’s hawkish stance.
(For those sports fans, the best analogy is Sugar Ray Leonard versus Roberto Duran when Duran quit mid-fight, which occurs at 1:35 of this video: http://www.youtube.com/watch?v=HPoWrWwwi8M)
The second derivative issue of sovereign debt in Europe relates to the European banking system and the impending collateral call on European banks. Our ever insightful Financials Team lead by Josh Steiner wrote a note yesterday titled, “European Debt Crisis: Where the Bodies Are Buried (The 13 Most Exposed EU Banks), with the following key takeaway:
“We find that there are numerous European banks with over 100% of their Core Tier 1 Capital committed to either PIIGS commercial loans or PIIGS sovereign debt holdings. For example, we found that 18 of the 40 largest European banks held 100% or more of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans. In 13 of these cases, the banks held more than 200% of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans.”
Is it Fashionable Consensus to be short of the Euro? Perhaps, but our research, risk management, and obstinance are telling us to stick with it.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research