“Throughout history, rich and poor countries alike have been lending, borrowing, crashing and recovering their way through an extraordinary range of financial crises….”
That quote comes from Carmen M Reinhart and Kenneth Rogoff’s book “This time is Different – Eight Hundred Years of Financial Folly”.
The book charts eight centuries of government defaults, banking panics and inflationary spikes – from medieval currency debasements to the subprime catastrophe – and according Deutsche Bank’s Jim Reid should be on the bedside table of every investor at the moment.
The interpretation we got from the book is that there is little reason to think that this time is any different from numerous financial crises through the ages and that this super-cycle of rolling bubbles will eventually end up in Sovereign defaults and/or higher inflation. However knowing when this will occur is clearly more difficult. Indeed the book provides no ‘smoking gun’ as to when a troublesome Government deficit spirals out of control.
Reading between the lines a catalyst seems to be when the market final doubts the sustainability of the funding. At this point problems can spiral very quickly. We can’t claim to know whether this is this year’s problem or whether it will take longer to truly manifest itself.
However we are confident enough that it will happen to want to continue to hedge the risk. The tail risk in the system remains extremely elevated. Government balance sheets have become the dumping ground for over a decade of rolling bubbles.
To which the Deutsche strategist notes that Wednesday was probably the worst day to date in the current period of Sovereign weakness.
Not only did SovX WE have its worst day since inception (+9bps wider) but this happened only two days after the market rejoiced at a successive syndicated Greece deal. To recap we saw Greece 5yr CDS +51bps to 375bps, Portugal +20bps to 153bps, Ireland +9bps to 147bps, Spain +19bps to 130bps and Italy +13bps to 118bps. A truly shocking day. While we still want to hedge Sovereign risk wherever we can, we are starting to see some serious dislocations emerging.
Firstly iTraxx Main and Senior Financials are now surely better macro hedges given they trade inside Sovereign risk. Secondly CEEMEA names have out-performed in the recent sell-off and are trading very tight relative to their more developed peers. Interestingly South Africa (153bps) now trades flat to Portugal and only just a little wider than Ireland. Poland (130bps) trades inside these and is flat to Spain. Austria (+89bp) is wider than Slovakia (+85bp) and Slovenia (+70bp).
The iTraxx Sov X Western Europe index.
(Click to enlarge).
This theme has also been picked up by James Chappell of Olivertree Securities.
For a small country, Greek fiscal/debt issues have had a remarkable impact on markets over the last 2 weeks. The bail-out of financials and fiscal stimulae have left governments stretched and themselves having no alternative to turn to. It is why a reassuring resolution on Greece, despite its size in a global context, is crucial for markets particularly before markets begin to raise louder questions over larger countries deficits.
In particular, Rogoff/Reinhart raise 2 important points in their book ‘This Time is different’:
1. Sovereign defaults have tended to lag banking crises by 2/3 years.
2. Once Debt/GDP rises above 90%, it reduces GDP growth by 1% – issue here is not ratios now but where they are likely to rise to next 2 years.
As a result, we see sovereign risk as the key swing factor for financials/markets particularly as current events bear a remarkable similarity to those that hit financials in 2008 (liquidity, looking to asia for new funding, mgmt trying to reassure markets on own plans).
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It seems that Pimco’s Mohamed El-Erian may also have dipped into Reinhart and Rogoff’s book. Writing for FT.com on Friday morning, he says the unfolding sovereign debt story will be the investment theme of the year.
Global investors worldwide are starting to pay more attention to what is unfolding in Greece. Yet most still think of Greece as an isolated case, just as they did for Dubai a few months ago.
With time, they will see Greece as part of a much larger investment theme that is a direct outcome of the global financial crisis: the 2008-09 ballooning of sovereign balance sheets in advanced economies is consequential and is becoming an important influence on valuations in many markets around the world.
As realisation spreads of this key sovereign investment theme, it is important to be clear about what Greece is, and what it is not.
El-Erian’s answer is that Greece is a big game of chicken between the Greek government and its donors.
Related links:
Europe is Lehman-fied… – FT Alphaville
Economy to Crash if It Keeps Debt Appetite: Rogoff – CNBC
Why we should expect low growth amid debt – FT