Euro Crisis Enters Dangerous Stage

By Comstock Partners

When the Greek crisis started to emerge in early 2010 we recognized the possibility of contagion and the potential threat to the global economic and financial system, although it was generally dismissed as a manageable problem by the investment community. Following is an excerpt from our comment of February 11, 2010. .

"The Greek fiscal crisis is just a symptom of world-wide credit problems that was signaled by the emergence of subprime loan disclosures as early as August 2006. The importance of subprime lending was not recognized until much later, but nevertheless evolved into a continuing series of economic and financial crises that continue until this day. The problem has now extended to sovereign debt, and, as usual, the weakest links are exposed first (Dubai and Greece) only to spread to stronger entities later. Not far behind are Portugal and Spain, then perhaps Italy… It’s not just a localized minor problem to be solved by some sleight-of-hand by the EU, but a debt crisis that could envelop the globe.It therefore seems to us that investors are making a big mistake if they assume that Greece is too small and unimportant to matter and that the rest of the developed world is somehow isolated from the turmoil. Greece is to sovereign debt what subprime was to private debt. It’s the possible start of a vast tsunami that threatens to overwhelm the global economic and financial system. Investors should take heed."

From the beginning it should have been obvious that if the Greek problem was not contained the other nations along Europe’s southern tier as well as Ireland were potentially at risk. That is why the acronym "PIIGS" came into being at that time. Despite the necessity to deal with the budding crisis in early 2010, Europe has dithered for almost two years with so-called plans that were too little and too late. Despite dozens of high-level meetings, pronouncements and inadequate plans put forward by various European entities, the crisis has now entered a new phase with the loss of market confidence in Italian bonds. Italy is the third largest economy in the EU and the eighth in the world. Its 2.6 trillion Euro debt is the fourth largest in the world. As many have previously noted, "Italy is too big to fail and too big to save."

From the outset in early 2010 it was clear that there were no good solutions. The troubled nations could undertake severe austerity measures, default on their debts, be bailed out in some manner or leave the EU. Unfortunately, each of these solutions has highly negative consequences both for the nations needing help and the stronger nations that would bear the brunt of the costs. If a palatable solution were possible it would have been accomplished relatively early in the crisis. Instead the EU has continually "kicked the can down the road".

We see no easy way out of the current turmoil. The result of enough fiscal austerity to relieve the debt pressures is a severe recession or depression. Historically, independent nations undergoing austerity have accompanied the policy with monetary ease and a devaluation of their currency.  This is something EU members cannot do as they share a common currency and therefore do not run their own monetary policy.  Default would cause havoc in the EU banking system that holds a significant share of the sovereign debt. A bailout would require at least two trillion euros, a sum that no one wants to pay. And breaking up the EU would cause major turmoil in global financial markets and economies.

So far the market has rallied strongly on every announced plan for the last year and a half only to decline again when it became clear that the crisis was not over. In our view, a solution is still not in sight. At best Europe will likely fall into a severe and prolonged recession with the potential for major global consequences. At worst, the global economic and financial system could completely unravel, leading to worldwide chaos. Even assuming the best, the U.S stock market, at current levels, is discounting a far better outcome than is likely to be the case. The strong rallies we see on any glimmer of hope indicates that investors are just as fearful of missing the next bull market as they are of a major downside break. We think the risks at this juncture are far greater than the possible rewards.