The PIIGS countries – Portugal, Ireland, Italy, Greece, and Spain – are in the midst of a sovereign debt crisis that threatens to not only sink their respective economies, but more importantly, to spark a contagion of economic collapse throughout global markets. (Unfortunately, I owe this article’s catchy title in part to Jim Cramer, CNBC market analyst and former hedge fund manager. Make no mistake though – I disagree with Cramer’s methods for advising the individual investor like you and me. His famous show “Mad Money” helped thousands of loyal viewers lose their shirts during the 2008-09 financial crisis.)
So you may be wondering what the European sovereign debt crisis is and how it might affect you. Let’s start with the first item – what is the crisis and how did it come about?
Throughout most of the 2000’s, the Eurozone witnessed strong economic growth and prosperity. (The Eurozone is the European Union’s economic cooperative, featuring the euro as the common currency.) In particular, Greece’s economy grew the most at a 4.2% rate during this timeframe. Of course, looking back, this growth was fueled by the rise in debt-based speculation, the use of derivative financial products, and who knows what other financial alchemy – the same witches’ brew that tanked the US economy. Once this bubble burst, Eurozone countries came back down to earth, with the PIIGS hit especially hard.
One of the biggest problems facing the PIIGS, and certainly contributing to the unfolding crisis, is their high deficit-to-GDP ratios. This is a measure of how much their annual budget deficit is compared to the country’s total economic output, or GDP. Even more simply put, it measures how much overspending the country is engaging in. So for example, let’s say a country with a GDP of $10 trillion had a 10% deficit-to-GDP ratio; this would mean that country was spending $1 trillion more than it produced economically in a given year. Some notable offenders in this area are Ireland (14.3%), Spain (11.2%), and Portugal (9.4%). (For comparison purposes, the US ratio was approximately 9.3% for fiscal year 2010.)
The first country in this potential domino chain is Greece. Greece’s economic troubles first began to surface in 2009, when budget deficits were revealed to be much higher than originally forecast. Foreshadowing financial instability, the credit ratings agencies such as Moody’s and Fitch downgraded Greece’s credit rating. This was followed in early 2010 by proposed austerity measures on the part of the Greek government, which received the approval of the EU with further budget cuts recommended. The Greek crisis accelerated in April, as borrowing costs for Greece rose and more significant austerity measures were unveiled. The EU approved a bailout plan for Greece in April, but interestingly enough the crisis continued through May as Greek citizens rioted in protest of the severe austerity measures and world stock markets plunged on the increasing volatility and threat of contagion (see the May 6 “flash crash”).
Things quieted down in the summer, but recent news regarding Ireland’s growing financial crisis have brought this issue back into the headlines. Its problems are similar to Greece’s, and also directly threaten the UK given financial and banking interactions between the two countries. Developments are unfolding quickly with respect to Ireland, and the means to stabilizing its situation remain to be seen.
Back on September 5, I tweeted the following: “European debt crisis has gone eerily quiet.” I consider this somewhat prophetic, as I was attempting to call attention to the fact that the usual media outlets had gone virtually silent on the crisis, yet the problem remained entrenched. Meanwhile, stock markets were rising unimpeded…remind anyone of the turkey analogy?
I would also posit that the PIIGS crisis serves as a referendum on more socialist-leaning states. The litany of financial promises and support to its citizens has proven too costly to maintain for many of these nations, and now the process of cutting back on such programs is the necessary but painful remedy. The Greek austerity measures tell the whole story, as their generous pension plans, low retirement age (61), and various tax rates all became fair game. That’s just a snapshot of the rollbacks required to stabilize the Greek crisis, and they’re not out of the woods yet.
So what does this all amount to for you as the individual investor? I think that, unless you’re following this story on a near-daily basis and have implemented sophisticated hedging protocols throughout your portfolio, the European debt crisis will blindside you and do serious damage to your investments. What kind of damage remains to be seen, but it’s fair to say based on what we saw back in May that a full scale eruption of this crisis would roil markets, create volatility spikes, and lead to heavy losses for investors who are lacking any sort of hedge against this crisis. (There are a variety of hedging approaches applicable here; regular readers of this blog will recognize the black swan protection protocol as my principal hedge.)
One indicator you can use among several to keep tabs on the crisis is the bond yield spread. Spreads provide some insight into how much the market is factoring in the possibility of a credit default. Take a relatively safe bond’s yield, and subtract that number from a relatively unsafe bond's yield – the difference is called the spread. So for example, let’s say German bonds are going for 5% yield, and Irish bonds are going for 10% -- the spread would be 5% (10% minus 5%). On the other hand, let’s say a French bond was going for 6% -- the spread between it and the German bond would be 1%, representing a relatively low level of default risk. Thus, if you wish to track the European debt crisis using tangible metrics, I’d suggest adding bond yield spreads to your list.
I’ll continue to post articles and commentary on the crisis so check back often for further insight. In the meantime, if you haven’t already, I suggest taking a close look at your portfolio with an eye towards protecting yourself from potential fallout from this crisis. Keep in mind that complete insulation will not be attainable, as the entire global economy is at risk here.
So you may be wondering what the European sovereign debt crisis is and how it might affect you. Let’s start with the first item – what is the crisis and how did it come about?
Throughout most of the 2000’s, the Eurozone witnessed strong economic growth and prosperity. (The Eurozone is the European Union’s economic cooperative, featuring the euro as the common currency.) In particular, Greece’s economy grew the most at a 4.2% rate during this timeframe. Of course, looking back, this growth was fueled by the rise in debt-based speculation, the use of derivative financial products, and who knows what other financial alchemy – the same witches’ brew that tanked the US economy. Once this bubble burst, Eurozone countries came back down to earth, with the PIIGS hit especially hard.
One of the biggest problems facing the PIIGS, and certainly contributing to the unfolding crisis, is their high deficit-to-GDP ratios. This is a measure of how much their annual budget deficit is compared to the country’s total economic output, or GDP. Even more simply put, it measures how much overspending the country is engaging in. So for example, let’s say a country with a GDP of $10 trillion had a 10% deficit-to-GDP ratio; this would mean that country was spending $1 trillion more than it produced economically in a given year. Some notable offenders in this area are Ireland (14.3%), Spain (11.2%), and Portugal (9.4%). (For comparison purposes, the US ratio was approximately 9.3% for fiscal year 2010.)
The first country in this potential domino chain is Greece. Greece’s economic troubles first began to surface in 2009, when budget deficits were revealed to be much higher than originally forecast. Foreshadowing financial instability, the credit ratings agencies such as Moody’s and Fitch downgraded Greece’s credit rating. This was followed in early 2010 by proposed austerity measures on the part of the Greek government, which received the approval of the EU with further budget cuts recommended. The Greek crisis accelerated in April, as borrowing costs for Greece rose and more significant austerity measures were unveiled. The EU approved a bailout plan for Greece in April, but interestingly enough the crisis continued through May as Greek citizens rioted in protest of the severe austerity measures and world stock markets plunged on the increasing volatility and threat of contagion (see the May 6 “flash crash”).
Things quieted down in the summer, but recent news regarding Ireland’s growing financial crisis have brought this issue back into the headlines. Its problems are similar to Greece’s, and also directly threaten the UK given financial and banking interactions between the two countries. Developments are unfolding quickly with respect to Ireland, and the means to stabilizing its situation remain to be seen.
Back on September 5, I tweeted the following: “European debt crisis has gone eerily quiet.” I consider this somewhat prophetic, as I was attempting to call attention to the fact that the usual media outlets had gone virtually silent on the crisis, yet the problem remained entrenched. Meanwhile, stock markets were rising unimpeded…remind anyone of the turkey analogy?
I would also posit that the PIIGS crisis serves as a referendum on more socialist-leaning states. The litany of financial promises and support to its citizens has proven too costly to maintain for many of these nations, and now the process of cutting back on such programs is the necessary but painful remedy. The Greek austerity measures tell the whole story, as their generous pension plans, low retirement age (61), and various tax rates all became fair game. That’s just a snapshot of the rollbacks required to stabilize the Greek crisis, and they’re not out of the woods yet.
So what does this all amount to for you as the individual investor? I think that, unless you’re following this story on a near-daily basis and have implemented sophisticated hedging protocols throughout your portfolio, the European debt crisis will blindside you and do serious damage to your investments. What kind of damage remains to be seen, but it’s fair to say based on what we saw back in May that a full scale eruption of this crisis would roil markets, create volatility spikes, and lead to heavy losses for investors who are lacking any sort of hedge against this crisis. (There are a variety of hedging approaches applicable here; regular readers of this blog will recognize the black swan protection protocol as my principal hedge.)
One indicator you can use among several to keep tabs on the crisis is the bond yield spread. Spreads provide some insight into how much the market is factoring in the possibility of a credit default. Take a relatively safe bond’s yield, and subtract that number from a relatively unsafe bond's yield – the difference is called the spread. So for example, let’s say German bonds are going for 5% yield, and Irish bonds are going for 10% -- the spread would be 5% (10% minus 5%). On the other hand, let’s say a French bond was going for 6% -- the spread between it and the German bond would be 1%, representing a relatively low level of default risk. Thus, if you wish to track the European debt crisis using tangible metrics, I’d suggest adding bond yield spreads to your list.
I’ll continue to post articles and commentary on the crisis so check back often for further insight. In the meantime, if you haven’t already, I suggest taking a close look at your portfolio with an eye towards protecting yourself from potential fallout from this crisis. Keep in mind that complete insulation will not be attainable, as the entire global economy is at risk here.
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