2-09-2010

Building Blocks of the Wall of Worry

To put "lipstick on a pig" is a rhetorical expression, used to convey the message that making superficial or cosmetic changes is a futile attempt to disguise the true nature of a product[i]. In recent years, a panoply of politicians have used this phrase in campaigns and in describing what they deemed to be futile propositions. In today’s charged financial environment, we want to know if the E.U. is trying to put lipstick on Portugal, Ireland, Italy, Greece and Spain’s fiscal outlook. We also want to determine how much it really matters.

I think the naysayers that liken today’s fiscal and bond market crisis in Europe to that of the subprime mortgage and derivatives meltdown should get their orders correct. The time of order of these developments is linked but not functionally dependent. The order of magnitude of the crisis is not comparable. 

There is no doubt that the economies of the PIIGS were over-financed in the last ten years. They benefited from the real estate bubble. They have been impacted by the world recession and against a fairly weak set of fundamentals they now are challenged. 

The main issue is that the PIIGS are really farms with theme parks. Although agriculture and tourism don’t dominate these countries’ GDP, it is important in each and gives them a raison d’être as part of what are otherwise unremarkable industrial complexes. Ireland does have a service and tech piece but it can’t pull the country along. What is remarkable is that they are part of the EU. The EU is facing the conundrum of having to make sure that these countries don’t default on their sovereign debt without having the teeth to impose austerity unilaterally. In fact, it is now obvious that the “old world” labor systems in place in these countries may lead to civil disobedience at some level around belt tightening that is sorely needed. 

However, it is clearly in the best interest of the powers that be in the EU to make sure that there is a managed outcome that falls short of a bailout, but gives and takes to get the job of stabilizing these countries done. European banks are exposed to these countries and will need to participate in a workout. Calling this a second sub-prime mess, though, is really misleading. 

The markets don’t really believe that this situation will create a domino effect like we saw in sub-prime mortgages. Greek ten year bonds trading at 6-7% is hardly a panic mode interest rate. If the EU was expected to provide a massive bailout, the German ten-year wouldn’t be trading at a rate that is ¼ to ½ percent better than the U.S. ten year. Here in lies the rub; the current European crisis is certainly real and requires attention but it is mostly Bricks in the Wall of Worry. 

The important facts, as we interpret them, are that the world economy is in the early stage of a self-sustaining recovery. It’s being led by China. There are already pressures on inflation and interest rates there, and the Chinese central bank is on the case. They will most likely allow a revaluation of their currency upward rather than screw down on credit substantially. The U.S., in a following mode, is starting to post data points that show we are also in recovery. We will have some pressure soon and have to raise interest rates moderately. The market foresees this and we are thus having a correction in the stock market. This is normal and we will be back in a bull market mode later this year. The Wall of Worry is made up of many types of bricks. This month’s flavor is European credit and China tightening. Later, we will worry about higher interest rates, inflation, and eventually, year over year comparisons getting harder. The market climbs the wall of worry. It has in past cycles, and it will in this cycle. When the market doesn’t have a lot to worry about is when investors should. 

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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