The 2011 Credit Crises and Market Volatility
Posted by Rick Miller on October 14, 2011
- The current credit crises in both Europe and in the US are “sovereign” crises: they reflect investor concerns about government ability to repay debts.
- Investor concerns are clearly present in declining stock prices and stock market volatility.
- Stock market volatility is likely to continue until governments resolve both sovereign credit crises.
- The next several months are likely to be unpleasant for investors.
The 2008-2009 credit crisis was a private company event. Even though government action facilitated the excessive risk taking that triggered the crisis, it was primarily private companies (mostly banks) that failed (or are failing) rather than sovereign governments. For example, AIG, Bear Stearns and Lehman Brothers became insolvent, not the US government; IceSave and Bank of Ireland, Allied Irish Bank, EBS and Irish Life and Permanent, not the Icelandic and Irish governments; and Spanish savings banks, not the Spanish government. (One could argue about whether Fannie Mae and Freddie Mac are private or government entities, but their insolvency did not call into question the soundness of US Treasury bonds).
These banks lent money to borrowers who turned out to be unable to pay. Therefore, the banks could not repay the investors and depositors who had entrusted money to them.
In each case, the governments involved “bailed out” the banks (except for Lehman Brothers). In effect, the governments lent money to the banks so that they could repay their investors and depositors. The governments borrowedthe money they needed to make those loans. They issued bonds.
The governments promised the bond buyers (in some cases, that would be you and me) that taxpayers (in the case of the US, that would definitely be you and I) would repay the loans. In ordinary times, that would not be a problem. Economies would grow, tax receipts would grow even without tax increases, and governments would be able to pay off the extra bonds without any fuss.
Unfortunately, these are not ordinary times. The US government has borrowed a great deal to fight two expensive wars. Greece was considerably overextended before the crisis, as were Spain and Portugal. US and European governments both struggle with large retiree entitlement programs. These programs place an increasing burden on government finances as more citizens retire and the number of workers per retiree shrinks.
As a result, some European governments have relatively high levels of debt. They were already at some risk of disappointing their bondholders and constituents. The bailout lending increased government debt levels further. That heightened concern that future tax revenues will be insufficient to pay debt interest and principal and to provide promised goods and services to their citizens. US government debt levels are higher than they have been at least since the 1960s. While not as high as the most stressed European governments’ debt levels, they are still cause for some investor concern.
In short, the current credit crisis is a government or sovereign crisis. The markets have lost confidence in the credibility and credit worthiness of several governments.
Governments in this situation have several options. They can:
- Cut back on goods and services – “austerity” as we hear about in the case of Greece. This makes the recipients of government services unhappy – they receive fewer services than they expected.
- Raise taxes to cover their increased obligations. This makes taxpayers unhappy – people don’t like to pay more taxes (especially in a recession).
- Default – pay less than the principal and interest payments that they promised. This makes the bondholders unhappy. The purchasing power of the bond interest and principal payments they receive is smaller than expected, and may also arrive later than expected. In addition, when the bondholder is a bank, bank depositors may worry about the bank’s soundness and withdraw their deposits. If the default is large enough and banks hold enough defaulted debt, there can be a “run” on the affected banks, which can lead to a credit crunch much as we saw in 2008-2009.
- Print money to pay the principal and interest. This leads to a decline in the value of the money – to inflation. This also makes bondholders unhappy – the purchasing power of the bond interest and principal payments they receive is again smaller than they expected.
None of these options is good in the short run – each one makes someone unhappy!
The decisions about which option or combination of options to choose are political decisions. Therefore, the decision process will be messy and slow. Markets strongly prefer clarity and speed.
A summary description of each situation may be helpful.
The European political problem:
- Greece is spending a good deal more than it takes in, and has already borrowed more than its annual income (its net debt is roughly 150% of its GDP (national income)). The markets (private investors) won’t lend Greece any more money. Greece can’t print money. So, Greece is trying to both raise taxes and cut spending and thus avoid default.
- European governments (notably France and Germany) have said that if Greece can reduce the amount it borrows each year, they will “bail out” Greece (the governments will lend Greece the money that private investors won’t).
- There is concern that if Greece does default, then market concerns about creditworthiness will shift to other countries that use the Euro (Euro-zone countries) and have large debts and deficits, notably Ireland, Portugal, Spain and Italy.
- There is also concern that if Greece defaults, banks that hold lots of Greek debt may fail – the losses may wipe out their equity. This concern could lead to a run on those banks, and then on other banks … a full blown bank credit crisis. This would be very negative for economic performance throughout Europe, and for the rest of the world.
- As a group, Euro-using countries appear to be creditworthy – all of the Euro-using countries together have net debt of about 65% of GDP, and Germany’s alone is about 55% of GDP. As a group, investors are not worried about their ability to pay. That is, if the Euro-zone countries (including Greece, Ireland, Italy, Portugal and Spain) borrowed as a unit, there would be no credit crisis.
- However, Europe does not have unified decision-making or unified borrowing. Each of the 17 countries that uses the Euro must agree on any bailout loan terms and even whether they will contribute to the loan and how much. Each has its own interests and its own political decision-making process.
- It will take considerable time for this situation (Greece, Ireland, Portugal, Spain, and Italy) to resolve. Unusually high market volatility will continue until it does.
The US political problem:
- The US has a significant net debt (about 70% of GDP) and deficit (annual borrowing over 8% of GDP).
- The large deficit means that the debt continues to grow. Nevertheless, even future higher levels of debt appear to be manageable based on most authoritative forecasts. That is, there is little investor concern about the US’s ability to pay its debts.
- However, the US Congress must specifically approve increases in the debt (by raising the “debt ceiling”). If it fails to do so, the US government will be unable to meet all of its obligations. As we saw in late July, markets can be unnerved by uncertainty about US government payments.
- The Republicans want to reduce the deficit by cutting spending on goods and services only, and not by raising taxes.
- The Democrats want to reduce the deficit with a mixture of spending reductions and tax increases.
- Neither party controls the Congress, nor do the two parties appear to be willing to compromise sufficiently to reach agreement.
- It will take considerable time for this situation (composition of deficit reduction) to resolve. Unusually high market volatility will continue until it does.
In both cases, there is considerable uncertainty both about what will happen next, and about whether and when resolution will occur.
Stock markets have reacted negatively to both of these situations, with US stocks down over 10% since the end of June, and international and emerging markets down even more. Stock markets have also been very volatile (e.g., down 6% from Wed Sep 28 through Mon Oct 3, then up 6% through Thu Oct 6). This has been going on for some time as I wrote in a previous email.
Stock markets are forecasting this abnormally high volatility to continue. The VIX, a market indicator that summarizes investor expectations of future volatility, has fluctuated between 30 and 50 over the last two months. This is well above normal levels of 10-20, although we have seen much higher (the VIX reached 80 in the fall of 2008). [The VIX forecasts future volatility (roughly, the up and down range) of the S&P 500 based on option prices. It represents investors’ views of stock price uncertainty.]
The European and US economies are both fundamentally strong. However, both economies must address their problems convincingly in order to recover fully. Stock market performance is unlikely to improve and volatility is unlikely to return to more normal levels until governments persuade investors that solutions are well under way.
The next several months are likely to be unpleasant for investors.Uncertainty and volatility can be distressing. Unusually high volatility will mean many days when the stock market will be down, and more than a few when the decline will be large – 3% or more. Please contact me if you have concerns about your portfolio allocation or about your investments in general.