Issue 19 • June 1, 2011

PIIGS Too Big to Bail Out

Greece is back for a second round of feeding at the ECB bailout trough.

Just over a year ago, the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) of Europe began squealing from high debt burdens and roiled financial markets.

In May 2010, the European Central Bank (ECB) cobbled together a $157 billion bailout package to provide Greece with much needed liquidity, the first of the PIIGS to be bailed out, but not the last.¹

Ireland and Portugal followed with total bailout commitments (so far) of $364 billion (€256 billion), but the underlying issue that triggered the crisis is far from solved and additional PIIGS bailouts are likely.²

The central issue is not now — nor has it ever been — a liquidity issue alone. More fundamentally, it’s a solvency issue.

Bottomless Bailout Pit

In recent weeks, government bond yields for the PIIGS have blown out to new highs as bond prices have plunged.

This is a clear vote of no confidence from investors who don’t see a new round of ECB bailouts working any better than the last … and for good reason.

Yields on Greek 10-year government bonds reached 16.8 percent recently. That’s more than twice what they were a year ago after the first bailout.³

At this rate, Greece is effectively shut out of financial markets, as investors anticipate some sort of restructuring or default.

Portuguese and Irish government bonds are similarly priced, which means the three little PIIGS have little choice but to rely on the good graces of the ECB for fresh borrowing.

But Greece, Ireland and Portugal are just small piglets compared to the much larger problem economies of Italy and Spain.

Spain’s borrowing costs have been moving higher, too, and are near a record level. Italy’s interest rates rose to the highest level since November 2008, during the worst of the financial crisis.

It seems pretty clear that restructuring the massive debts of any one of the Eurozone PIIGS … let alone all of them … almost certainly will require Europe’s banking system to be recapitalized as well. In other words, it looks like a bottomless bailout pit to many investors.

The European Central Bank is on the hook. And although the ECB considers default unthinkable, it’s clear that financial markets are sniffing out restructuring of some kind.

After all, some Greek government debt is trading as low as 45 cents on the euro. And a Greek restructuring (even if by some other name) is likely to lead to a similar arrangement for Ireland and Portugal before those dominoes fall.⁴

If Spain and Italy were also dragged into the crisis, it’s game over. We believe a restructuring truly would be impossible for the ECB to pull off without lots of collateral damage — inflicted both to the ECB’s own balance sheet and on financial markets globally.

In order to finance multiple bailouts, the ECB has accepted questionable collateral from the PIIGS directly and from Eurozone commercial banks. So the entire EU has a lot to lose. It’s not exactly clear how much exposure the ECB has to the PIIGS, but data from Germany’s Bundesbank show that liabilities to the euro financial system have risen to €340 billion since the financial crisis erupted three years ago.⁵

Not surprisingly, voters in Berlin and Paris are not happy about using their tax dollars to bail out others … and the protesting masses in Athens, Dublin and Lisbon are fed up with spending cuts, tax hikes and other austerity measures being imposed on them by others while depressing their domestic economies.

What’s needed is strong leadership and decisive action from the ECB, not politics as usual and temporary Band-Aids. A column in this weekend’s Barron’s suggested that before the ECB throws more good money after bad, Greece should be allowed to bite the bullet now, restructure its debts and try to get its economy growing again.

As an aside, politicians in Washington should take note of Europe’s debt follies. That’s because if Congress can’t find a real solution, sooner or later global credit markets will dictate one … almost certainly on less favorable terms for the US.

Investing Is Relative

So how does Europe’s debt drama tie in to your portfolio choices?

First, let’s remember that investing is a relative game. By comparison, Europe’s ongoing debt woes makes the US look more attractive to global investors.

It all comes down to the relative attractiveness of one bond, one stock, sector or region or country over another.

Is Coca Cola a better buy than PepsiCo?

Should I favor the health care sector over consumer staples?

Are US stocks or bonds positioned to outperform Europe’s?

Little-noticed in the debt drama over the past few weeks is how resilient US stocks have been. In fact, dollar-denominated assets, in general, including US stocks, bonds, and even the greenback itself, are attracting new interest from global investors.

And while recent economic data has been somewhat disappointing here, the US still appears to be in better shape relative to Europe. True, US GDP is expanding at a slower rate than countries like Germany or France, but the PIIGS are sinking fast.

The Greek economy contracted -4.5 percent last year while Portugal shrank -3.5 percent last quarter. Italy is growing at a paltry 0.4 percent rate. Spain looks somewhat better with 1.2 percent growth, but with an unemployment rate of 21 percent — more than twice the US jobless rate — and Spanish home prices still deflating, we don’t expect much growth for Spain’s economy.⁶

Another negative factor is rising interest rates across major developed markets, including a recent rate hike by the ECB. Banyan Partners Senior Portfolio Manager Sebastian Leburn says, “Almost two-thirds of the central banks in the MSCI EAFE Index of developed market countries have begun tightening monetary policies.”⁷

Needless to say, higher interest rates may not be the best medicine for countries already dealing with a sovereign debt crisis and suffering slower growth as a result.

As the Eurozone debt crisis continues with no end in sight, the EU economy could be headed for stagnation. Or worse, the PIIGS could drag all of Europe into a full blown recession.

In such an environment, while the US economy may not be a perfect picture of health, we believe US stocks are poised to outperform other developed stock markets — and especially Europe’s — during the second half of this year.

As Banyan’s Chief Market Strategist Bob Pavlik notes, investors today are enthusiastic about investing in foreign markets and frequently ask us about our exposure to markets, such as China and India. However, while many overseas economies have good long-term growth prospects, foreign markets aren’t always the best place to be invested.

In fact, with so many uncertainties, many foreign stock markets simply aren’t performing as well as domestic stocks. The MSCI World Index (ex US), for instance, is up just 3.8 percent year–to-date, while the Dow Jones Industrial Average has gained 8.7 percent!⁸

Rather than investing directly in more volatile foreign markets, the Banyan Partners investment team believes one of the best ways to get international exposure is by owning big-cap US companies such as 3M (NYSE – MMM), Caterpillar (NYSE – CAT) and Johnson & Johnson (NYSE – JNJ) that generate a majority of sales from overseas.

All three of these companies are current buys at Banyan and members of the Dow … which happens to be outperforming global stocks by more than 2-to-1 so far this year.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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