The European Sovereign Debt Crisis has taken hold of the markets in the last several days.  And this is a real concern for investors everywhere. We are taking this situation very seriously.

First of all, some background. For decades, Greece has not balanced its government and municipal budgets and their sovereign debt (the debt floated by the government) has grown dramatically while their ability to service the debt has shrunk. Greece’s national debt is about $400 billion Dollars or about 113% of GDP (the size of their economy).  Greece has an overly large portion of their workforce working for the government at all levels. The Greek public sector is about 40% of the economy. To put that into perspective, we will offer a loose example …one could say that you have three private sector workers working to support two public sector workers. And this just cannot work economically. The demonstration of this is that Greece’s government deficit was almost 15% of GDP in 2009.

Today, the Greek Parliament has voted to implement the austerity measures required under the European bailout that is conditioned on very harsh cutbacks, primarily for government employees and retirees. Many Greek public sector workers can retire after only twenty years of employment. In essence what will happen is that the European Union and the IMF (International Monetary Fund) is lending money to Greece to pay off a portion of their debts, which are primarily held by German, Dutch and French Banks. Allowing Greece to default would otherwise force the Europeans to again bail out their banks.

If this were a story told in isolation we would already be past it. And, the markets would be much less volatile, but it is not. There are several countries in Europe that are being reported to have varying amounts of the Greek disease. Among them are Portugal, Spain, Italy and Ireland.

The figures seem to indicate similarity on the surface. But, each has different strengths and problems. The source of the problems in Spain and Portugal have been the housing bubbles that developed as these two economies surged in the last decade. The source of Ireland’s problems was a banking community that made some disastrous loan decisions prior to 2008. Even now Irish banks hold extremely large positions in European Sovereign debt, though fortunately exposure to Greece and Portugal are low. Italy is included more because of guilt by association, yet they suffer from chronic low GDP growth. Our opinion is that Italy does not really belong in the group.

There are some mitigating factors with Portugal, Spain and Ireland.

Portugal has already instituted significant austerity measures targeted at reducing the budget deficit to 2.8% of GDP. Parliament has already passed legislation to freeze public employee wages and benefits and raising income taxes. There is an attitude of grievance in Portugal that the country has been lumped in with Greece. Further, the Portuguese Government has rejected the need for a bail out. Their AA rating seems to indicate the same.

Spain is suffering at 20% unemployment and an economy that is barely showing any gains. Unlike many other countries, Spanish Banks are among the soundest in Europe primarily because of their exposure is South America, specifically Brazil. Additionally, Spain benefits by a domestic savings rate of over 24%. Additionally, Spain has a great deal of domestic wealth which is a strong ballast against what appears to be very stagnant economic prospects. There has been considerable parliamentary action on austerity measures, which has not generated any material social unrest. Even on May Day, there were only a few workers chanting for a general strike.

The Irish economy is experiencing a severe recession as large domestic imbalances correct, but there are recent signs that the pace of contraction is slowing. Ireland should benefit from the world trade upswing along with restored competitiveness as a result of the decline in wages and prices. The ongoing domestic adjustment will nevertheless be prolonged, and the economic recovery weak.

The budget deficit has swelled and public indebtedness has increased sharply. Substantial fiscal consolidation measures are already in place, but more will be needed over an extended period, which will require both further increases in revenues and cuts in public expenditure. With NAMA (the National Asset Management Agency), the government seeks to restore the banking system to health by recognizing and dealing swiftly with losses, thus contributing to the recovery. This should be implemented along with the necessary risk–sharing mechanisms to protect the taxpayer. It is hard to imagine that NAMA will have sufficient assets and credibility to withstand any major sovereign debt meltdown in Europe.

In summary, there is a great deal to be concerned about, but automatically connecting these countries through the Greek Contagion is a weak assumption that is more fear driven than reality. There is no doubt that in the short run, the US Equity and debt markets have reacted strongly in the face of these fears. The US equity market has already undergone a 10% reaction, which may extend to 15%. Fortunately, the European Debt Crisis has come at a time when the US economy is rebounding strongly. So far, it is too early to tell if the Crisis will change the trajectory of the US economy or markets, but if it does, we will reduce our exposures quickly.

Tags: European Debt Crisis, Greece, Sovereign Debt