The equity markets had little to be thankful for during the U.S.’s holiday-shortened week. The S&P 500 dropped by 4.7% through the normally bullish Thanksgiving week. Other commonly watched indexes fell even more. Not affected by our holiday, world markets likewise fell precipitously.
Expectations that Europe would cobble together a plan to prevent imminent economic collapse led to a spectacular October rally in stock markets around the world. However, as persistent bickering among heads of state decreased confidence in that outcome, markets sagged throughout most of November. Markets still go hour by hour waiting for a positive rumor from Europe. A plausible plan to “kick the can down the road” will likely lead to a substantial rally, especially with markets as oversold as they are today.
Nonetheless, the longer-term picture is getting darker by the day. Rating agencies downgraded sovereign bond ratings en masse last week. Moody’s cut Hungary to junk levels and Fitch did the same for Portugal. Belgium was downgraded. S&P warned that it may cut Japan’s rating. Fitch said that France’s triple-A was at risk. Investors also downgraded bonds on their own, independent of the rating agencies. The Italian ten-year bond reached 7.3%, and the two-year climbed over 8%. There is no realistic prospect that Italy will be able to grow its way out of this debt morass with debt service burdens at such levels. Even Germany, the financial engine of the Eurozone, saw its bond rates surge last week. In just over two weeks, German ten-year rates climbed from 1.72% to 2.25%. By way of comparison, the U.S. ten-year stayed at 1.96% over the same period. Fear is creeping in with respect to all of Europe. And Europe is a giant piece of the world’s economic and market composite.
As I write this on Sunday evening, a report is circulating that the International Monetary Fund is preparing a $794 billion rescue package for Italy. The rumor has overnight futures markets in rally mode. With markets as oversold as they have become over the past few weeks, snap-back rallies could be powerful if it looks likely that some sort of rescue package will defer a near-term debt collapse. On the other hand, long-term investors must remain conscious of the rapidly spreading deterioration of underlying fundamentals. Massive debt problems don’t cure themselves. Left to their natural outcomes, they unwind in a deflationary spiral. Rarely through history, however, do governments and central banks allow natural outcomes. More often than not, money printing becomes the defense of choice, resulting in a debt burden reduction through inflation. In extreme situations, runaway inflation eliminates all debt but introduces economic chaos. The last example of such an outcome for a major industrial country was in Germany in the 1920s. In any inflationary environment, varying only by degrees, lenders (bondholders) are penalized and borrowers are rewarded.
Today’s investors are by rights in a serious quandary. The financial system, at least in Europe, is in danger of collapse. Perhaps investors will believe in a rescue plan that will defer the pain for a few years, and equity prices may rise in celebration. Holders of sovereign bonds in perceived safe-haven countries (the U.S., Germany and Canada, for example) may profit if a disinflationary or deflationary recession unfolds. On the other hand, such bondholders may be beaten up badly if central banks resort to the printing press to alleviate the debt pressures.
Eventual outcomes will be politically determined. Successful investors may succeed more by their ability to anticipate political outcomes than by a deep understanding of investment fundamentals. In such an environment we rely on our underlying philosophical guideposts, which have stood us in good stead in this extremely dangerous century-to-date. In a high-risk environment, reduce risk exposure. Buy risk-bearing assets only when you can acquire them at extremely attractive valuation levels. Never lose sight of the fact that there will always be another opportunity to make significant gains. You will not be able to take advantage of that opportunity, however, if you lose a substantial amount of your assets when markets decline.