GREECE MIGHTN´T BE THE WORST OF THE MARKET´S PROBLEMS / BARRON´S MAGAZINE ( A MUST READ )

Up and Down Wall Street


THURSDAY, JUNE 16, 2011

Greece Mightn't Be the Worst of the Markets' Problems


By RANDALL W. FORSYTH

Signs of stagflation adds to sovereign-debt woes, spurring a flight from risk assets to the port in the storm, Treasuries.

The steep drop in prices of risk assets Wednesday was widely blamed on the deepening crisis in Greece. If only that were the extent of our problems.


That's not to take away from the dire straits in which Greece finds itself. While the situation worsened with a general strike and violent demonstrations in Athens were broadcast on a seemingly endless loop on television screens around the globe and Prime Minister George Papendreou said he would reshuffle his cabinet, the further signs of deterioration in the U.S. economy were overshadowed.


What emerges after a day that saw U.S. equity values sliced by some $300 billion, or 1.7%, according to Wilshire Associates, is that the worsening Greece crisis comes against a background of slowing economic growth and rising inflation but limited options for policy makers.


Meanwhile, the dollar jumped and Treasuries rallied. The benchmark 10-year note yield plunged to 2.97% from 3.10% as investors rushed for the safe harbor of U.S. government notes from the sea of troubles elsewhere. It is a measure of such fear if investors clamored for yields below 3%, which is less than the rate of consumer inflation.


From the purely financial standpoint (as opposed the human toll of the crisis on the Greek people), Moody's Investors Service placed three major French banks, Credit Agricole, BNP Paribas and Societe Generale, under review because of their exposure to Greek debt. These, like many large European banks, are active borrowers in the dollar funding markets, which means they are likely counterparties to U.S. banks that lend there. Fears of contagion worsened but, unlike in 2008, the cost of funding by banks did not skyrocket.


Call it the dog that didn't bark. Banks around the world are flush with the reserves from central banks, either through the quantitative easing by the Federal Reserve in the U.S. or the Bank of England, or borrowings from the European Central Bank. They have been sitting on these reserves -- instead of lending them -- as a precaution of another crisis.


After the crisis of 2008, monetary authorities also now are prepared to deal with a liquidity crisis of massive proportions. They have seen the destruction wrought by modern-day bank runs, and have created all manner of facilities to deal with them.


Insolvency is more than illiquidity; it means you owe more than you can repay, which is Greece's situation. That is what's implied by Greek 10-year bonds being quoted at a yield of more than 18%. That number assumes, unrealistically, that interest and principal will be paid on time. In reality, the returns will be less after the haircuts are made.


Even though creditors will likely share in losses on Greek bonds -- as supported by the German government but still opposed by the European Central Bank -- banks should be able to avoid the funding crisis that followed the fall of Lehman Brothers.


It would appear that the generals at the central banks have prepared well for the last war. Not that there won't be casualties this time; but a systemic crisis seems less likely.


What may prove a more nettlesome problem is deteriorating economic conditions, marked by slower growth and higher inflation. Commentators dispute the use of the term stagflation because today's numbers fail to rise to the 1970s and early 1980s standard of double-digit unemployment and inflation. But prices are rising faster than real output is expanding, which would fit with a reasonable definition of stagflation.


The consumer price index is up 3.6% from a year earlier after a rise of 0.2% in May. Meanwhile, real gross domestic product grew at an annual rate of 1.8% in the first quarter and is likely to show real growth in the 2% range in the current quarter. While the consensus calls for a second-half pick-up, it's unlikey real GDP will match the rise in prices seen over the past 12 months.


That was emphasized by a paltry 0.1% increase in industrial production last month, which was hampered to some extent by supply-chain problems resulting from the Japanese disaster in March.


But the Empire State manufacturing index showed an outright contraction within the New York Fed district in June while nationwide industrial production rose a less-than-expected and paltry 0.1% in May. The Philadelphia Fed index, due out Thursday, should show whether the Empire really struck out.


Meanwhile, the National Association of Home Builders reported its index of confidence among builders plunged to 13 in June from 16 in May. A reading below 50 indicates things are more bad than good.


Declining home prices not surprisingly continued to drag down confidence. But here's the really insidious thing beleaguered builders have to contend with: rising materials prices.


So, they're caught in the same vise squeezing so many businesses and households -- rising prices but stagnant incomes and falling home prices. Stagflation may be like the late Supreme Court Justice Potter Stewart's definition of pornography: you can't define it but you know it when you see it. And that's what it looks like to me.


That's the problem for which policy makers lack an answer. Fiscal and monetary stimulus may have staved off an economic disaster in 2009 but have not produced a recovery sufficiently robust to bring the unemployment rate below 9%. At the same time, these same policies have produced upward pressure on prices, which hurt real purchasing power and profit margins.


That stimulus now is being reduced. U.S. fiscal policy is being tightened on the state and federal level while the pain in Europe is evident. Monetary policy is being snugged, from the Chinese central bank raising interest rates to the ECB signaling an interest-rate hike next month to the Fed ending QE2.


As intractable as the Greek debt problem may appear, dealing with slow growth and troublesome inflation may prove even more difficult. That would be consistent with the flight from stocks with reasonable valuations for Treasuries with negative real returns. Any port in a storm.


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