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Aurora, Il USA
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By Bill Gross
A 12-year-old coffee mug has a permanent place on the right corner of my office desk. Given to me by an Allianz executive to commemorate Pimco's marriage in 1999, it reads: "You can always tell a German but you can't tell him much."
It was hilarious then, but less so today given the events of the past several months, which have exposed a rather dysfunctional euroland family. Still, my mug might now legitimately be joined by others that jointly bear the burden of dysfunctionality.
"Beware of Greeks bearing gifts" could be one; "Luck of the Irish" another; and how about a giant Italian five-letter "Scusi" to sum up the current predicament?
The fact is that euroland's fingers are pointing in all directions, each member believing they have done more than their fair share to resolve a crisis that appears intractable and never-ending. The world is telling them to come together; they're telling each other the same; but as of now, it appears that you can't tell any of them very much.
The investment message to be taken from this policy food fight is that sovereign credit is a legitimate risk spread from now until the "twelfth of never."
Standard and Poor's shocked the world in August downgrade of the US – one of the world's cleanest dirty shirts – to double A plus. But what was once an emerging market phenomenon has long since infected developed economies as post-Lehman deleveraging exposed balance sheet excesses of prior decades.
Portugal, Italy and Greece hit the headlines first, but "new normal" growth that was structurally as opposed to cyclically dominated exposed gaping holes in previously sacrosanct sovereign credits.
What has become obvious in the last few years is that debt-driven growth is a flawed business model when financial markets no longer have an appetite for it. In addition to initial conditions of debt to gross domestic product and related metrics, the ability of a sovereign to snatch more than its fair share of growth from an anorexic global economy has become the defining condition of creditworthiness – and very few nations are equal to the challenge.
It was in this "growth snatching" that the dysfunctional euroland family was especially vulnerable. Work ethic and hourly working weeks aside, the euroland clan has long been confined to the same monetary house. One rate, one policy fits all, whereas serial debt offenders such as the US, UK and numerous G-10 others have had the ability to print and "grow" their way out of it.
Beggar thy neighbour if necessary was the weapon of choice in the depression, and it has conveniently kept highly indebted sovereigns with independent central banks afloat during the past few years as well. Depressed growth with more inflation, perhaps, but better than the alternative straitjacket in euroland.
As currently structured, euroland's worst offenders now find themselves at the feet of a Germanic European Central Bank that cannot be told to go all-in and to print as much and as quickly as America and its lookalikes.
The European Union's imposed fiscal solution is to "clean up your act", but, in the process, to impose years of deflationary relative wage policies on a rather spoiled southern citizenry. Perhaps they will stand for it, perhaps they won't. But, as time winds on, a rather permanent credit spread of damaging proportions threatens these economies with higher bond market yields, increasing rather than decreasing debt to GDP levels. Sovereign creditworthiness and potential default become greater downside probabilities, indicating a greater likelihood of significant losses.
Italian bond market yields have declined as fast as they went up in the past few days , proving that technicals and market psychology are an important dynamic to consider as well. But with 10-year rates in the 6-7 per cent range – and topping 7 per cent on Tuesday – Italy would require an annual primary surplus of nearly 5 per cent in order to prevent an accelerating increase of its debt-GDP ratio. Temporary technocrats and a new prime minister have their hands full.
Investors, then, must be leery of the self-reinforcing dynamic that has many fathers and spreads much of the blame: ad hoc and insufficient policies from fiscal and monetary authorities; decades of balance sheet and savings abuse from the southern euroland periphery; unresponsive and insufficient support from supranational agencies, including the International Monetary Fund; a me-first attitude from developing nations that control global reserves. All of them join the world's most dysfunctional family – euroland – in telling others what to do, but not listening much.
As a result, deleveraging, fiscal tightening and potential defaults are on the economic and investment horizon. Investors should be in a "risk off" mode. When this is finally over, a lot of parties will owe the world one giant "Scusi".
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