It does appears that the European Union is now taking the necessary steps to address their economic problems; the eurozone is a flawed union and a number of member nations are less solvent than they originally represented when they entered into this union.
Buyer beware apparently.
The sovereign debt problem in Europe is less about the fear of countries (such as Greece and Italy) running out of money to pay their debt. The real concern is how great an impact a default would have on financial institutions that hold these sovereign debts. The critical issue is the financial solvency of the financial institutions that have invested in sovereign debts around Europe. Because financial institutions provide the economic lubrication to make economies function more efficiently, a freezing of these institutions would have a significant negative impact on the global economy. When U.S. financial institutions froze in 2008, we saw America's economy ground to a halt.
Markets have welcomed promises by German Chancellor Angela Merkel and French President Nicolas Sarkozy to come up with a “comprehensive plan” for resolving the crisis by the end of October. French Budget Minister Valerie Pecresse said France would use public money to help with bank recapitalization if needed instead of using the European Financial Stability Facility. This is a positive move indicating that France is moving closer toward accepting Germany’s position on bank recapitalization.
The latest efforts as announced by France and Germany suggest that they recognize that financial institutions desperately need to be recapitalized; we could not agree more. Recapitalization is necessary, and the bottom line is someone, somewhere, will have to lose money. Eurozone countries will be asking banks to accept losses of up to 50% on their holdings of Greek debt. Deutsch Bank and Dexia (which is the subject of an active rescue plan), are but the tip of the iceberg in terms of outstanding debt exposure to weak euro nations. Even US banks like Morgan Stanley are now caught up in the fear contagion.
Taking a ‘haircut”, a write-down or adjusting original terms of any debt deals is an inevitable part of the solution. This will ultimately result in financial institutions absorbing the pain. This is an important recognition, and a reality that both Germany and France are finally facing. As a result, we are now seeing them stepping up efforts to work in a coordinated way to ring fence financial institutions that will likely be subject to defaults from marginal sovereign nations. Reality finally seems to be apparent to European leaders.
The net result, if effectively implemented, will be to stem the panic in these financial institutions. Secondly, in a coordinated way, the write down of assets that are clearly not worth what they once were will finally occur. The cascading effect from this write down will be that the stronger sovereign nations including Germany and France will now be required to pick up a bigger burden in order for the European Union to be a functioning body. The net result will be lower GDP growth across Europe for a significant period of time. We believe because the nature of the problem is related to sovereign debt rather than corporate debt, the resulting impact will be greater than what was seen in the U.S.
Europe is entering into the phase of “sober recapitalization” and this will impact their overall standard of living and GDP growth for years to come. In reality, Europe is already in this phase, as is the U.S., and consumers and businesses have been extremely cautious as they allocate funds in this very difficult environment.
We are not expecting a global economic collapse. That’s not going to be the case in my view. Instead, we expect slower growth. The nature of a slow growth environment is that any negative news will have a significant impact on market volatility. The combination of slower growth and lower returns, coupled with increased volatility makes for a very uncomfortable environment.
Michael Yoshikami, Ph.D., CFP®, is CEO, Founder and Chairman of YCMNET's Investment Committee at YCMNET Advisors. Michael is a CNBC Contributor and appears regularly on the network. YCMNET is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutional investors and individual investors. The firm works with clients around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010 and 2011. He oversees all investment and research activities of the firm and is actively engaged on a daily basis in the firm's securities analysis activities and determines the macro tactical asset allocation weightings for client portfolios. He works with YCMNET's investment team in integrating behavioral investing strategies with the firm's core fundamental perspective. Michael holds a Ph.D. in education, other advanced degrees, and holds the Certified Financial Planner® (CFP) designation.