“The Emperor fiddles while Rome burns” is an apt description of the current situation in Europe. The lack of political will to deal with Greece’s sovereign debt problems in an effective and timely manner has created significant uncertainty and raised all too familiar fears of an emerging financial crisis. These fears punished global equity markets during the third quarter as investors fled equities en masse. We believe these fears are overblown, but the markets will continue to experience significant volatility until a definitive plan is laid out by the Europeans.
It should come as no surprise that Greece is bankrupt. In a country where tax avoidance is considered a sport, the Greek government became over-reliant on debt financing to fund its lavish social programs and bloated state bureaucracy (20% of the workforce are state employees). Unfortunately, as American home owners realized, there is only so much debt one can carry. As Greece’s debt burden increased, investors began to balk at taking on more of it. With a lack of willing investors, Greece has had to turn to the European Community to be bailed out. This bail-out, however, comes at a price as the Greeks are being forced to implement severe austerity programs and sale of state assets in an attempt to repair their finances.
Unfortunately, cost cutting and asset sales will not be sufficient. Owners of Greek debt will have to take significant writedowns on these obligations. Further, concerns about the level of debt carried by other European countries, namely Ireland, Portugal, Spain and Italy have also been raised. Investors fear massive writedowns of sovereign debt could damage European financial institutions – which own a significant amount of this debt – potentially making them insolvent. As such, the issue at hand is how to deal with Greece in an orderly manner so that the integrity of other sovereign nations and the European financial community is maintained. While challenging, this is achievable. The use of a TARP-like rescue fund to backstop losses within the European financial institutions would have the desired effect of shoring up the balance sheets of European banks, while providing Greece some relief from its debt burdens.
This is a difficult time for investors as they are faced with a seemingly endless cavalcade of bad news from the media. However, unlike 2008, we are not faced with a liquidity crisis but rather a crisis of confidence. As mentioned, firm action by the European Union will provide a catalyst for markets to rebound. While fears of a global recession grow, it is not a forgone conclusion. Global economic data remains positive. China is acting responsibly in slowing its growth to a more manageable level, while American consumers continue to pay down debt at a rapid pace, with savings rates now at their highest level in three decades. Further, manufacturing levels continue to improve in the U.S., while auto sales have remained robust. In addition, American leadership is finally having a sane conversation about its level of personal taxation, which remains too low in that country. When Warren Buffet advocates an increased tax burden on the rich, many listen.
The fundamentals of the companies within our portfolios remain very attractive, with strong balance sheets, cash generation, superior management and responsible Board governance. We have never followed the herd mentality of the investment community; this time is no different. Investing in gold and long-term bonds, viewed as safe havens in these uncertain times, will prove to be poor investments in a rising interest rate environment. We prefer maintaining our core positions in the consumer staple, utilities and financial services sectors, while adding to positions in those areas that have been beaten up – the economically sensitive sectors, such as Industrial Products, Energy and Mining. Global growth, led by emerging markets and infrastructure spending, will continue on its steady, secular path.