Over the last four weeks of market turmoil we have communicated with clients mostly via email and the monthly letter. Here is a brief summary of those communications (click on each for the full communication, though it is only in Spanish, emails from Aug 5th and Aug 9^th, letter from Sept. 1^st), with only a few new comments.

This is not 2008, yet

The type of market action of the last 4 weeks (especially the selloff momentum during the first 6 business days of August) has pushed many to wonder whether this is a repeat of 2008. Though the market dynamics are similar in terms of being mostly guided by fear and a vicious cycle of selling founded in the belief that everybody else believes we are all selling, there are some very important differences. Let us be concise:

–       The analogy could be founded in the fact that 2008 started as a banking crisis caused by the deterioration of a large pool of assets (mortgages), while we could now face a European banking crisis due to the deterioration of the loans to the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain).

–       Though in 2008 the stock of mortgages in the US economy was a known data point, the real problem was the incredible expanding mesh of structured products and derivatives based on that pool of mortgages. From a particular portfolio of mortgages, structuring desks had repackaged them in tranches of different seniority, got them rated and sold. The problem was mostly the expanding complicated mesh of derivatives based on those tranches, as well as repackaged pools made of only derivative structures. These structures and their derivatives ended up in balance sheets across the globe. Most importantly, because of their artificially high ratings, they ended up in pools of ‘conservative’ investments, including money market funds. As the quality of the underlying mortgages deteriorated with falling housing prices (a class made of millions of loans), the ratings proved surreal, re-pricing started complicated and untractable chain reactions through the myriad of structures and derivatives, producing increasing uncertainty about losses across the global financial system. This was a long and exponential process as prices and liquidity fell, which at some point produced its own vicious cycle.

–       Currently in Europe, the stock of debt issued by the PIIGS (and their private sectors) is known, as well as most of the owners of that debt. There is not much structuring on top of that debt stock. There is a stock of credit derivatives, but it is a quantifiable and tractable issue, which does not appear to be anywhere close to the expansive and complicated mesh out of mortgages leading to 2008. Moreover, the quality of the underlying asset is easier to understand, as it is the capacity to pay of a sovereign within a monetary union. It is true that the European financial system is over-extended (measured in terms of its assets relative to EU’s GDP), and over-exposed to these risks and each other.

–       Back in 2008 the size of the problem was not only large relative to GDP, but difficult to grasp how derivatives had expanded that original size and where it reached. As the prices of those complicated and obscure instruments collapsed, the asymmetries of information across the financial system were pervasive, crippling the capacity of agents to transact. Gradually, trading of simple securities became riskier as the creditworthiness of counterparties became uncertain. This phenomenon is less likely today in

–       In Europe today there is much more clarity of who owns what type of debt, what that banks’ provisions are, etc. Banks have recapitalized, and in many cases have today a much higher level than before. Leverage in the system in general is significantly lower, not only at trading houses, but also in Hedge Funds.

–       Though there are many other differences, these are the key ones, which is why we still believe that a crisis of the magnitude of 2008 is not yet the most likely scenario, thus not worth preparing for.

–       Because the scenarios have changed, we did reduce risk a month or so ago, and changed the composition of the exposure towards a more defensive one. If we could simplify the scenarios in three: 1) a resumption of the recovery in G7, as was expected 3-4 months ago, with growth rates going back towards 2.5% in G7, and those in EM staying above 5%; 2) a mediocre G7 outlook (growth between 0 and 1%) with EM growth around 4%; and, 3) a recession in G7, with a non-trivial contraction and growth in EM falling well below 4%. Scenarios 2 and 3 have increased probabilities at the expense of 1, making them all roughly equally likely. In scenarios 1 and 2 global equity markets are attractive (with the regional and sectorial preferences that we have established before), while scenario 3 merits a significant reduction of risk.

–       We have reduced equities to 30%, commodities to 10% (with a bias to further reductions), and changed the composition of equities to defensive sectors, with a particular focus on dividends.

What worries us?

Europe is clearly the key risk, and though we believe there are important differences with 2008, the complexity and magnitude of the challenge there is such that it has the potential to become a serious crisis. Poor crisis management by a cumbersome combination of 17 political systems is what makes this more complex than what major institutional changes already are.

We have written many times before that a pre-emptive Greek restructuring, executed with Uruguay 2003 as a model is the optimal path. Actually, restructuring the debt of those countries most likely unsustainable, to then establish the Eurobonds as the common funding instruments (see the Blue bonds proposal, by the Bruegel Institute). But this is not more than a dream when compared to what seems politically feasible. True that progress has been made: restructuring is now in the words (though timid) for Greece, and leaders have signaled that the road ahead is further fiscal integration. But nothing seems to be fast or efficient enough to avert a default in Greece and contagion to affect the rest. This is the key risk in markets today.