The SEC claim on Goldman Sachs is no longer an aggregate risk to the market. Greece still is.

The news last Friday about the SEC claim on Goldman Sachs had an effect on markets across the board. Today we are all more aware of the issues, the grey areas and the most likely scenarios for that dispute. In a letter to our clients last Sunday we expressed our view and elaborated on the issues (being a client has some benefits beyond portfolio management…).

The relevant issues affecting the markets over the next few weeks, in our view are: Greece, China, financial reform in the US, and economic and earnings data. We are also monitoring some tail event risks. Let us say a few words on each of those topics, concisely.

Greece
We have already elaborated on our ideas about the euro’s structural problems (letters to clients, some in blogs). In short, the euro cannot compete with the dollar, due to a large extent to its lack of a meaningful federal fiscal authority, which can survive severe fiscal difficulties of its members (country members in the case of the euro, states in the case of the dollar). The euro is as good as the sum of its parts. The dollar is more than that. Greece helps highlight these structural differences as well as other institutional differences. These european problems cannot be solved with a financial rescue package for Greece.

Greece’s fiscal and government debt picture, together with its productivity growth and economic growth potential (relative to the rest of the euro zone), make Argentina’s case in 2001-2002 look like a simple case. The market for Greek debt has not reacted much to its rescue package announcement because it does not address the fundamental problems of Greece and the European Union (EU). It is very difficult to assign a high probability to the scenario in which Greece’s public sector adjusts by more than 10% of GDP during the next 3 years, passes reforms to increase productivity growth enough to reduce its competitiveness issues, and returns to growth. Thus, it is easy to infer that the EU had designed its rescue mechanism as a benevolent way to postpone Greece’s oust from the union, given that it would be able to say that 2-3 years of strong financial support were not enough.

The solution is not simple, as it requires a combination of debt restructuring and exiting the euro. Uruguay’s 2001-2003 experience should serve as an example of what to do. A pre-emptive debt-restructuring (without default) is the best option. In the case of Uruguay, the IMF provided the credible threat that induced bondholders to participate in a debt-restructuring swap. In the case of Greece, the EU can provide it, threatening to stop support or to expel it from the euro if there is no restructuring. Not being experts in Greek economics, we leave the details to others.

China
The overheating of the Chinese economy, the measures to address it, and the potential currency appreciation have been recurrent themes in the markets, as they should.

China’s economy is growing strongly, but its government’s efforts are only to slow it down, and are unlikely to achieve a fast or strong enough result to produce a real negative effect on trading partners. Whether bubbles are being created is a different and more profound topic, which we will address separately.

The strong Asian recovery is one of the key economic developments today, which we fortunately had envisioned for about a year, and our portfolios have reflected that. We believe in the continuity of this phenomenon, and the gradual appreciation of many of the regional currencies.

We believe the Chinese currency is bound to appreciate beyond what is priced by NDFs, which is why our portfolios are exposed to CNY.  Singapore’s recent sudden decision to appreciate its currency is one signal of the momentum behind this development.

Economic and earnings data
Economic data from the US, Asia and Latin America continue to surprise on the upside. There is almost no serious economist predicting a double dip. We agree with the view that the global economy is converging to its new secular growth path. It is very important to follow G7 countries’ fiscal issues, as that burden is bound to be a drag for growth for those countries. We continue to believe the non-G7 OECD countries and best EM countries  will outperform the latter. However, we are re-assessing our view on the US, as it remains the most flexible and adaptive economy, capable of generating changes to address its fiscal problems. As an anecdotical aside: which other country has (or has had) its president, central bank president, finance minister and most of congress explicitly calling its fiscal situation unsustainable? What other country has had such honest own-characterization and not seen its asset prices collapse?

Financial reform
This is the next symbolic piece of legislation the government is seeking to add to its list of merits (after health care reform). In this case, the congressional negotiations are evolving in a much smoother and productive manner. Unfortunately, this debate happens in an overall populist environment. The end result is not yet known. But following the details and their impact on the functioning of the market matters.

In sum, these are the relevant phenomena we believe will affect markets over the next few weeks (plus a few tail-risk events). Our view is that economic and earning data will suffice to support markets, and potentially take them higher soon. We maintain most of the main ideas behind the design of our portfolios. We see most other issues as noise, which can escalate to real problems.