Sovereign Crisis Roadmap

We recommend selling risky assets into strength over the near term. Even with an
expected announcement on Greece following the EU Summit today, the road to repair
will be a long, painful journey buffeted by tremendous uncertainty—not typically a great
environment for risk-taking. While the announcement details will garner the headlines,
the real medium/longer term issue for the markets is not whether troubled sovereigns
get the needed aid/liquidity, but rather, whether the aid and the accompanying
necessary fiscal retrenchment leads to an unexpectedly soft mid-cycle economic
slowdown—or, worse, a double dip—for the developed world.

What the markets are missing. CDS spreads on Greek sovereign debt, yield-curve
steepness, and earnings expectations implicit in equities are all too sanguine given the
severity of the crisis. The market is underestimating the tough domestic fiscal reform
needed, without which ECB liquidity support is unlikely to be forthcoming. And because
of the close interrelationships between the European banking system and sovereign
credit, the contagion effects are much greater than the market perceives.
Crisis reinforces our core views and recommendations. In a risk-differentiating
environment: (1) the euro will continue to weaken regardless of how the Greece
situation evolves; (2) the significant economic growth differential of the emerging world
(6.9% vs. 2.3%) will reassert itself, and thus its outperformance relative to developed
markets; (3) if and when markets settle down, we expect the 10-year to meaningfully
underperform as the flight-to-quality subsides; and (4) the trade in global equities is still
high-quality stocks that can handle uncertainty-induced swings.

At present, the Greek CDS spread at 355bp is pricing in a 28%
default probability over the next 5 years. This is up from a 9.5%
cumulative default probability back in June 2009. While we take real
issue regarding implied default probabilities on sovereign CDS, it is
nonetheless a useful point of context. Although Greece’s inclusion in
the EU complicates matters somewhat, we have yet to see a sovereign
or credit “crisis” bankruptcy-averting restructuring deal at a meager
price point of 355bp.

From a curve perspective, we would also have anticipated a flattening
of the various government curves, yet we experienced a parallel shift
instead. From a European earnings growth perspective, bottom-up
IBES consensus is 35% for 2010, and 24% in 2011. Given the
necessary fiscal retrenchment in Europe, those growth expectations,
particularly for 2011, seem potentially heroic.

Markets are in the early stages of differentiating risks. In its
simplest form, the negative market reaction around the sovereign debt
concerns of peripheral Europe is a natural by-product of “the end of the
easing,” both real and perceived. From necessary fiscal tightening in
Europe to monetary tightening in China, the markets are simply
reacting to the withdrawal of liquidity. With respect to the peripheral
Europe situation, the combination of fiscal austerity and contagion
concerns, which, not surprisingly, are linked, will persist for some time
to come, and thus so will volatility.

READ FULL REPORT HERE