Fears of sovereign debt defaults drove traders into panic mode on Thursday, sending stock prices lower around the world. If this sounds familiar it should. Talk of defaults, credit contagion, and the onset of a negative feedback loop were all reminders of the extreme pain investors endured in the not too distant past due to problems with debt and credit.
The core problem is that the countries in question – Portugal, Italy, Greece, and Spain (I.E. the PIGS) – have big debt problems. And as my father is fond of saying, “If your outflow exceeds your income, then your upkeep will surely be your downfall.”
Getting back to the topic at hand (too much debt), the question becomes, what countries don’t have huge debts? Every day, the papers highlight the growing public debt in the U.S. and the U.K. and the numbers involved are simply astronomical. So, why are the markets so worried about the PIGS and their debt?
The difference is the U.S. economy is so large that our debt is always in demand. Thus, the good ol’ USofA probably can get away with borrowing and spending our way out of the Great Recession.
However, when it comes to Greece and Portugal, this is most definitely not the case. In fact, Portugal tried to auction off 500 million Euros of bills on Thursday and had only 300 million worth of takers. As a result of this “failed auction” traders instantly began to worry about the country defaulting on future debt payments.
From an economic standpoint, the fear is certainly warranted. The economies of the world have been hit and hit hard by the global recession. As such, incomes to governments are down significantly from 2007 levels. And if the PIGS can’t borrow money in the open market, then the question of how they are going to meet their debt obligations becomes a tough one to answer.
While there have been no defaults and there are none imminent, the issue of a credit contagion was on the minds of traders Thursday. If (a big if at the present time) one of these countries were to default on a debt payment, the action would create losses at the banks that lent them the money. And as you may recall, losses at banks causes capital problems. Both actions create downgrades, which causes selling, and so on, and so on.
However, it is important to keep in mind that at this stage of the game, we are really talking about fear in the market. And fear can be a very powerful motivator – especially after the two of the worst bear markets in a generation turned 401(k) plans into 201(k) plans. Thus, there is a chance that the current fear-based panic could turn projections of a major correction into self fulfilling prophecy. And if this becomes the case, then investors may want to dust off those strategies for managing risk.
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