The selloff this week is due to the quick and simultaneous effects of concerns on the 3 main risks on the global economy. For some time now we had identified 3 key risks, and after a quick recovery from May-June’s volatility, those 3 risks came to center stage at once:

1-    Euro crisis, due to the institutional flaws underlying the currency, which manifest in weak fiscal position. Market is now focused on Italy, which has a high level of debt and low growth, but a small deficit (no primary deficit). Italy does not seem to have a solvency problem, though Greece does.

2-    US fiscal problems, with the August 2nd debt ceiling deadline approaching and the debate not showing a clear path ahead. Debt markets do not believe a technical default is likely, but the debate produces a bail of uncertainty on all markets.

3-    Oil prices and the Middle East transitions (or lack thereof), now with Syria’s oppression of popular demonstrations now followed by attacks on G7 embassies of countries seen as supporting the popular uprising.

The key event is clearly the European crisis, and how quickly it has turned into market pressure on one of the 3 largest economies in the currency zone. Italy’s debt-to-GDP ratio of about 120% and very low growth (0.6% annual average growth during the last 12 years) seems to make it one of the countries the market focuses on in terms of capacity to refinance. However, its fiscal position is not dramatic (flat primary deficit, needs a 3% primary surplus to meet EU rules). Any reasonable fundamental analysis would show that Greece is clearly not sustainable, maybe Portugal, less so Ireland, and clearly not the case for Spain or Italy. In an ideal world, the policy reaction is designed accordingly, potentially differentiating those cases, to isolate sustainable countries while allowing the clearly unsustainable to restructure.

Every time we discuss the institutional weaknesses of the euro we do highlight that the key risk is the potential coordination failure amongst politicians in the region. The currency union without a fiscal union, and no regulatory unification produces differences that are difficult for different political systems to coordinate and deal with efficiently during a crisis. This is why we have seen the debate transit through ‘no default’ to ‘burden sharing’ to ‘selective default’ to ‘no selective default but voluntary re-profiling’ back to ‘maybe restructure or allow selective default’.

The other two main risks do concern us, but are not threatening the global recovery as the shock to confidence from the euro crisis does. The US political system is clearly working under the common principle that a technical transitory default is not an option. The question is the size of the fiscal deal to be struck before the debt ceiling vote. A USD 4 trillion (10 year fiscal adjustment) target does not seem realistic at the moment, but even a USD 2 trillion deal would be better than expected and be positive for markets. We do believe there is a serious possibility that the dollar is at the beginnings of a comeback, in part due to a better fiscal deal this year, some inflation pushing the Fed to at least a verbally vigilant position, and economic growth during the rest of the year improving. Labor data last week was certainly not helpful for this scenario.

Back to Europe, despite our skepticism about the capacity of EU politicians to produce an efficient crisis resolution mechanism, we believe that somehow the outcome will differentiate Spain and Italy from Greece (and maybe Portugal), and the euro will not unravel in a quick fashion. In the short-term this means market intervention to defend Italy. In the medium-term it means a debt-restructuring mechanism for those not sustainable, hopefully designed and implemented by the EU and IMF, with the example of Uruguay in mind.

Conclusion: we had reduced risk on May 5th, bought some back by June 20th, and are looking at these volatility with caution. As our basecase shows signs of happening, we would see these weeks as an opportunity to increase risk. However, there is no need to rush in, as these events do have the potential to become more virulent.

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