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A Five-Step Guide to Contagion

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Why European debt matters to the United States.

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As the European Union and International Monetary Fund wrestle with how to address the sovereign mess, our financial fate can be drilled down to one very simple question: Will we see contagion, as we did with Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG), Bear Stearns and Lehman Brothers, or will the current congestion be contained in the context of an evolving globalization?

The bulls will offer that corrections must feel sinister if they're to be truly effective. They're right, of course, but I will remind you of a salient point made by Professor Peter Atwater on Minyanville. If sovereign lifeguards saved corporations when the financial crisis first hit, who is left to save the lifeguards?

Over the last few weeks, we've seen significant widening in overseas credit spreads, including Hong Kong, Switzerland, Indonesia, Malaysia, Portugal, and New Zealand. As markets are fluid and policy takes time, the lag must be factored into the fragile equation, particularly as the European Union is structurally interlinked.

Sadness

We can talk about how the capital market construct forever changed, how our constitutional rights have been challenged or how the lifestyles of the rich conflict with the struggle to exist. While those dynamics remain in play, they miss an entirely more relevant point for purposes of this discussion. (See The Declaration of Interdependence)

Social mood and risk appetites shape financial markets. One of the greatest misperceptions of all time was that The Crash caused The Great Depression when The Great Depression actually caused The Crash.

It's been a full year since Minyanville fingered Eastern Europe as a modern day incarnation of a sub-prime borrower. The question is therefore begged, what if Greece is Fannie Mae, Portugal is Freddie Mac, Spain is AIG, Argentina is Wachovia Bank, and Ireland is Lehman Brothers? (Also read Eastern Europe, Subprime Borrower)

Contagion, by definition, arrives in phases and we must remember that Greece is a symptom of the problem, not the problem itself. Regardless of what IMF or Euro Zone "cross border solution" we see, it'll simply buy time, much like the bearded nationalization of Fannie and Freddie pushed risk out on the time continuum.

Given the trending direction of social mood and the discounting mechanism that is the market, the perception that defines our financial reality must remain front and center in the mainstream mindset.

Acceptance

In September 2008, we offered that the government invented fingers to plug the multitude of holes that sprang open in the financial dike. That imagery would again apply if there were viable fingers attached to a healthy and able arm.

While many dismiss the notion that Greece or Portugal "matter" in the global financial construct, I'll explain why they might. Concerns in the Euro Zone could manifest through a "flight to quality" in the US Dollar, as it has to the tune of 8% in the dollar index (DXY) since the December low.

Those hoping for a stronger greenback should be careful for what they wish, much like the "lower crude will be equity positive" crowd learned in 2008. In an "asset class deflation vs. dollar devaluation" environment, a weak currency is a necessary precursor to -- but no guarantor of -- higher asset class prices. (Se Hyperinflation vs. Deflation)

The hedge fund community currently has the carry trade on in size. If the greenback continues to strengthen, the specter of an unwind increases in kind. Should that occur, asset class positions financed with borrowed dollars would come for sale across the board.

The point of recognition will eventually arrive that our debt issues are cumulative; when that happens, the contagion will no longer be contained. In the meantime, as we edge from here to there, be on the lookout for the unintended consequences of European austerity initiatives, including but not limited to social unrest and the abatement of risk appetites.

Risk management over reward chasing as we together find our way.

R.P.
No positions in stocks mentioned.
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