What should general investors expect following the Banco Espirito Santo news?
The best-case scenario is that Banco Espirito Santo's (ELI:BES) collapse is an isolated incident and the European Central Bank (ECB) steps up and acts aggressively to support stakeholders and the market.
The worst-case scenario is the following:
Many have been wondering how countries with 20% or higher unemployment rates have "recovered," and now those concerns will rise to the surface.
Since one Austrian bank has already run into trouble, the likelihood that the Portuguese bank's collapse is an isolated concern is low, and some of the weaker banks in the struggling countries may not withstand scrutiny.
Over the past few months, I have commented on the fact that foreign holdings of Spanish and Italian bonds have increased -- a sign that mutual funds and possibly hedge funds have been buying (at or near the tights).
There is very little liquidity, so if a combination of factors -- weak economies, Germany not doing as well as expected (off the football pitch), weakness in banks that have escaped scrutiny, and periphery positions from total return investors at bad levels -- are enough to topple the performance chase, we could see the pullback continue.
The Spanish and Italian stock indices (iShares MSCI Spain Capped ETF (NYSEARCA:EWP) and iShares MSCI Italy Index ETF (NYSEARCA:EWI) in ETF land) have large exposures to banks and should be good shorts. Shorting SPDR S&P 500 ETF Trust (NYSEARCA:SPY) with a heavy dose of our own banks coming into a potentially weak earnings season also makes sense.
For the past few months, ECB President Mario Draghi has hinted at and promised QE in light of his "whatever it takes" talks, and that might now be tested. This the first real test of the attitude in Europe about risk mutualization versus punishment.
The tone set by Germany and the ECB will go a long way towards either calming markets or causing more fear. It has been awhile since the Germans have said "Nein, Nein, Nein." I expect that European leaders that matter (German Chancellor Angela Merkel) and central bankers will say and do less than the market expects (and expectations were already too high on the sovereign debt side).
From my "damned if you do, damned if you don't" report, the economic side of the draw has taken the lead, but I wouldn't discount the geopolitical side from piling on.
From my Treasury reports, the 10-year US Treasury note and US long bond have a deep short base. The front end has little room to rally, so flatteners still make sense here.
Editor's Note: For more from Peter Tchir, check out TF Market Advisors.
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