The complacent calm that has overtaken financial markets thus far in 2013 will be put to a rigorous test in the coming days. This is due to the news that came out of Cyprus over the weekend. On Saturday, the tiny island nation and member of the European Monetary Union received a bailout in order to rescue their collapsing banking system. It is not the fact that emergency action was required in an attempt to rescue yet another troubled European economy, however. After all, such news has become almost commonplace in today’s post crisis world. Instead, what is notable and potentially problematic for financial markets is the manner in which this latest bailout is being carried out.
So how can such a small place like Cyprus have any meaningful effect on the global economy? After all, the United States will produce enough output in the next 12 hours to match the Cyprus GDP for the entire year. It is because of the potential spillover effects resulting from how the bailout being imposed.
In short, Cyprus is receiving a 11 billion euro rescue package from the European Union (ESM) and the International Monetary Fund (IMF). But in order to receive these bailout funds, the Cypriot government must impose a 5.8 billion euro tax on bank deposits. Otherwise, the Cypriot banking system will be left to collapse and the country would likely have to exit the euro currency. As the deal stands as of late Sunday night, this includes a 9.9% tax on uninsured deposits over 100,000 euros and a 6.75% tax on INSURED deposits up to 100,000 euros. It is precisely on this point where the Cyprus rescue plan has roiled the markets heading into the trading week. For the tax is not being applied to shareholders or bondholders where the risk of loss is understood. Instead, it is being levied on depositors. And not just uninsured depositors, but also INSURED depositors. On this point alone, we are now moving into dark and murky unchartered waters in this latest phase of the post crisis period.
When I teach the chapter on money and banking in my macroeconomics classes, I conduct a case study on what happened to the banking system during the financial crisis. This includes a detailed examination of how bank balance sheets work. The case study explores how the investment value for stockholders and bondholders in certain banks were either wiped out or heavily impaired as a result of the crisis. But the one part of the bank balance sheet that is always considered essentially bulletproof in the study is insured customer deposits. In short, if a customer deposits money with a bank, these funds will be made good to the customer no matter what and for good reason. The following example to better illustrate what is happening this weekend in Cyprus shows why protecting insured deposits is so important.
As a purely hypothetical illustration, imagine you have a checking account at your local bank here in the United States. Not a long-term investment account with stocks, bonds and commodities where it is understood that prices fluctuate on a daily basis. Not even a money market mutual fund where some incremental risk of principal is assumed to achieve a slightly higher interest rate. It is a checking account that you are using to manage your daily budget including paying your bills and accessing cash for immediate required expenditures. Suppose you have $100,000 cash in your FDIC INSURED checking account, which means that even if the bank goes bankrupt tomorrow your money is fully guaranteed by the United States government. Going into this weekend, you would have $100,000 in cash in your checking account that you would understandably assume is completely safe. But under the Cypriot bailout scenario, you find out after the bank closed on Saturday that your account is only going to be worth $93,250 when it reopens on Monday because the U.S. government has suddenly and unexpectedly taken $6,750 from your checking account in order to carry out an emergency bank rescue plan. Not only would you likely be upset and your confidence shaken, but you may also be inclined to rush to the bank to withdraw the remainder of your money as quickly as possible to protect against the potential for any future and unexpected levies. Such are the origins of bank runs, and this is exactly what is happening right now in Cyprus.
This, of course, is not happening in the United States, and Cyprus is a very small place. So why does all of this matter to global financial markets? Because Cyprus is a member of the European Monetary Union. And they are being induced to take these actions against insured depositors along with political reasons in order to continue using the euro currency. But Cyprus is not the only country in the euro zone that is dire financial straits and potentially in need of rescue funds. So too is Greece, Portugal, Ireland, Spain and Italy. And for a person that is living in any one of these other at risk European economies that is watching what is happening in Cyprus this weekend, their natural instinct is to wonder whether their bank deposits may suddenly be next. As a result, many depositors across Europe are likely evaluating whether they need to get to the bank in the coming days to withdraw their own money. If we were to see bank run activity pick up momentum in any of these European countries in the coming days, it could have a meaningfully destabilizing effect. And the one thing more than anything else that financial markets including stocks dislike, at least in normal market environments, is uncertainty.
The potential fallout effects from the unexpected situation in Cyprus highlights the continued importance diversification in today’s post crisis investment markets. The stock market has steadily risen in 2013, but they have been alone in this advance as bonds have been flat to slightly lower and precious metals have fallen into correction. Unfortunately for stocks, however, the rally thus far this year is being almost exclusively driven by the flow of liquidity from the latest QE monetary policy stimulus program from the U.S. Federal Reserve, as economic growth has otherwise ground to a halt and corporate earnings have fallen into decline in recent quarters. In short, the recent stock rally is built on sand and is now overextended from a technical standpoint. Thus, any sudden shocks have the potential to evaporate the year’s worth of stock gains in a matter of days. Whether the events in Cyprus ends up being such a shock remains to be seen – stocks futures are down -20, or -1.3%, on the S&P 500 heading into overnight, but stocks have proven remarkably resilient to any bad news under the influence of QE, so a positive close on Monday would not at all be a surprise. But high quality bonds and precious metals are already well overdue to regress to the mean relative to stocks, particularly at this stage of the latest QE program, and these categories would stand to benefit most under any correction scenario. Thus, a rotation of liquidity out of stocks and into these more defensive safe haven categories is also a more than likely outcome even without the Cyprus situation.
I had already reduced portfolio stock allocations considerably ahead of the weekend before the outbreak of events in Cyprus. This was due in part to the fact that the stock market had arrived this past week at major long-term resistance in the 1555 to 1580 range on the S&P 500 Index, for this is exactly where the stock market first peaked in March 2000 and topped out again in October 2007 only to go on and decline by more than -50% in both past instances. Given the fact that the recent move higher in stocks is already overextended and long overdue for at least some sort of correction, stocks are at a minimum likely to pause and face serious headwinds at these levels. And this expectation coupled with the recent news out of Cyprus is supportive of waiting on the sidelines in cash with the proceeds from these recent stock sales into new investments is a prudent strategy at least for the moment until some clarity is gained on how these events are likely to play out in the coming days. The next few trading days should help explain a lot on how things are likely to play out in the weeks and months ahead.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.