“The next six months are likely to include many challenging moments for investors. Debt worries across Europe and the US are justified. However, the outlook for continued growth in China and thus our robust trading activities seem secure.”
Last week we noted the likelihood that hedge funds would commence an attack on equity markets in response to the sovereign debt crisis in Europe. The crisis centres on the deteriorating outlook for Greece, despite its predicament having been predicable for at least a year.
Greece is estimated to be an economy with GDP of about $500B and government debt of about $700B. According to the International Monetary Fund, Greece is the 32nd largest economy in the world, with a population of 11.3 million. In the last 12 months it has generated a trade deficit of $35B, a current account deficit of $26B and is forecast to have a fiscal deficit of $40B in this financial year. This latter forecast of a fiscal deficit of about 8% of GDP defies logical analysis as the interest bill alone on the Greek debt would approximate this level.
Greece’s unemployment rate has reached 15%, inflation is running at about 4% and its ten year bonds have popped above a 16% yield. A cursory glance at the above statistics would lead any reasonable economist, if not a school boy, to conclude that Greece is going to default. There is no way out and so what does it mean? What will the response be of the European Union and the markets?
In our view, because the default has been coming for such a long time, the market will deal with the ramifications fairly well. Indeed the delay in the default timing has been due to the continued intervention of the European Central Bank (ECB). The ECB has been delaying the inevitable in an attempt to shelter European banks from having large write downs of their Greek bond holdings. The major holders of Greek government debt would appear to be German and French banks. Thus, once the default occurs our prediction is that the German and French Governments will be forced to underwrite their banks deposits once again, just like they did in 2008. The governments may even buy Greek debt from their banks and transfer the losses to their own fiscal positions. Hopefully there will be a bank tax for this arrangement. In any case the markets will reset and prepare themselves for the next possible default – from Ireland, Portugal, Spain or Italy.
A quick glance at the big euro members
Figure 1. The economic predicament of the eurozone
Source: The Economist
The above countries represent 70% of the eurozone and it is striking to observe that it is Germany and to a lesser extent The Netherlands, that are driving the international trade of the region. Indeed the eurozone would look pretty awful without the Germany economy.
Think of it this way. If you subtract Germany from the eurozone then the GDP drops to about $14.2T which is the approximate size of the US economy. When you make this adjustment then the eurozone has remarkable similarities to the US, with a high trade deficit and high unemployment. Whilst the fiscal deficit of Europe (ex Germany) is uncomfortable at 5% of GDP it is actually half the rate of the US deficit (10% of GDP). On this basis one can conclude that the real debt problem resides in the US and not Europe. (On the other hand, the US has a growing and younger population and a far more dynamic and innovative economy.)
Eurozone total government debt is currently estimated to be about 80% of GDP or about $15T. Thus Greece represents about 4% of the zone’s debt. On a worst case scenario a 50% write off of Greek debt would represent a $350B hit to bond holders of which the bulk would ultimately be felt by the ECB, German and French institutions. Hence we can see the basis of the disagreement between these governments as to how to deal with Greece. The German view appears to be hardening such that it considers that it is better to support its own banks (and it can afford to) rather than supporting the Greek Government. The French want more bailout money, from everyone, to go to Greece because it cannot afford another bank bailout. Its economy and fiscal position is already stretched.
Figure 2. Share of total eurozone debt
Source: Thomson Reuters Datastream
In our view the bigger issue for Europe could well be the emergence of Italy as a major debt problem. Its public debt is ballooning to 120% of GDP and is approaching $3T or 23% of total eurozone debt. This week it was put on credit watch by Standard & Poor’s (stable to negative) for a downgrade and this is a most concerning development. The above leads us to the following conclusions:
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> The eurozone has many years of slow growth ahead and there is a developing rift between Germany and France as to how to deal with the problem;
> The problems of Greece, Ireland and Portugal are manageable but an escalation of worries to Italy and Spain would be far more serious;
> Australia’s public debt position is far superior to that of Europe and the US and we are confident that fiscal assistance for the Australian financial system is available should it be required;
> The constant banter by global hedge funds that Australian banks could be stretched by wholesale funding costs or mortgage stress misses the importance of Australia’s superior sovereign debt position and our growing economy; and
> The world’s bond markets are fractured and are not operating efficiently. It is truly bizarre that Italian 10 year bonds yield 4.8% against Australian bonds of 5.2%.
The next six months are likely to include many challenging moments for investors. Debt worries across Europe and the US are justified. However, the outlook for continued growth in China and thus our robust trading activities seem secure. Unfortunately, at present our country’s political leadership is failing to set an agenda or a strategic vision that our business leaders, investors and householders can embrace or be inspired by.
Given this context we continue to believe that portfolios should maintain a healthy cash balance as opportunities are likely to be presented in coming months in a very volatile market.
As for the Australian banks, we note that current share prices suggest that earnings will fall substantially in 2011/12. Based on current evidence we suggest that this is unlikely but we note with some caution the attack by international hedge funds on our banks. Our worst case scenario would be for flat earnings resulting in a rise in payout ratios – lifting dividend yields towards 6% fully franked. We discount the issues surrounding offshore wholesale funding but suspect that residential property across Australia will correct over the next year by 5 to 10%. However, even this rate of decline will not materially affect the banks as it is unemployment that causes defaults, not price movements, and employment levels are likely to remain strong.
The US
US economic indicators continue to disappoint with industrial production numbers flat, new house sales struggling off rock bottom and house prices declining by over 3% over the last year.
The supply of existing houses will probably remain an issue. There is an estimated 1.8 million homes which are more than 90 days delinquent, in foreclosure or bank owned. This represents a so-called “shadow inventory” set to add to the unsold supply of 3.87 million previously-owned homes already on the market.
The US Government has breached its Congress-sanctioned debt limit but is able to trade on for another two months whilst politicians grandstand in their quest for media coverage. The debate is a simple one. Republicans don’t want the rich to pay more tax and want government expenditure to fall. Republicans love quoting Ronald Reagan’s quip: “Government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidise it.” The Democrats on the other hand want to increase taxes for the rich and maintain expenditure. As the US apparently heads for “default,” the US bond market has rallied with two year yields touching 0.5% and 10 year yields falling to just 3.1%. Seldom has the irrationality of financial markets been so starkly exhibited.
The major investment banks have suddenly upgraded their commodity price forecasts for oil and copper. This view follows hard on the heels of the recent corrections caused by the associates of the investment banks – the hedge funds – who en masse panicked markets a few weeks ago. One is constantly left wondering whether the forecasts of investment banks have any credibility at all.
Europe
Europe’s debt crisis deepened as eurozone political leaders clashed with central bankers after floating the prospect of extending maturities on Greek bonds. That “soft” restructuring may also be accompanied by more loans to Greece, which received a 110 billion euro bailout last year. Currently it is estimated that the ECB holds 47 billion euro of Greek bonds (just under 10% of bonds on issue) and it is likely that this will be restructured at some not too distant point.
The Greek Government has agreed to sell stakes in a range of government owned enterprises which have a market value of 2.1 billion euros. The Government plans to complete the sale of Postbank by the end of the year, and to sell 75% stakes in Piraeus Port Authority and Thessaloniki Port Authority SA. It also intends to extend the concession for Athens International Airport this year. Greece owns 20% of Hellenic Telecommunications, which has a market value of 3.2 billion euros. It has the right to sell a 10 percent stake to Deutsche Telekom AG, which already holds 30%.
All up reports suggest that Greece must raise 15 billion euros through asset sales and reduce its deficit to attract general eurozone support.
Italy was hit by credit ratings agency S&P’s decision to cut its outlook to “negative” from “stable.” In an explanatory statement, S&P said it did not expect Italy to seek financial help from the EU or the IMF due to the “absence of significant imbalances.” The sheer size of its public debt effectively makes it too big to bail out effectively. It is difficult to work out whether this statement is positive or negative.
Lloyds and Royal Bank of Scotland are among 14 UK lenders whose debt Moody’s Investors Service is considering downgrading because the withdrawal of government support may increase their credit risk. British banks are trying to wean themselves off government assistance after receiving about 1 trillion pounds (US$1.6T) in capital and guarantees following the collapse of Lehman in 2008. Australian banks received a small downgrade last week and so the credit agencies appear to be active – finally!
Asia
Japan is now in a severe recession following its tsunami and has recorded two negative quarters of GDP contraction. The Japanese Central Bank outlook statement suggests the June quarter will also be negative with a dramatic decline in Japanese household expenditure. Exports are being affected by significant supply disruptions.GDP contracted an annualised 3.7% in the three months through March, following a 3% drop in the December quarter (pre Tsunami).
NZ announced a record budget deficit of 8.4% of GDP for fiscal 2012 but it is aiming for a surplus by 2015. Total government debt will peak at 30% of GDP in 2015 and that would not rate a mention in Euro land. It is interesting and sobering to note in passing that the earthquake in Christchurch has had a relatively greater impact on the New Zealand economy than the tsunami has had on the Japanese economy.
