The global economy is facing major hurdles which require decisive action. Initial responses have not been enough. This post looks at the inter-related risks of a further slowdown and deteriorating sovereign debt situation in Europe.
A sick patient
After a good initial recovery, the global economy is back in intensive care. The recovery that began in the middle of 2009 has weakened. There is now an increased urgency for strong policy actions in Europe and the US in order to avoid a full relapse.
There are two big inter-related problems. The first is that economic recovery has slowed to a crawl in the major developed economies. The second is that sovereign debt problems in Europe, as well as the US, have worsened.
These two trends have increased risks, and taken their toll on confidence – for consumers, companies, and investors.
These concerns are not just hype. The latest data confirms a significant slowdown in the major western economies over recent quarters. The European sovereign debt crisis has deteriorated further.
The medicine has not been enough
The immediate outlook for Greece’s debt problems is very uncertain.
Greece has just missed an important target. The latest budget approved by Greek cabinet predicts a budget deficit for 2011 of 8.5 per cent of GDP, compared with the agreed target of 7.6 per cent.
It’s still likely that Greece’s efforts, which include job losses and big salary cuts, will be enough for European officials to support the next payments due on Greek bonds in the coming weeks.
But the longer term prospects for Greece remain poor.
The severe austerity measures that Greece has undertaken to bring its budget deficit down from almost 15 per cent to 3 per cent of its economic growth by 2014 has resulted in deep recession and civil unrest.
This is only making it harder for Greece to implement a range of necessary adjustments to meet its onerous financial obligations.
Some form of ‘default’ on Greek government bonds remains likely at some stage. The challenge will be to control, or ‘ring fence’ the consequences. The markets are not yet convinced that Europe’s leaders are up to this challenge.
Preventing the disease from spreading
Sovereign debt defaults are not unusual. Greece has been in default more than 50 per cent of the time since gaining independence in 1829. But this time Greece’s problems are Europe’s problems and the numbers are much larger than before.
Greek public debt is now about US$500 billion. To put this in perspective, Argentina’s debt was US$82 billion when it defaulted in 2001 and Russia’s debt was at US$79 billion when it defaulted in 1998.
US economist David Hale has concluded that European Banks have around US$163 billion of exposure to Greece, while non-European banks have around US$44 billion. France has the largest exposure followed by Germany and then the UK. More than half of Greece’s public debt is now owned by official institutions such as the International Monetary Fund (IMF) and the European Central Bank (ECB).
The risk of default has come at a really bad time, when growth in the major economies may be about to turn negative.
The worst possible outcome would be an uncontrolled default. This would probably entail Greece leaving the European Union. The risk of contagion would be very high for other high debt European governments and the broader financial system.
The markets are grappling with a range of possible solutions, including the expansion of the existing bailout fund (European Financial Stability Facility) from €440 billion to around €2 trillion and the formation of common Euro bonds.
A controlled default is a possible option to bring Greece’s debt back to more manageable levels – both in the short and longer term.
What does this mean for investors?
In recent months, the deteriorating outlook has led to a renewed bout of selling ‘risky’ assets such as shares and the Australian dollar and resulted in strong flows in perceived safe markets such as US government bonds and cash.
The recent falls in sharemarkets is already pricing in the risk of a major slowdown in profit growth. On most conventional valuation measures, this means that markets have become oversold.
The global sharemarket is trading at a discount of approximately 30 per cent and the Australian sharemarket is trading at a discount of 22 per cent.
For some stocks in these markets, valuations have been effectively pricing in no real profit growth.
Oversold markets do not mean that markets can’t fall further, or that new developments might emerge to justify these levels.
They do mean that investors should seek to avoid becoming forced sellers at a time when markets are undervalued,and longer term investors face a potentially attractive entry point for new cash into the market.
Another feature of oversold markets is that they can react sharply to any good news.
A combination of a stronger US dollar, slower growth, fall in commodities and uncertainty surrounding future interest rate movements by the RBA has caused more volatility in the Australian dollar.
Over recent months, this volatility has halved the fall in global equities for Australian based investors.
The most recent ‘flight to safety’ has seen US Treasury bond yields fall to 2 per cent. Bond yields and prices have an inverse relationship. For example, a rise in the yield of a ten year treasury bond from 2 per cent to 3 per cent would result in a capital loss of approximately 8.5 per cent.
In this kind of environment, it’s even more important to have a plan which allows for uncertainties rather than relying on predictions.
The current situation may get worse before it gets better. Alternatively, a path to resolving the current imbalances may be achieved, in which case the markets may adjust to a better outlook.
Plans which allow for a range of outcomes can help investor confidence. Ensuring sufficient cash is available for short term needs helps reduce the risk of becoming a forced seller into oversold markets. A disciplined plan for longer term growth assets reduces temptation to switch into overbought assets – which may not be as safe as they seem.
For more back ground on this issue, you can also read my previous posts:
Sovereign debt defaults: Not an unusual occurrence (July 2011)
Greece is going to come back into the splotlight (May 2011)
Greece – The fire is out, but there are still problems (May 2010)
