Periodic panic attacks related to macro concerns have been a recurrent theme of the past two years. Meanwhile, almost behind the scenes at the micro level, companies have consistently surprised analysts with stronger than expected operating performance. Over the past 12 months, corporate profits have grown by 39% in the US, 35% in Europe and 27% in China.
The question remains then, will macro events derail the positive bottom-up story?
Our baseline scenario is that most likely they will not. This explains our continued positive view towards global equities. However, we acknowledge that in today’s “unusually uncertain” environment the risks remain elevated.
Europe’s sovereign debt crisis: high stakes
Our greatest concern currently is the situation in Europe. For some time now, we have been of the view that any crisis contained to smaller peripheral countries such as Greece, Ireland or Portugal would be manageable and not pose a systemic risk.
The EU/IMF bailout facilities put in place in May should comfortably cover the funding requirements of these countries for the coming few years. Moreover, there is a clear determination among European officials that these countries will not be allowed to default (or restructure) before 2013, when a permanent stabilisation mechanism is expected to be introduced.
An escalating crisis
But the crisis has, in many ways, become more serious in recent weeks. Spain especially and Italy have experienced a sharp rise in bond yields (over 100 basis points and 50 basis points respectively on 10-year yields in little more than a month) as the market anticipates the next domino to fall after Greece and Ireland.
If we are correct to think that Portugal’s situation is of only minor significance to the wider European financial system, the key questions become: will Spain be forced to seek a bailout? If so, can Europe afford it?
The situation in Spain is closer to Ireland than Greece. The former countries both ran surpluses and previously had very low levels of government debt. On the face of it, their governments looked extremely prudent. But both countries experienced enormous housing and construction bubbles fuelled by cheap credit that have since gone into reverse with a vengeance. Spain enacted fiscal stimulus; Ireland austerity, but the respective recessions have had severe consequences for public finances.
The implosion of nominal GDP, house prices and the financial sector has been much greater in Ireland, however. Ultimately, bank losses torpedoed the Irish government.
At present, there are concerns that the banks could do the same in Spain. In our view, it seems likely that Spanish banks will need more capital injections. Unlike Ireland, however, based on a severe stress-test analysis we think those capital requirements are unlikely to pose a major risk to sovereign solvency. That said, bank financing requirements in the first half of 2011 are large and pose a liquidity risk.
From a fundamental perspective, our conclusion is that, while extremely challenged, Spain’s position looks considerably less dire than that of either Greece or Ireland. Spain appears solvent; the others did not, in our view.
Belief undermining fundamentals
But fundamentals are only worth so much in the current environment. ‘Beliefs’ determine the outcome because they affect behaviour: a collective belief that the Spanish sovereign might be insolvent can in effect make it so. Without intervention, a crisis of liquidity can quickly become one of solvency. In economist jargon, there are ‘multiple equilibria’; to anyone else, ‘anything is possible’.
This being the case, the stakes are high: Spanish government debt is greater than the sum of Greek, Irish and Portuguese government debt. Doubts would arise over the ability of the current European stability funds to finance a Spanish bailout. Were Spain to go to the brink, Italy, with approximately €1,800bn debt outstanding and around €250bn to finance annually would also face intense pressure. It is easy to see how this crisis could get worse.
Increased investor risk appetite, some good news from Spain, a recovery in growth, a more proactive ECB policy, a pre-emptive increase in EU/IMF bailout facilities – all are plausible reasons why investor concerns might ease. However, in our view, it is impossible to tell with certainty how this all ends, which is why Europe’s peripheral sovereign debt problem continues to pose a risk to global markets.
Winston Churchill once said, “Americans can be counted on to do the right thing…after they have exhausted all other possibilities”. We have to hope that the same applies to European policymakers.
