Five Global Risks to Monitor in 2012 (Hester)
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Five Global Risks to Monitor in 2012
Bill Hester, CFA, Hussman Funds
January 2012
As we're all a bit forecast weary by this point in the year, here's a list — not of prognostications — but rather of potential risks that may come into even greater focus this year. These risks – whether they intensify or pass – will likely play an important role in driving the performance of global stock markets in 2012.
1) The Persistence of Wide Spreads Among European Debt – Even if Bond Holders are ‘Rescued'
There are two components of the European credit crisis — debt levels and economic growth prospects. While the conversations to this point have leaned mostly toward reducing debt levels, economic growth prospects and the overall viability of a common currency will likely get a closer look this year, especially as Europe heads for recession.
During this two-year crisis investors have continually called on the ECB and euro area leaders to ‘fix' the debt issue: by wiping out half of Greece's debt, by protecting Italy's access to debt markets through bond purchases, or by suggesting a levered EFSF, the euro area's rescue vehicle.
But even if the ECB does bend to the will of the bond markets this year, and begins to buy sovereign debt directly, the single currency is left with all of the same weaknesses that existed prior to the crisis: the inability to tailor interest rate policy for each individual economy, the lack of foreign currency adjustment needed to offset differences in competitiveness, and growth-limiting trade dynamics throughout the area.
Martin Feldstein, a long-time euro skeptic, in this month's Foreign Affairs magazine made the point this way: “During the past year, Germany had a trade surplus of nearly $200 billion, whereas the other members of the eurozone had trade deficits totaling $200 billion. A more comprehensive measure that factors in net investment income reveals that Germany has a current account surplus of nearly five percent of GDP, whereas Greece has a current account deficit of nearly ten percent of GDP. Put another way, Germany can invest in the rest of the world an amount equal to five percent of its GDP, whereas Greece must borrow an amount equal to nearly ten percent of its GDP to pay for its current level of imports”.
One of the strongest benefits at the introduction of the common currency was that investors priced government debt similarly across the euro area. During this period investors thought of the euro area as a group of countries that would not only share a currency, but also share economic performance and long-term outcomes. Smaller countries and those of southern Europe experienced the greatest amount of benefit from converging yields. Yield on Greek debt fell by more than half in less than 10 years. Even stock market valuation ratios converged. The spread between the countries with the highest and lowest PE ratios dropped by more than half during the period.
While this period could have been used to improve some of the issues surrounding productivity, competitiveness, and trade dynamics among countries, what occurred instead was that governments took on larger amounts of liabilities, and as interest rates fell, housing bubbles formed. With that period passed, it's difficult to imagine that investors will soon return to the mindset that Portugal, Ireland, or even Italy, will soon again converge materially – in either economic performance or level of credit risk — with Germany.
I highlighted this risk and the graph below early in the European credit crisis ( The Great Divergence ). At that point the sovereign debt of Portugal was priced at 200 basis points above German bunds, compared with 1100 basis points today. Here is an updated graph.
There is a long history prior to the period of the shared currency where spreads among countries and with Germany were dramatically and persistently wider than even today. This was because expected economic growth rates, inflation expectations, and the real rates required by investors differed. Now that investors have been reminded of the structural weaknesses of a common currency – even outside of the discussion of high debt loads — persistently high spreads may be here to stay. Those spreads will surely play a role in the potential long-term growth rates of economies and euro area stock market valuations.
2) Sovereign Debt Rollover Risks
When the history of the European Credit Crisis is written, it'll likely be in two parts. The first part will cover the debt crisis of the smaller European countries – mainly the woes of Greece, Portugal, and Ireland. It will cover Greece's admission that its accounting didn't add up. And how Ireland's bad bank debt was turned into sovereign debt – which tripled its debt to GDP ratio in just three years. It will also cover the trajectory of peripheral sovereign bond yields in the face of investor uncertainty, where yields were first pushed above seven percent, and then eventually to much higher levels, forcing a rescue program.
The second part of the story will be about Italy and Spain, and potentially France, and how they were either pulled into the fiscal debt maelstrom or whether the ECB and euro area leaders were able to ring-fence them from the more troubled smaller euro countries. It will cover whether investors pushed these core countries from liquidity concerns to solvency concerns. While these chapters are still being written, the outcome may very well be available to historians (and investors) much sooner than many are expecting. One reason is because of the vast amount of sovereign and bank debt that is due to mature this year, all of which will needed to be rolled over because of existing budget deficits. The two countries that pose the greatest risks for rolling over this debt are Italy and Spain.
The chart below gives some sense of the relative importance of Italy – and to a slightly lesser degree Spain – in meeting its rollover demands this year versus the smaller euro area countries. The graph shows the cumulative amount of debt that will mature this year in the countries listed. (These totals count all government debt coming due – including shorter term notes – and are therefore larger than estimates of only long-term debt.) The graph shows the limited bond market needs (and therefore rescue funds needed) of Greece, Portugal, and Ireland, relative to those of Italy. Also, notice how steep the line is for Italy's maturing debt during the first four months of the year – when almost half of this year's total debt will mature.
It will be important to watch bond auction demand in Italy and Spain in the beginning of the year. The recent bid to cover ratio – a measure of the eagerness of bond investor to participate in an auction – for Italy's 10-year notes has mostly been in line with results from early last year. Of course, the level of yield will also matter. The chart below shows the weighted coupon of the existing debt outstanding for each country (in blue) versus the current yield (using the weighted maturity of existing debt) of its bonds (in red). For many years during the Euro's first decade, borrowing costs continued to fall versus the average cost of the existing debt of these countries. This trend has now changed for most of Europe, except Germany and France. This will likely continue to further widen economic divergences among countries.
This is one more benefit Germany is deriving from the crisis. In addition to a weaker euro, which helps fuel its export-oriented economy, the cost of financing its sovereign debt relative to its existing debt continues to fall while the smaller countries struggle with rising financing costs.
3) The Depth of Italy's Recession
It would be difficult to overemphasize the importance of Italy retaining access to the bond markets, and mitigating further losses in its sovereign bonds. According to the Bank for International Settlements, foreign claims on Italian debt total $936 Billion – that's larger than the combined foreign claims on the debt of Portugal, Ireland, and Greece. And core Europe is long a mountain of Italian debt. French banks, for example, hold 45 percent of Italy's liabilities. Much more is at stake than France losing its Triple-A rating if Italy moves from a liquidity concern to a solvency concern.
What eventually would force that shift is if investors come to believe that the country's ability to handle its debt load over the long term is compromised. Those concerns can be partly alleviated if Italian Prime Minister Mario Monti delivers a balanced budget by 2013, which he promised this week. Unfortunately, near-term economic risks could make these goals difficult to meet in practice.
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Tags: Account Surplus, Bond Holders, Bond Markets, Credit Crisis, Debt Issue, Debt Levels, Debt Markets, Foreign Affairs Magazine, Foreign Currency, Global Risks, Global Stock Markets, Growth Prospects, Hussman Funds, Interest Rate Policy, Martin Feldstein, Prognostications, Reducing Debt, Single Currency, Sovereign Debt, Trade Dynamics
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