Similar issues overseas: reduce debt
The Greek vote didn't end the eurozone debt crisis, which is at risk of morphing into a new, concerning phase that could ensnare Spain and Italy.
Contagion still a risk
Source: FactSet, iBoxx. As of July 12, 2011.
At this point, continued lack of decisive steps by policymakers has let confidence slip so far that it may be difficult to rein it back in; and Greece, Portugal and Ireland are becoming increasingly tethered, despite different problems and levels of severity. Greece has had the most severe problems and has missed fiscal targets, but Greece alone is small and is mainly a concern due to its interconnectedness and threat to the union that uses the euro. Inability to stabilize Greece does not give markets confidence policymakers can address other crises that may crop up in the future.
Investors have been further spooked by plans to involve private sector participation in a second Greek bailout, making a return to capital markets more difficult for both Portugal and Ireland as well, which may end up needing second bailouts of their own.
We are concerned about potential for contagion to Spain and Italy, due to their large debt burdens. Why is Italy being drawn in to the fray? Despite keeping fiscal spending generally in check, Italy has the world's third largest public debt load, at over $2 trillion, and a fragile sentiment environment has pushed rates higher. At high debt levels, continuing to refinance debt at rates in excess of potential economic growth is unsustainable.
However, Italy has some things going for it other peripheral countries don't:
- the banking system is in better shape because unlike Spain and Ireland, Italy did not have a housing bubble,
- unemployment is falling,
- debt is primarily held domestically due to high levels of private savings, and
- Italy has a fiscal surplus before factoring in debt service.
A new austerity budget is underway, but there may be ongoing lapses in confidence if political pressure ahead of 2013 elections results in modifications. Additionally, Italian banks are thinly capitalized and own a high percentage of capital in government debt, compromising their stability, and are rumored to be less enamored with holding Italian debt.
Ultimately, we view the differences as significant enough that we don't believe Italy (or Spain) need bailouts, but further lack of market confidence could put contagion at risk.
There is no magic bullet for stabilizing the eurozone debt crisis, only choosing between two unappealing choices—take losses now, or take them later. The threat of contagion and insistence of private sector participation has increased the possibility of recognizing losses now. Meanwhile, peripheral nations also need to address growth by making moves to improve labor market productivity and flexibility, and encourage development of new businesses and industries.
The bottom line? Economic growth in the eurozone may be hindered as we believe eurozone banks need more capital and may raise lending rates and/or scale back credit extension.
Should we reduce international allocations as a result of European headwinds? In a word, no. We view an allocation to international stocks as an important diversification tool for investors, as there is the potential to gain access to differentiated growth and currency diversification. We are positive on the developed markets of Canada and Japan, and believe a renewal of growth in China and Japan could be positive not only for the Asian region, but also export-oriented countries such as Germany.
Will debt in China create a bank crisis?
Part of the bull case for China is that growth has not been fueled with debt, with lower levels of debt at both the government and household level than many developed markets. At the central government level, debt-to-GDP in 2010 was reported at 18%, low relative to the 92% level in the United States, 77% in the United Kingdom and 84% in Canada.
Meanwhile, local government debt in China is subject to much debate, even among government sources. The most recent estimate came from the National Audit Office, of 10.7 trillion RMB ($1.65 trillion), or 27% of GDP, which differs from a previous estimate by the central bank of approximately 14 trillion RMB ($2.15 trillion), and the banking regulator earlier said the amount was 9.09 trillion RMB. A Moody’s study using the three government estimates and making delinquency assumptions estimated future potential non-performing loans (NPLs) at 8-12% of loans. Meanwhile, BCA Research in July indicated NPLs would increase to 4% for two years if the bad loans hit across 2012 and 2013.
Why the scrutiny on debt? Infrastructure and property construction contribute over 50% of China’s growth, and if growth has been fueled by reckless lending, this would raise questions about the sustainability and quality of growth.
While we acknowledge some of the debt likely financed questionable infrastructure projects and may have been involved the property boom, we view sentiment toward China as overly pessimistic. In our Bears versus Bulls China article in May, we used a 10% NPL rate and put potential losses at 5.2 trillion RMB, or $800 billion. This is large but manageable, as the government has over $3 trillion in foreign exchange reserves at their disposal.
Meanwhile, a tightening cycle to rein in property speculation and lending may be in late innings. Home sales have stabilized after plunging, and construction has restarted, particularly for the government's affordable housing program. Liquidity in the banking system is tight and credit access is restrictive.
While inflation may still rise and additional tightening measures could still be implemented, we view a hard landing, or severe slowdown in growth, as unlikely. The Chinese government can quickly introduce policy to reaccelerate growth, and has already begun new stimulus and the injection of money into the banking system.
Local Chinese investor sentiment improving
Source: FactSet, Shanghai Stock Exchange. As of July 12, 2011.
Local investors in China have prompted a rise in the Shanghai Composite. The Chinese stock market has been a forward looking indicator for both global growth and emerging markets, and while an upward move may indicate global growth may be on the mend, we remain neutral on emerging markets at this point.
Visit www.schwab.com/oninternational for more international perspective.
Important Disclosures
The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
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