We believe that the combination of several of the following tools is likely required to stem contagion; in order of likely least resistance by policymakers:
- European-wide deposit insurance to stem the flight of deposits from peripheral banks
- Recapitalizing European banks with bailout funds from the temporary European Financial Stability Facility (EFSF) or longer-term European Stability Mechanism (ESM) that takes over starting in July
- Giving the EFSF/ESM bailout funds a banking license to increase firepower
- Euro bonds
Unfortunately, these tools require either parliamentary or general public approval, and therefore cannot be enacted in short order. We believe it will likely take more market turmoil before policymakers' hands are forced to implement some combination of these tools.
In the meantime, we expect a continuation of the same rollercoaster loop: markets riot (eurozone peripheral stock and bond markets fall), policymakers react with half-measures, markets sigh relief, policymakers relax (either timeliness or strictness toward austerity and progress toward solutions), and then markets riot again. The most resisted concept, euro bonds, is likely needed to arrest the rollercoaster longer-term.
While we believe the probability of a Greek exit increases as the year progresses and over the next several years, a Greek exit isn't necessarily a fait accompli. Read more about the prospect of a Greek exit in Q&A: What a Potential Greek Exit Means for Investors at www.schwab.com/oninternational.
As for the market impact, we believe the potential for downside risks and the likelihood of high levels of ongoing volatility have increased, and therefore we continue to recommend an underweighting of Europe. We realize there could be sharp rallies in European assets, but believe there is an unfavorable risk/reward profile, and prefer a defensive US-biased asset allocation for developed market exposure. Over the intermediate term, we have a positive view toward both a diversified emerging market equity allocation and toward the Chinese equity market. But an underweight in international stocks overall is likely appropriate at this time.
Outside of the impact on markets, the uncertainty about the debt crisis, combined with contagion fears, is putting significant downward pressure on European economic growth. While there is talk about growth stimulus measures in Europe, sustainable growth likely needs large systemic changes, and the political winds are blowing in the wrong direction—toward more government spending and away from free market reforms.
China can stimulate, up to a point
In contrast to Europe, China still has levers for growth. China's slowing economy has primarily come from two main areas: exports and investment. While the Chinese government can't do a lot to influence exports, it can influence investment spending. Property construction is likely to continue to fall because the government is restricting growth. However, after a sharp falloff, there are signs that infrastructure spending is about to reaccelerate, which could offset some of the impact of slowing property construction. Positive signs include a statement from Chinese Premier Wen endorsing increased credit allocation for projects and an uptick in project spending by the central government.
Infrastructure spending could reaccelerate
Source: FactSet, National Bureau of Statistics of China. As of May 29, 2012.
Contrary to concerns about too much infrastructure, in our opinion, China appears to be relatively underdeveloped, particularly in the inland provinces. However, we would caution investors extrapolating either the size or type of stimulus China pursued in 2008-09. China's investment is likely to shift over time toward power generation, energy efficiency, and productivity-enhancing initiatives. Additionally, the government is mindful of the risk of over-spending and creating future bubbles and crises.
Monetary easing in China has also begun, with three cuts to the bank reserve requirement ratio (RRR) thus far. While additional RRR and/or interest rate cuts are possible, monetary policy has become less potent. The economic slowdown, particularly in exports (especially to Europe), has reduced loan demand. While we believe economic growth could weaken further, we are encouraged by the change in posture from Premier Wen, stating that it was time to give "more priority to growth." Judging from the outperformance of the Shanghai Composite Index over the past two months, the domestic Chinese may agree.
Read more international research at www.schwab.com/oninternational.
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.The S&P 500® index is an index of widely traded stocks.Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.Past performance is no guarantee of future results.Investing in sectors may involve a greater degree of risk than investments with broader diversification.International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
