Apparently, European policymakers shared the market concern, cobbling together a "bailout" for the Spanish banking system of up to 100 billion euros ($125 billion). While there are positives, the negatives seem to outweigh the positives. Among the concerns and questions:
- Loans typically come with conditions. What types of operational changes will be forced upon the banks? Who will supervise and enforce the conditions? Will insolvent banks be shut down and bad assets written down?
- The bailout only addresses one of Spain's problems. The economy is still contracting, the housing bubble continues to deflate, the fiscal deficit remains elevated and lack of control over local government budgets has not been addressed.
- Further credit ratings downgrades are likely for two reasons. The Spanish government is on the line to repay the loans, resulting in an immediate jump in Spain's debt-to-GDP level. Also, existing Spanish government bondholders could have junior status in the capital structure, as it appears the permanent bailout fund, the European Stability Mechanism (ESM) that begins in July, will be used and would be senior to existing holders.
If the aid comes from the ESM, it could scare investors away from Spanish government bonds. As a result, it only took hours for the market to shift from relief to concern, as the bank bailout may have accelerated the need for the Spanish sovereign to have a bailout of its own. This is a dangerous new phase of the crisis, as Spain's economy and debt are approximately four times larger than Greece.
A broader Spanish bailout threatens the Union
Source: FactSet, Bloomberg. As of June 12, 2012.
If Spain needs a further bailout, the burden on the remaining non-bailout countries would increase. The credit default swap (CDS) chart illustrates that as the perception of a Spanish government default grows, the pressure on Germany also increases. At a 607 basis point spread, the CDS market is pricing in a 40% chance that Spain will default on its debt in the next five years.
Additionally, the link to Italy has not been severed, with Italian and Spanish government bond yields rising in near tandem. While Italy has stronger fundamentals than Spain by some measures, an elevated pubic debt level and unwillingness to change notoriously inflexible labor laws shackles growth. Fewer foreign investors at Italian bond auctions has resulted in increased reliance on Italian banks to buy government debt, a worrying trend that faced other peripheral countries in early crisis stages.
We believe we are accelerating toward the point where Europeans may need to make a bigger decisionāeither unite or break apart. Components of unity include both a banking and fiscal union. A banking union would likely need a European-wide deposit insurance program, common bank supervision and a way to resolve insolvent banks (a bank resolution mechanism). However, Germany is resisting a banking union without closer fiscal union. They seek a coordinated European approach to reforming labor markets, social security systems and tax policies, among other things.
In contrast to uniformity, protectionist measures are gaining traction. In addition to rolling back the retirement age to 60 from 62, the administration of France's new leader, Hollande, is slated to introduce legislation to increase the costs to fire workers and shift production to lower-cost locations. We typically try to find "what can go right" when sentiment is so negative, but find it difficult to imagine countries giving up sovereignty anytime soon.
As a result, the market remains vulnerable to swings in sentiment, a factor in our underweight bias toward Europe. The most resisted concept, joint euro bonds, is the solution that is likely needed to finally arrest the rollercoaster. We will be watching to see if Germany's Council of Economic Advisors proposal for a European Redemption Fund (ERF) garners acceptance as a first step toward joint debt.
Europe pressuring global growth
Economic growth in Europe has taken a hit from fiscal austerity, uncertainties about government bailouts and credit contraction. While competitive strength and ties to emerging markets have resulted in continued economic growth in Germany, the European Union (EU) comprises 58% of Germany's exports. As a result, recessions in many EU economies are weighing down even Germany.
Germany is not immune
Source: FactSet, German Federal Statistics Office, Eurostat. As of June 12, 2012.
We've remained concerned about the health of the European banking system and the impact on economic growth. Lending is likely to suffer more while banks continue to incur losses on both public and private sector debt, while also raising capital requirements and reducing leverage. Confidence in the banks could benefit from a deposit insurance program to stem capital flight, as well as recapitalization. We believe a longer-term banking union could result in substantial consolidation of the European banking system.
As a region, the eurozone's size is large enough to influence global growth. In particular, China's exports to the eurozone fell into negative territory on a yearly basis during March and April before rebounding to 3.4% growth in May. However, the focus on the importance of exports to the Chinese economy may be overstated. Gross exports are roughly 27% of China's GDP and the EU is 18% of exports, resulting in the EU having a 4.9% impact on China's economy. For comparison, the EU has a 2.0% impact on the US economy.
More important is investment spending, and here the Chinese government can influence growth. After a sharp fall, there are signs infrastructure spending is about to reaccelerate, which could partially offset the likely upcoming slowdown in property construction. Additionally, financial conditions have eased with better credit supply and an interest rate cut, and a stimulus program to incent the purchase of energy-saving home appliances and vehicles will likely add to future growth.
While emerging markets could be vulnerable during "risk-off" periods, we have a positive intermediate and long-term view. Within emerging markets, we like China because its stimulus programs are in an earlier stage than elsewhere, and because it has financial flexibility. Longer-term, market-based reforms could reduce the profits of state-owned companies that dominate the Chinese index.
Read more international research at www.schwab.com/oninternational.
Important Disclosures
The MSCI EAFEĀ® 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 500Ā® 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.
