Nick Armet asks what the Greek debt crisis means for the future of the global equities market.
For only 3 per cent of the eurozone economy, Greece has caused big trouble around the world. The question is whether its rescue package is enough to calm investors and leave in place the global economic and share market recoveries for the longer-term.
The larger-than-expected A$160 billion austerity package for Greece, the eurozone bailout package of more than a $1 trillion and a commitment by the European Central Bank (ECB) to buy European sovereign bonds certainly reduce the danger for now.
But investors are still concerned about other eurozone economies under similar fiscal pressures to Greece.
On balance, they probably shouldn’t fret so much. Greece, a country of only 11 million, is a basket case worthy of junk status that may succumb to its problems because of structural weaknesses — namely working practices, retirement laws, political stability and the size of the state.
And while there were clarifications on how large the government debt of Greece is, there has been little new information on government finances in peripheral European economies that explained the market action leading up to the bailout package for the eurozone, which encompasses 16 European Union countries that are home to about 330 million people.
The upward pressure on Irish government bond yields and credit-default swaps (CDS) spreads before the package was announced (to above 250 basis points in early May from about 150 basis points in January) is particularly interesting.
This is because Ireland was widely applauded by bond investors for tackling its deficit and outlining a credible restructuring plan. This suggests the market behaviour before the latest rescue package was more sentiment driven.
The fact that increases in Greek, Portuguese and Irish CDS spreads, which represent the cost of insuring against default in the underlying bonds, exceeded jumps in corresponding bond yields suggest speculative money was behind much of the recent market action before the eurozone packaged was announced.
However, investors are right to be cautious. Many commentators suggest the whole eurozone experiment is still shaky and another country may become unstuck.
Might we still see a domino effect?
While the most likely sources of further trouble, Portugal, Ireland or Spain, have problems, none are as sick as Greece. Spain certainly doesn’t appear to be.
While the economy suffers from high unemployment and the Government needs to undertake fiscal tightening, a recovery is emerging.
The bleak debt environment seems to have been priced into stock markets; however, Spain’s potential to gain from the rapid growth of Latin America appears to have been underestimated on the basis of current valuations.
Portugal, at first glance, has similarities to Greece. The European Commission believes government assumptions of positive growth this year and next are over optimistic.
However, like Spain, Portugal is not Greece. Its 9.4 per cent 2009 budget deficit is more than 3 percentage points lower than Greece’s 13.6 per cent shortfall and, crucially, the country has successfully cut its debt before.
Ireland’s 2009 budget deficit is actually higher than Greece’s. In terms of the total stock of public debt, however, Ireland’s is estimated to be a manageable 65 per cent of output, while Greece’s is a ruinous 110 per cent.
No banking crisis appears imminent
European banks, overall, have a limited exposure to this potential crisis in comparison with sub-prime mortgages.
The Bank of International Settlements estimates that European banks’ exposure to Greek, Spanish and Portuguese debt represents only 5 per cent of total bank assets.
So the idea of persistent contagion seems unlikely given the relatively better economic and corporate situation in the other peripheral economies, the credibility of their governments and the lack of exposure among the European banking sector in general.
Changed days call for changed investment tactics
Financial markets wanted swift, decisive and aggressive action from eurozone authorities to ease their concerns about Greece and other countries — and they got it.
Markets rallied strongly as details of the eurozone rescue package emerged, and it became clear to investors that eurozone and global financial authorities were prepared to pull out all stops to avoid any escalation of the Greek debt crisis.
The immediate reaction saw equity markets surge and risk spreads tighten, while the gold price fell and the euro strengthened.
But the success of the rescue measures will be judged over longer time horizons. Investors must assess the short, medium and long-term impact of the overall package, its durability and the potential for unintended consequences.
The package makes an individual country issue into a European issue, and it gives the pressurised economies space to get their finances in shape.
What is most clear is that European policymakers have risen to the challenge set by the markets, broken with tradition and boldly expanded the
limits of their policy response. The market and the authorities are now in agreement: uncharted waters call for uncharted policies.
As a result, investors have more confidence that the turmoil can be navigated.
The ECB has historically taken a hard line on inflation, with little or no consideration given to economic growth.
The commitment to buy sovereign bonds is therefore something of a watershed moment for a central bank that has been reluctant to consider anything but inflation targeting policies.
While the markets have welcomed the new flexibility, inflation remains the enemy above all others, and it should be noted that the monetary impacts of bond purchases will be sterilised or, in other words, offset via liquidity operations to avoid inflation risks.
Still, a two-tier eurozone economy appears to be developing, as high debt levels and austerity measures make growth prospects gloomy for peripheral Europe. This is a big concern because of the implications for monetary union.
Recovery still intact
So what else can we say of the future? Global economic growth remains robust. Corporate earnings are healthy.
The recovery in stock and credit markets is unlikely to be materially derailed by the recent events in Greece, which was always going to need a bailout.
That is not to say countries such as Spain, Portugal and the UK do not have tough choices to make. It’s just that they have more scope to make them.
We know there are pockets of slower growth in the eurozone, but the area will benefit from healthy global and emerging market growth. Developing economies are contributing significantly to global growth and the eurozone is one of their key sources of machine goods, commodities, services and finished products.
In this light, European stock markets may offer excellent opportunities for investors looking for relative value. Another net positive for many European companies is that the weakness in the euro makes their products more competitive.
The midst of a crisis often presents attractive, valuation-based opportunities for astute investors prepared to take a medium-term view.
Fidelity’s equity managers are united in their thoughts that there is significant medium to long-term value to be found among this volatility in European equities.
Many European shares are overlooked and undervalued, and our portfolio managers are finding interesting ideas across the continent’s equity markets that have more capacity than most to surprise positively.
Nick Armet is an investment commentator at Fidelity International.
