Global Markets in Difficult Balancing Act
Posted by Larry Brundage on October 17, 2011
The third quarter of 2011 was one of those periods that seem to occur all too often in which the international equity markets synchronize for a downward move. They would not get a perfect 10 for their synchronization, but with negative returns in all of the single country ETFs that we follow (ranging from Peru at -6.5% to Poland at -36.8%) it was close enough to make investors feel queasy. Fortunately for investors, this quarter was not nearly as bad as the 2008 experience and this month we are already seeing signs of a turnaround.
The disturbing part about this downturn is that it has similar characteristics to the 2008 problem – gross malfeasance on the part of governments followed by poor judgment by bankers willing to go along for the ride. In 2008 the problem stemmed from an aggressive push by the U.S. government to increase home ownership while ignoring the economic realities that face many first time homebuyers. The banks transmitted this policy to the financial system, having had their arms twisted by aggressive regulators, by pushing financially untenable or unintelligible mortgages onto the weakest potential homebuyers. The problem was inflamed as the bankers packaged those mortgages as “safe” securities and then sold them to other financial institutions and the public.
In the 2011 case, the problem stemmed from the initially flawed creation of the euro and the European central bank, combined with governments willing to cheat on their fiscal restrictions without having significant consequences and banks willing to invest in the government bonds of the errant countries. The flaw with the euro is the disconnect between monetary and fiscal policy. In the United States, we have one central bank and one central government. Yet in Europe they have a central bank, but each member country maintains autonomy over its federal budget. As a consequence, when you have a situation like we do in the United States in which federal government policies result in retarded economic growth and increased unemployment, the Federal Reserve can act as a counterweight, easing monetary policy to help alleviate the economic pain. In Europe the central bank can only establish one monetary policy, so generally they choose a policy that is appropriate for the largest European economies, Germany and France. As a consequence, in the middle of the last decade when France and Germany were growing modestly, the European central bank kept interest rates moderately low. But in Ireland and Spain those low interest rates caused real estate bubbles endangering their banks in a similar fashion to the problems the U.S. banks experienced in 2008.
Greece had a different problem: running a budget deficit that was higher than the European rules would allow and hiding that fact from the European Union. So Greece’s national debt began to get uncontrollably high. Italy and Portugal had similar problems, just not to the extreme degree that Greece had, and they were forthcoming to the EU.
A separate problem brewed in Europe during the middle of the 2000’s. All banks, whether in Europe or anywhere else in the world, are required to put aside a certain amount of capital to protect against a default when they make a loan. The amount of capital that they put aside relative to the size of the loan is based on the riskiness of the loan and is often regulated by some government agency. When a bank buys a bond it is essentially making a loan. In Europe many of the banks bought bonds issued by the various European governments. At the time the European regulators did not require the banks to set aside any capital to protect from losses on those loans. Furthermore, the yields on bonds of countries within the European Union did not differ substantially from one another because investors felt that the fiscal restraints that the Union placed on each member country would keep their creditworthiness sound.
These situations caused no problems as the European (and world) economies were growing up until early 2008. However, as the U.S. banking problem started to spread throughout the world and caused a global recession, these flaws in the European Union began to crack. Why? Well, in Ireland and Spain demand for housing started to dry up and housing prices began to recede. At the same time unemployment began to rise and mortgage defaults began to increase. In Ireland the federal government bailed out their banks, ballooning their own national debt. Spain’s problem is somewhat more subdued than Ireland’s but they are in the process of propping up some banks and liquidating others. As the recession hit Greece, Italy and Portugal, tax revenues began to fall and demands on government resources such as unemployment insurance began to rise. The increases in national debt levels have been devastating.
Normally, a country with such a high level of debt can address the problem in two ways. The first is to devalue its currency. The benefit of this action is that it reduces the cost of the county’s exports, making its products more competitive and thus boosting its economy. Likewise it makes imports more expensive, thereby reducing the demand for imports and improving the domestic demand for its own products. All of this improves economic growth, and hopefully, increases tax revenues. This all sounds fine in theory. In practice it is not quite that easy and in the case of the problem countries of Europe it is impossible since they are using the euro and have no control of their own currency value.
The other action a government can take is to default on its debt. As this problem has unfolded since 2008, it has become increasingly apparent that the only option for some of these countries, particularly Greece, is to default on its sovereign debt. As a result, some of the major banks throughout Europe that held this debt became increasingly less stable. Recall that these banks had come through the 2008 experience somewhat weaker just as the U.S. banks did and needed time to rebuild their financial strength. That rebuilding period has not fully taken place, so this crisis is hitting fragile institutions.
Without the problem of the banks, Greece would not be an egregious problem for the Europeans. The Greek economy is only about 2% of the European economy. But the banks make it a much larger problem, particularly since many of the larger European governments worry that if Greece defaults, some of the other shaky countries may also decide to default.
The situation began to look like the U.S. debt ceiling crisis, with the European governments dithering about what to do and dragging their feet about taking any action to solve the problem. There are really only three possible courses they can take. The first is to do nothing, an unlikely course since some countries would likely default, causing the banks to default, badly damaging the entire European economy. The second possibility is to let at least Greece default and provide aid to the banks to limit the effect on other economies. While that might prove to be a lesson to countries that allow their debt to get too high, it certainly would be a stain on the European Union. Thus we are left with the third option which is to provide direct support to the weaker European countries. That is what is being worked on right now and it appears increasingly likely that the structure for that solution is going to be in place in the next few weeks.
It is the dithering and the fear that the crisis would turn into a pan-European economic crisis that has caused the problem in the international equity markets. Now it is the optimism that the support structure is about to be put in place that has allowed the financial markets throughout the world to begin to slowly rise during these first few days of October.
With that all said, here’s the scorecard of the best and worst performers for the quarter.
You can see from this chart that the Europeans dominate the bottom of the list. Russia made an appearance in the bottom most likely because one of the consequences of the fear in the markets is that commodity prices, including oil, fell too. The energy industry is a major part of the Russian economy, thus the link to the Russian stock market.
On the plus side, Peru was a surprise as their newly elected president, who had a history of Hugo Chavez type rhetoric, initially seems to be holding to his current promises to be more oriented to free markets. Japan benefited from the strength of their currency; the yen was up 4.4% versus the dollar during the quarter. In fact, the yen was one of only 3 currencies that appreciated against the dollar during the quarter, which in part helps to explain the dismal performance of the international index as a whole.
Looking to the future, we expect the current halting improvement in the markets to continue. There is too much at stake for the Europeans if they did not continue putting together their rescue plan. Consequently it is more than likely to continue, allowing the markets to heal. The best performance will probably be in the Asian countries, as they continue to directly avoid the American malaise and the European doldrums. China is the question mark for Asia as it needs to slow its inflation and continue shifting from a heavy export orientation to more domestic consumer consumption, all the while maintaining a growth rate that keeps the lid on dissatisfaction among its citizens. So the world is in the middle of a difficult balancing act, but isn’t it always?