Investing is a complex game. For all the focus on bottom up fundamentals, sometimes it is really macro considerations that guide stock prices. Or rather, sometimes macro events pre-empt the changes in the underlying earning potential. I think we are seeing that now, with the investment focus firmly on events in the Euro Zone and particularly Greece. These issues may seem tangential, but a lot of US companies have been reporting weaker European numbers recently and are referencing an increase in caution amongst European customers.
For example, NetApp $NTAP repeatedly mentioned caution amongst CEOs over the European crisis as being a reason for giving such weak guidance. GE $GE declared that it was watching Europe with ‘caution’ and that even trading in healthcare in Europe was ‘tough’.
The banking sector is not immune either and, if there is a credit shock caused by a hard default in Greece ,the banks with large European operations like JPMorgan Chase $JPM or Goldman Sachs $GSS will get hit too. However, it doesn’t stop there. Technology is a major export industry for the US and despite its strength this year Apple $AAPL would not be spared. As for the eponymous
Facebook $FB whilst everyone is –correctly- focused on its lack of a coherent strategy to monitize mobile, it’s easy to forget that it needs to increase penetration rates and revenue generation from less mature markets in Europe.
I guess what I am trying to say, is that no industry is truly immune from a potential European crisis. With this in mind, I thought it would be useful to produce some rough numbers for what the Euro Zone needs to do with its debt situation.
Stabilizing the Debt/GDP Ratio
I think most people would agree that the key to reducing bloated Government Deficits is to initially stabilize them and then reduce them. Therefore, I’m going to try and find a way to quantify what these Governments need to do to adjust from their existing plans in order to do this. This could serve as a useful indicator for the feasibility of their plans. All the numbers and projections are taken from OECD data.
For those that are interested, the calculation for the ‘stabilizing deficit’ is equal to (Debt % GDP *(i-g))/(1+g) where ‘i’ is the borrowing rate (assume the current 10 year yield) and ‘g’ is the nominal GDP growth rate.
Greece, Portugal and Ireland are obviously not financing themselves in the marketplace but rather, are being financed by loans from the ECB. I don’t want to dwell on Greece because, simply put, I think they are going to default and leave the Euro soon.
With regards to Portugal and Ireland, I think that, realistically, they are going to have to take future haircuts on their debt. The European banking system won’t like this, but it has had long enough to prepare. Another point, the UK/US has substantive performing assets (banks) that they bought as a consequence of the crisis, so their net position is rather better than implied here.
The data under ‘stabilizing deficit’ is particularly interesting. It represents the Government Deficit that a country could run in order to stabilize the Debt/GDP ratio. Any country with a positive number implies that they need to run a surplus. A negative number implies that they could run a deficit and still theoretically stabilize the forecast Debt/GDP.
I’ve represented this data graphically here. Negative is good.
Of course, this is wonderful but what we need to do is understand just what kind of adjustments should need to be made from their existing plans in order to start stabilizing the Debt/GDP ratios. This is what the adjustment column is for. Again, I have demonstrated that here positive is good.
According to this analysis -which I confess is only a rough estimation- only Germany is actually on schedule to start reducing its Debt/GDP ratio in 2012. It could even spend more in 2013 and still be reducing the ratio. As for the rest, they need to do more to reduce spending. Of particular concern will be Spain and its troubled housing market, whereas, Italy’s situation looks better than the UK’s.
Can it be Done?
The real question relates to the possibility of achieving these targets. Governments have reduced debt ratios over sustained periods in the past, but it hasn’t been done in a global environment of slow growth. Perhaps the best way to judge this would be to see what has been achieved over the last couple of years?
I’ve compared what the OECD was forecasting in 2011, for 2012 Debt/GDP versus what they are estimating now. It’s a good way to see what kind of improvements have been made. In this case I am going to look at net financial Debt/GDP because I think it gives a better approximation. Positive is good.
Italy, Spain and Ireland have shown that they can shave a few points off Debt/GDP so it can be done.
In conclusion, I think Portugal and Ireland will have to see future haircuts on their debt if they are to get back to a sustainable debt path. However, what investors need to understand is how much of an outlier Greece is. In truth they were never really in with a chance and, I think their retention in the Euro Zone is only causing them and everybody else, more damage than good at the moment.
These problems will be ongoing and with us for years to come. That said, if Greece is dealt with and Portugal and Ireland see haircuts, it is not unfeasible that the Euro Zone will hold and all of its countries will get back to raising money on the debt markets.
For example, NetApp $NTAP repeatedly mentioned caution amongst CEOs over the European crisis as being a reason for giving such weak guidance. GE $GE declared that it was watching Europe with ‘caution’ and that even trading in healthcare in Europe was ‘tough’.
The banking sector is not immune either and, if there is a credit shock caused by a hard default in Greece ,the banks with large European operations like JPMorgan Chase $JPM or Goldman Sachs $GSS will get hit too. However, it doesn’t stop there. Technology is a major export industry for the US and despite its strength this year Apple $AAPL would not be spared. As for the eponymous
Facebook $FB whilst everyone is –correctly- focused on its lack of a coherent strategy to monitize mobile, it’s easy to forget that it needs to increase penetration rates and revenue generation from less mature markets in Europe.
I guess what I am trying to say, is that no industry is truly immune from a potential European crisis. With this in mind, I thought it would be useful to produce some rough numbers for what the Euro Zone needs to do with its debt situation.
Stabilizing the Debt/GDP Ratio
I think most people would agree that the key to reducing bloated Government Deficits is to initially stabilize them and then reduce them. Therefore, I’m going to try and find a way to quantify what these Governments need to do to adjust from their existing plans in order to do this. This could serve as a useful indicator for the feasibility of their plans. All the numbers and projections are taken from OECD data.
For those that are interested, the calculation for the ‘stabilizing deficit’ is equal to (Debt % GDP *(i-g))/(1+g) where ‘i’ is the borrowing rate (assume the current 10 year yield) and ‘g’ is the nominal GDP growth rate.
Greece, Portugal and Ireland are obviously not financing themselves in the marketplace but rather, are being financed by loans from the ECB. I don’t want to dwell on Greece because, simply put, I think they are going to default and leave the Euro soon.
With regards to Portugal and Ireland, I think that, realistically, they are going to have to take future haircuts on their debt. The European banking system won’t like this, but it has had long enough to prepare. Another point, the UK/US has substantive performing assets (banks) that they bought as a consequence of the crisis, so their net position is rather better than implied here.
The data under ‘stabilizing deficit’ is particularly interesting. It represents the Government Deficit that a country could run in order to stabilize the Debt/GDP ratio. Any country with a positive number implies that they need to run a surplus. A negative number implies that they could run a deficit and still theoretically stabilize the forecast Debt/GDP.
I’ve represented this data graphically here. Negative is good.
Of course, this is wonderful but what we need to do is understand just what kind of adjustments should need to be made from their existing plans in order to start stabilizing the Debt/GDP ratios. This is what the adjustment column is for. Again, I have demonstrated that here positive is good.
According to this analysis -which I confess is only a rough estimation- only Germany is actually on schedule to start reducing its Debt/GDP ratio in 2012. It could even spend more in 2013 and still be reducing the ratio. As for the rest, they need to do more to reduce spending. Of particular concern will be Spain and its troubled housing market, whereas, Italy’s situation looks better than the UK’s.
Can it be Done?
The real question relates to the possibility of achieving these targets. Governments have reduced debt ratios over sustained periods in the past, but it hasn’t been done in a global environment of slow growth. Perhaps the best way to judge this would be to see what has been achieved over the last couple of years?
I’ve compared what the OECD was forecasting in 2011, for 2012 Debt/GDP versus what they are estimating now. It’s a good way to see what kind of improvements have been made. In this case I am going to look at net financial Debt/GDP because I think it gives a better approximation. Positive is good.
Italy, Spain and Ireland have shown that they can shave a few points off Debt/GDP so it can be done.
In conclusion, I think Portugal and Ireland will have to see future haircuts on their debt if they are to get back to a sustainable debt path. However, what investors need to understand is how much of an outlier Greece is. In truth they were never really in with a chance and, I think their retention in the Euro Zone is only causing them and everybody else, more damage than good at the moment.
These problems will be ongoing and with us for years to come. That said, if Greece is dealt with and Portugal and Ireland see haircuts, it is not unfeasible that the Euro Zone will hold and all of its countries will get back to raising money on the debt markets.
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