Wednesday, June 13, 2012

Why Europe Matters To Your Portfolio

With markets being moved around by Europe, I thought it would be helpful to give a brief summation of what investors should expect from Europe in the coming weeks. One key date is the Greek election on June 17. At this point, I suspect many US investors will be scratching their heads and wondering why a country with such a tiny portion of global GDP has such an effect? The answer is that Greece affects Europe and Europe affects the world.

Companies like General Electric $GE, Apple $AAPL and McDonald’ $MCD are all multinationals with significant European exposure, but the risk doesn’t stop there. Even if US companies do not have large direct exposure, the knock-on effects of a financial crisis in the European banking sector will be felt by the US banking sector. The traditional safe havens of healthcare and consumer stables are unlikely to work well either. Buying Coca Cola $KO or Merck $MRK may give the appearance of safety, but hard pressed consumers cut back on soft drinks and snacks in a recession, and indebted Governments will do anything they can to cut health care spending.

For example, McDonald’s generates more than 40% of its revenues from Europe. The same figure is 24% for Apple, but Europe generated 46% revenue growth for the company on a yearly basis. Europe is obviously a key area for GE and, it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. As for Coca Cola, in the last quarter, it generated more profits from its Europe segment than it did from North America! Merck generates 30% of its sales from EMEA, but any slowdown will also hurt margins as medical bodies will not be keen to spend or may accelerate plans to buy generics.

What is the Problem?

I have a more detailed analysis of the debt problems in an article linked here. However, a simplistic graphical depiction summarizes the issue quite well.

These projections are from the IMF, with the Greek number coming from an OECD estimate. The problem countries are the so-called ‘PIIGS’. Spain may seem ok, but it has a major problem with its collapsing housing market putting pressure on its banking system. Spain’s debt load will inevitably increase as it takes on loans in order to recapitalize its banks.
We can see what the market thinks, by way of looking at the yields on 10 year Government Debt.

For now, we need to understand that Greece, Portugal and Ireland are not financing themselves in the open market.

How are Greece, Ireland and Portugal Surviving?

The EU-IMF are giving loans in order to buy time for them to make the structural reforms necessary so they can get back to a sustainable debt path. The problems are structural so the solution must be structural. As such, the EU-IMF monitors performance on an ongoing basis and releases bailout installments on a conditional basis. It is hurting.

There is simply no way around the fact that cutting public sector wages and employment, whilst attacking entrenched self interests is going to cause a significant amount of social tension. Especially in such an anemic growth environment.

The report card on these countries will probably see a positive rating for Ireland, a cautious thumbs-up for Portugal and, then there is Greece. The Irish made their adjustments swiftly and in a disciplined manner, including a large scale recapitalization of its banks at the cost of racking up more debt. No matter, they are following the program. As for Portugal, they passed a recent mission review and the EU-IMF summarized position thus

“The program remains on track amidst continued challenges. The authorities are implementing the reform policies broadly as planned and external adjustment is proceeding faster than expected... ...the authorities are determined to stay the course of adjustment and reform. Broad-based political support and social consensus is a key contribution to a successful adjustment.”
So whilst Portugal’s situation is precarious and, somewhat dependent on economic developments, the country is making the required structural reforms.

What About Greece?

Greece is not achieving what Ireland or Portugal has been able to do. The reasons for this are myriad but mainly relate to the political structure of Greece. Despite having voluntary debt write downs organized for them and ongoing support, nothing has worked. Whatever the underlying reasons for this, the conclusions are still the same.Greece has not been able, or willing, to make sufficient structural reforms. Nor has it adequately responded to the continual requests from the IMF that it find a way to collect taxes from its wealthy.

When asked about the risks to the EU-IMF program, the mission head Poul Thomsen, identified structural reform.

“to get the recovery going we need to get a strong impulse from productivity-boosting reforms and failure to launch such reforms could indeed mean that we will not get to this sort of inflection point where it starts going up any time soon, but that the economy will continue to trend down for longer than expected.”
He then specified reform of the public sector.

“if there is failure to undertake strong structural reforms inside the public sector, I cannot see how the deficit can go down without structural reforms. There are no more, as I’ve said before, low-hanging fruit, no more easy adjustment. Fiscal adjustment needs to be underpinned by fiscal structural reform.”
And this is where it gets tricky.
It is hard to implement significant public sector reforms when the economy is doing well, but when it is in freefall, it becomes nigh on impossible. Again, I don’t seek to apportion blame. I’m just telling it how it is. There is significant resistance to reform in Greece.

It's All About Greece, For Now

In conclusion, having isolated the immediate problem to Greece (although Spain too has significant issues) it is now time to look specifically at what is going on there and, potential outcomes in the upcoming elections on June 17th. I will do this, shortly,  in a forthcoming article.

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