May 27, 2011
European Commission's recent upward revision of the forecast on Greece's debt-to-GDP ratio has re-ignited sovereign debt woes in Europe, resulting in the recent market volatility. What should investors do in view of the current problem?
Author : Cheong Chee Kin
Key Points
On 13 May 2011, European Commission revised Greece’s debt-to-GDP ratio upwards, re-igniting Europe sovereign debt woes
Greece managed to slash spending in 2010, but due to 2009 debt revision, overall reduction fell short of target
This triggered a possibility of a halt in financing from EU and IMF, resulting in an ultimate default or debt restructuring by Greece
Market jitters appear justified as there is real risk of possible contagion
Key risk remains political as the actions taken by EU leaders will determine the stability of the monetary system
Being unable to price such risk, we prefer to trek with caution and focus on longer term prospects – valuations
Europe remains attractively priced based on a conservative fair PE ratio of 12.5X
Do not disregard Europe and maintain a well diversified portfolio
Over the past one week, global equity markets have been correcting moderately, with most falling between 2.0% to 4.0% in respective local currency terms. The culprit behind the recent moderation was Greece and the probability of them defaulting in their loans payment.
Good job, but not enough
Slightly more than one year ago, Greece was offered a EUR 110 Bn financial assistance package, a joint rescue package from the EU and the IMF. The rescue package was to provide the necessary financing to the Greek government as the open market had effectively shut their doors by demanding more than 15% to hold Greek bonds. See “Rescue package a done deal for Greece” for more information.
Since then, the Greek government has diligently reduced spending, a pre-requisite of the rescue package to ensure tranche disbursement of the agreed financing. As shown in Chart 1, Greece has managed to lower their “deficit as % of GDP” by 4.9%, the largest reduction among all other European nations and only slightly below their committed adjustment of 5.5%. Unfortunately, with Greece’s 2009 deficit being adjusted higher in subsequent revisions, the overall results fell short of the intended target.
Weakening debt figures sent market into jitters
On 13 May 2011, the European Commission revised their forecast of European nations’ gross debt-to-GDP ratio. Among which, the three weakest peripheral nations, namely Greece, Portugal and Ireland all saw significant upward revision of debt figures (See chart 2). The deteriorating estimates proved too much for investors to bear as profit taking and risk aversion saw global equity markets correcting.
All peripheral bonds were badly hit, particularly Greek debt. Over the shorter term, investors are worried that Greece may not meet required debt reduction figures to received funding from the rescue package. They will then be forced to turn to the open market for the required funding, an unrealistic task as the market currently demands 17.2% yield to hold their 5-year bond (as of 24 May 2011). With no channel for refinancing, the Greek government will be forced to default on their payment and restructure. Fears of a probable default has also sent the 5-year credit default swap for Greek bonds to a record high of 14.8%, with a 71.0% probability of a default and a recovery rate of 40% of par value (Bloomberg data as of 24 May 2011).
Possible Chain Reaction
Focusing on the core European nations as well as the weaker fringe economies under scrutiny, we evaluate the respective countries’ gross bank claims on foreign debt to determine their absolute exposure (in Bn EUR) as well as their relative position (as a % of total foreign debt). The data is presented in Table 1
While it has been quoted frequently that both Germany and France have large amount of Greek debt exposure (Germany: EUR 25.4 Bn, France: EUR 39.6 Bn), the proportion of Greek debt to total foreign debt held remains low and manageable (Germany: 1.1%, France: 1.7%). Should Greece default, resulting in a total loss (an extreme assumption of zero recovery rate), it is still likely that the core European nations may emerge unharmed, provided that the default happens systematically and in a controlled manner.
However, it is worrying that Portugal has a significant vested interest in both Greek and Irish debt (6.6% and 14.4% as a % of total foreign debt). Should either Greece or Ireland fall, it is likely that Portugal will follow suit. There may be a snowballing effect as the fall of Portugal may possibly drag Spain along. Spain has EUR 64.2 Bn of Portuguese debt exposure (which amounts to 6.2% of total foreign debt held by Spanish banks), a cost which Spain may not be able to bear given their current fundamental weakness unlike the core European nations.
Given the co-integration of financial systems within the European Union and the significance of Spain’s economy to Europe, the fall of Spain may prove too much for the EU to handle. As we can see in Chart 3, all three core European nations have large stakes in Spanish debt, with a subtotal of EUR 325.3 Bn among themselves. Hence, should contagion reach to Spain, the monetary system in Europe is likely to crack and could easily trigger a new global financial crisis. One key thing we need to highlight though is that this is an extreme worst case scenario and it is not what we believe will happen. While this may not be our base scenario, contagion worries remain real and market volatility does appear justified over the short term.
What should I do in view of the current problem?
We acknowledge the risks revolving around Europe. However all predictions on possible outcomes remain purely speculative. Political risk remains the key risk as the action taken by the EU leaders will determine the outcome of the sovereign debt crisis. We have witnessed the commitment and various extreme measures taken by the EU leaders to ensure continuity of the monetary union as well as the financial system. Given the lessons of the recent financial crisis, we have confidence that they are likely to act on the side of prudence. Moreover, if the result is an isolated credit event (no chained reaction), Europe is likely to emerge unscathed. Should it be a full blown contagion, global equity markets will be impacted as there is unlikely to be any decoupling given the massive global integration.
We hence keep our focus over the longer term and as seen in chart 4, consensus are expecting positive earnings growth for European companies over the next three years with earnings reaching a record high by end 2012 (data as at 24 May 2011). While we disregard short term volatility, we still trek with caution and compensate for Europe’s political risk by assigning a conservative fair PE of 12.5X (historically, the market trades at an average of 15.6X) for the market. Given the recent sell off, the Stoxx 600 index trades at an attractive forward PE ratio of 11.0X, 9.7X and 8.9X based on 2011, 2012 and 2013 estimated earnings.
Conclusion
Europe’s sovereign debt problem has been lingering for more than a year since Greece asked for financial assistance in May 2010. Since then, we have seen Ireland and Portugal doing the same and markets correct on several occasions due to heightened fears. However, markets have recovered and climbed further on improving global economic conditions and sustained corporate profitability. We urge investors to ignore short term volatility and focus on the longer term. We therefore propose some of the following actions that may help them weather market uncertainties.
Do not disregard Europe and maintain a well diversified portfolio
Prefer European equity funds which have an overweight in Germany
Why you should overweight Germany within Europe
Avoid speculating the market over the short term
Cheong Chee Kin is an analyst of iFAST Financial Pte Ltd.
European Commission's recent upward revision of the forecast on Greece's debt-to-GDP ratio has re-ignited sovereign debt woes in Europe, resulting in the recent market volatility. What should investors do in view of the current problem?
Author : Cheong Chee Kin
Key Points
On 13 May 2011, European Commission revised Greece’s debt-to-GDP ratio upwards, re-igniting Europe sovereign debt woes
Greece managed to slash spending in 2010, but due to 2009 debt revision, overall reduction fell short of target
This triggered a possibility of a halt in financing from EU and IMF, resulting in an ultimate default or debt restructuring by Greece
Market jitters appear justified as there is real risk of possible contagion
Key risk remains political as the actions taken by EU leaders will determine the stability of the monetary system
Being unable to price such risk, we prefer to trek with caution and focus on longer term prospects – valuations
Europe remains attractively priced based on a conservative fair PE ratio of 12.5X
Do not disregard Europe and maintain a well diversified portfolio
Over the past one week, global equity markets have been correcting moderately, with most falling between 2.0% to 4.0% in respective local currency terms. The culprit behind the recent moderation was Greece and the probability of them defaulting in their loans payment.
Good job, but not enough
Slightly more than one year ago, Greece was offered a EUR 110 Bn financial assistance package, a joint rescue package from the EU and the IMF. The rescue package was to provide the necessary financing to the Greek government as the open market had effectively shut their doors by demanding more than 15% to hold Greek bonds. See “Rescue package a done deal for Greece” for more information.
Since then, the Greek government has diligently reduced spending, a pre-requisite of the rescue package to ensure tranche disbursement of the agreed financing. As shown in Chart 1, Greece has managed to lower their “deficit as % of GDP” by 4.9%, the largest reduction among all other European nations and only slightly below their committed adjustment of 5.5%. Unfortunately, with Greece’s 2009 deficit being adjusted higher in subsequent revisions, the overall results fell short of the intended target.
Weakening debt figures sent market into jitters
On 13 May 2011, the European Commission revised their forecast of European nations’ gross debt-to-GDP ratio. Among which, the three weakest peripheral nations, namely Greece, Portugal and Ireland all saw significant upward revision of debt figures (See chart 2). The deteriorating estimates proved too much for investors to bear as profit taking and risk aversion saw global equity markets correcting.
All peripheral bonds were badly hit, particularly Greek debt. Over the shorter term, investors are worried that Greece may not meet required debt reduction figures to received funding from the rescue package. They will then be forced to turn to the open market for the required funding, an unrealistic task as the market currently demands 17.2% yield to hold their 5-year bond (as of 24 May 2011). With no channel for refinancing, the Greek government will be forced to default on their payment and restructure. Fears of a probable default has also sent the 5-year credit default swap for Greek bonds to a record high of 14.8%, with a 71.0% probability of a default and a recovery rate of 40% of par value (Bloomberg data as of 24 May 2011).
Possible Chain Reaction
Focusing on the core European nations as well as the weaker fringe economies under scrutiny, we evaluate the respective countries’ gross bank claims on foreign debt to determine their absolute exposure (in Bn EUR) as well as their relative position (as a % of total foreign debt). The data is presented in Table 1
While it has been quoted frequently that both Germany and France have large amount of Greek debt exposure (Germany: EUR 25.4 Bn, France: EUR 39.6 Bn), the proportion of Greek debt to total foreign debt held remains low and manageable (Germany: 1.1%, France: 1.7%). Should Greece default, resulting in a total loss (an extreme assumption of zero recovery rate), it is still likely that the core European nations may emerge unharmed, provided that the default happens systematically and in a controlled manner.
However, it is worrying that Portugal has a significant vested interest in both Greek and Irish debt (6.6% and 14.4% as a % of total foreign debt). Should either Greece or Ireland fall, it is likely that Portugal will follow suit. There may be a snowballing effect as the fall of Portugal may possibly drag Spain along. Spain has EUR 64.2 Bn of Portuguese debt exposure (which amounts to 6.2% of total foreign debt held by Spanish banks), a cost which Spain may not be able to bear given their current fundamental weakness unlike the core European nations.
Given the co-integration of financial systems within the European Union and the significance of Spain’s economy to Europe, the fall of Spain may prove too much for the EU to handle. As we can see in Chart 3, all three core European nations have large stakes in Spanish debt, with a subtotal of EUR 325.3 Bn among themselves. Hence, should contagion reach to Spain, the monetary system in Europe is likely to crack and could easily trigger a new global financial crisis. One key thing we need to highlight though is that this is an extreme worst case scenario and it is not what we believe will happen. While this may not be our base scenario, contagion worries remain real and market volatility does appear justified over the short term.
What should I do in view of the current problem?
We acknowledge the risks revolving around Europe. However all predictions on possible outcomes remain purely speculative. Political risk remains the key risk as the action taken by the EU leaders will determine the outcome of the sovereign debt crisis. We have witnessed the commitment and various extreme measures taken by the EU leaders to ensure continuity of the monetary union as well as the financial system. Given the lessons of the recent financial crisis, we have confidence that they are likely to act on the side of prudence. Moreover, if the result is an isolated credit event (no chained reaction), Europe is likely to emerge unscathed. Should it be a full blown contagion, global equity markets will be impacted as there is unlikely to be any decoupling given the massive global integration.
We hence keep our focus over the longer term and as seen in chart 4, consensus are expecting positive earnings growth for European companies over the next three years with earnings reaching a record high by end 2012 (data as at 24 May 2011). While we disregard short term volatility, we still trek with caution and compensate for Europe’s political risk by assigning a conservative fair PE of 12.5X (historically, the market trades at an average of 15.6X) for the market. Given the recent sell off, the Stoxx 600 index trades at an attractive forward PE ratio of 11.0X, 9.7X and 8.9X based on 2011, 2012 and 2013 estimated earnings.
Conclusion
Europe’s sovereign debt problem has been lingering for more than a year since Greece asked for financial assistance in May 2010. Since then, we have seen Ireland and Portugal doing the same and markets correct on several occasions due to heightened fears. However, markets have recovered and climbed further on improving global economic conditions and sustained corporate profitability. We urge investors to ignore short term volatility and focus on the longer term. We therefore propose some of the following actions that may help them weather market uncertainties.
Do not disregard Europe and maintain a well diversified portfolio
Prefer European equity funds which have an overweight in Germany
Why you should overweight Germany within Europe
Avoid speculating the market over the short term
Cheong Chee Kin is an analyst of iFAST Financial Pte Ltd.
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