PORTFOLIO POINT: Global financial stability has vastly improved over the past year or so, and while risks remain elevated, there may be good opportunities to buy assets cheaply if market turmoil returns.
This is my first weekly column for Eureka Report and I’m going to take the opportunity to open with a two-part outline of the investment markets as I see them. For today’s edition, I want to discuss issues to do with global financial stability – especially why some key countries in Europe, such as Spain and Italy, are in better shape than you might imagine – and then next week I’ll be writing on some crucial macroeconomic themes.
At the broadest level, we need to understand that a good portion of the volatility we’ve witnessed over the last few years can be attributed to a misunderstanding of the economic cycle and the economics of debt. It is imperative that if we are to try and predict the future and invest successfully, we understand the past and the current state of play. We must look at the global economic backdrop, recall the causes of the global recession and make an assessment of our progress since. Now, I’m not going to review the GFC, but for the purpose of this note, it’s important to remember that the crisis and subsequent recession was, at its very core, a correction from a credit-fuelled real estate boom.
There were two key elements: Firstly, there was the financial aspect – the rapid increase and subsequent contraction in housing-related credit and the ensuing collapse in the valuations of associated financial products (securitised products, CDOs, etc). Put more simply, there was a savage hit to global financial stability. The second aspect, which I’ll discuss next week, involved the more traditional macroeconomic or structural drivers of the economic cycle – the periods of over- and underinvestment that typically drive things.
Thus far, the global financial system has staged a marked recovery since the depths of the crisis, and we know how banks, governments and central banks stabilised things –through a process of write-downs, liquidity and capital injections, nationalisations and simply taking bad assets off bank balance sheets. Today, bank balance sheets are in a much healthier position and we are left with a situation where most major global financial institutions have already met, or are well on their way to meeting, the increased capital buffers required under Basel III. In Europe, for instance, the aggregate core Tier 1 ratio (effectively retained earnings and common equity) for major institutions was 8.9% as at June 2011. This already exceeds requirements under Basel III for a ratio of 7% (although the definition of capital is tighter under full Basel III implementation) and is well on its way to meeting the European Banking Authority’s (EBA) more rigorous requirement that the major institutions have a ratio (on a temporary basis) of 9% by June of this year. Many banks exceed even this level, with ratios of 12% or higher.
With the banks in better shape, what remains? Well, there are still risks to global financial stability, certainly, and they largely have to do with concerns over sovereign creditworthiness. Specifically, there are ongoing fears over solvency and liquidity, and, again, the potential impact this may have on bank balance sheets. We saw this flare-up in 2011, but we also saw the response: the ECB pumped out about €1 trillion in two 3-year long-term refinancing operations – or in other words, the ECB provided cash to European banks, which then in turn bought up sovereign bonds to use as collateral for future operations. This, by the by, is also why the EBA introduced the temporary 9% core Tier 1 ratio, to have a capital buffer that could offset any writedowns on sovereign debt holdings. So the banks have an enormous capital buffer that is sufficient to withstand any further writedowns on sovereign debt/other assets, and the ECB has shown that it stands ready to provide liquidity to the market – and to governments indirectly through the banking system and the process of investment – in times of panic.
Now the bigger question that investors must ask themselves is whether concerns over Spain and Italy are reasonable or rational, from a fundamental perspective. Do they pose in and of themselves a real threat to financial stability? I suggest they do not, fundamentally, and this has important investment implications. Greece was a unique case: it was insolvent and was in that position, basically, because consecutive governments, and the bureaucrats who served them, lied about their accounts. The larger economies, and the ones that matter – Spain and Italy – do not have the same issues. They are not insolvent and do not have the governance issues that Greece had. The charts below from the IMF explain why this is the case.
When we talk about debt, and when you as an investor read about it, the discussion nearly always focuses on one side of the accounts only – liabilities.
Figure 1: Debt burdens (2011) in selected advanced economies – % of GDP
If you do this, you get a false view of the problem at hand. The above chart, courtesy of the IMF, would suggest that Spain and Italy – in fact all of Europe – have a massive problem with debt levels at 200-300%, even 400%, of GDP, including government and the non-financial private sector. But this is only part of the story; it is impossible to have a reasonable discussion about debt without talking about assets as well.
Figure 2: Household financial assets and gross debt (2011) – % of GDP
The second figure, shown above, reveals that Spain’s public debt position (shown on the horizontal axis) is one of the best in the developed world (60%). Less well known is that the net position of households is actually quite good too – they don’t actually have any net debt (denoted by the negative sign on the vertical axis). Net household debt is actually at -70%. You can get a better sense of that in the third figure: Spain’s households have net financial assets equivalent to about 70% of GDP. It sounds bad when we talk about gross debt of 80% of GDP, but this figure is meaningless without considering the assets that underpin it. Spain’s net position is a strong one and the same chart shows that financial assets (i.e. not including housing) less gross debt is 70% of GDP.
Or in other words, if Spanish citizens paid off all their debts, they would still have 70% of GDP in financial assets. The only weakness with Spain, referring back to Figure 1, is that the debt they do owe, they owe to foreigners, and so they have high net external liabilities (denoted by the large red circle), along with Ireland and Portugal. This is only a problem if the country reverts back to the peseta; with the euro, it is not an issue.
Figure 3: Household financial assets and gross debt (2011) – % of GDP
As for Italy? Well, you can understand, looking at the above charts, why policymakers are a little perplexed by market concerns. At over 100%, public debt is high and as a long-term issue needs to be addressed, certainly. But Italy has had a debt-to-GDP ratio of over 100% since the mid-1990s. More to the point, Figure 2 above shows that Italy has moderate external liabilities (denoted by the small blue circle); that is, debt is an internal affair, with internal savers lending to internal borrowers, and governments borrowing from their own citizens. The third chart, in turn, shows that citizens have a very strong financial position anyway, with gross debt at 50% of GDP and net financial assets – remember that does not include houses – of about 150%. Italy is a very, very wealthy country. Note in Figure 3 where some other counties – such as Norway and Denmark, for instance – sit in relation to Spain and Italy. Note also where Australia sits.
So global financial stability has improved; fundamentally it is quite good. Things remain tense and risks are elevated, but the risks are largely about irrational changes in sentiment and the impact this might have on liquidity. The only threat then is perception, and at the moment things have settled down, which is why you are seeing many of the key market stress indicators come off, although sovereign spreads have increased again recently.
Figure 4: Market stress indicators; 3m Euribor-3m OIS and EUR/USD 3m basis swap
Figure 5: Italian and Spanish 10-yr bond spread to 10-yr bund
Will things remain settled into perpetuity? No, of course not. But the above analysis strongly suggests to me that it is tactically advantageous to take advantage of these bouts of market turmoil by buying assets on the cheap, and I’ll offer further support for this view in my next instalment. Buy the dips, as they say; if there is one key take-away from recent history, certainly I think that would be it. It has proven to be very profitable. Mind you, so has selling the rips, but trying to predict a twist in sentiment is harder. Trade with it, by all means; swim with the tide – but note it for what it is.