Given the volatility of the global markets in recent years, foreign currencies have become a substantial factor to consider when investing in non-U.S. securities. The BRICs (Brazil, Russia, India, and China), generally known as the most influential emerging markets, are experiencing various situations that have had a negative effect on their respective currencies. Brazil has seen a resurgence in its consumer default rate as previous bad loans are manifesting themselves. Many analysts believe that this is similar to the recent subprime loan collapse in the United States, as the consumer debt default rate reached 7.6% in April. India is in danger of losing its investment grade rating due to trade and budget deficits. Russia’s main export of crude oil has suffered a 26% drop in price this quarter alone, driving investors to more stable nations. China has avoided the major drops that other currencies have versus the dollar, and the economic policies have thus far kept the currency value at a secure value, though it dropped over 1% in the second quarter. Furthermore, home prices fell in 54 of 70 cities tracked in China during the month of May. China has also reduced its annual growth target to 7.5% from 8.0% due to the slowing of demand for its exports as consumer demand in other nations has been sluggish.

The weakening currencies could present an opportunity for investors looking to enter emerging markets, as it may increase the competitiveness of the emerging markets countries affected, and hurt corporations based in developed countries with strong presence in the BRICs. For example, analysts believe the currency effect in Brazil will be a significant headwind this quarter for Coca-Cola Co., which has been investing heavily in South America and has experienced substantial growth in the region.

This week’s chart shows trends in tax revenues, indexed to 2007, for a group of ten selected countries (based on rolling twelve month averages for each). Taxes are the main source of government revenues and a crucial factor for the fiscal stability and economic growth of countries. Tax revenues are appropriated for public works, interest payments, financial assistance, education, infrastructure, growth incentives, and counter cyclical measures.

As the chart illustrates, there has been a divergence of tax revenues between developed and emerging market countries. Since 2007, most emerging market governments’ tax revenues have increased while the majority of developed countries’ tax revenues have either decreased or slightly increased.¹ Many developed countries across the world continue to face revenue headwinds as they de-lever and recover from the 2008 financial crisis and subsequent economic slow-down, all of which have lowered tax revenues.

Going forward, this chart suggests a much more favorable backdrop for emerging market countries compared to developed countries. An increasing trend in tax revenues should allow emerging market countries to allocate money to public services as well as investment in infrastructure, education, research and development, and other important factors that contribute to countries’ long-term success and prosperity. Developed countries are struggling to maintain public services and programs with limited revenues and are being forced to borrow money; the U.S. has over $15 trillion in debt outstanding and is projected to run a deficit of approximately $1.2 trillion in 2012.² As this occurs, investment in infrastructure, education, and other important growth platforms is placed on hold as more money is allocated towards debt and interest payments.

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¹ Bank of Korea, Bank of Italy, Federal Reserve, Bank of Thailand, UK Office for National Statistics, Bank of Greece, National Bank of Poland, Bank of Japan, Bank of Spain, Bank of the Republic of Columbia

² Congressional Budget Office as of 03/31/2012

Another round of bailouts, totaling €130 billion, was approved for Greece on Tuesday. As with other Greek bailouts, the receipt of the money was contingent on further budget cuts and austerity. Going forward, Greece faces two main concerns, one short-term, and one long-term. In the short-term, Greece will likely continue to experience solvency/liquidity pressures, as large debt and deficits require continued aid and debt write-downs. The approved bailouts help relieve these pressures.

However, continued austerity in the face of negative GDP growth and large deficits may exacerbate Greece’s financing problems. Austerity has improved Greece’s finances less than expected, as budget cuts result in lower GDP and thus lower tax revenues. As recently as March 2011, the IMF expected Greece’s contraction to bottom in 2010, and resume growth by 2012. New estimates from the Eurogroup expect the GDP contraction in Greece to bottom in 2012, and resume growth by 2014. It is difficult to see how this goal is achievable utilizing similar policy prescriptions that have failed to work in the past. Forecasts may still be overly optimistic.

Regardless, short-term solvency issues can continue to be relieved by further bailouts as long as there is political will. Longer-term competitiveness problems may be more difficult to solve. EU officials hope that Greece can transform into a competitive, export-driven economy. Currently Greece, along with other PIIGS countries, runs a large current account deficit. Simultaneously, Germany runs a large current account surplus. One of the main drivers in the competitiveness gap between Greece and Germany are differences in unit labor costs. Unit labor costs measure the average costs per unit of output, and are calculated as the ratio of total labor costs to real output.

The chart above shows the change in unit labor costs for select Eurozone countries since 2002. Greece’s labor costs over this period have risen significantly, while Germany’s have barely budged. The two main solutions to this gap are relative inflation in Germany (unlikely given its history), or years of wage deflation in Greece. This suggests that the adjustment period for Greece as long as it remains in the Eurozone could be quite long indeed.

The Financial Stability Board (“FSB”) recently released a list of global systemically important financial institutions (“SIFIs”). Based on information from its website, the FSB was established in 2009 and acts to promote financial stability. The current Chair of the FSB is Mario Draghi, the new head of the European Central Bank (“ECB”).

SIFIs are financial institutions deemed large and complex enough that their failure would cause ripple effects throughout the financial system. Of the twenty-nine banks on the FSB’s list, nine are American, and seventeen are European. The full list is shown below:

Asia

• China: Bank of China
• Japan: Mitsubishi, Mizuho, Sumitomo Mitsui

Europe

• Belgium: Dexia
• France: Banque Populaire, BNP Paribas, Credit Agricole, Societe Generale
• Germany: Commerzbank, Deutsche Bank
• Italy: Unicredit
• Netherlands: ING
• Spain: Santander
• Sweden: Nordea
• Switzerland: Credit Suisse, UBS
• United Kingdom: Barclays, HSBC, Lloyds, Royal Bank of Scotland

North America

• United States: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street, Wells Fargo

This week’s chart shows CDS spreads on SIFIs of select countries. For countries with multiple banks on the list, the average CDS spread of available data is taken.

Rises in the CDS spreads of SIFIs represent growing concerns about systemic risk. Because these financial institutions are large, opaque, and interconnected, rising investor worries about the European debt crises can lead to rising investor concern about the financial health of SIFIs.

As seen in the chart, CDS spreads on Italian banks (Unicredit) began to widen in June. In July, 10-year yields on Italian government debt leapt from 5.0% to nearly 6.0%. The ECB began purchasing Italian bonds on August 8, quickly bringing 10-year Italian yields back down to 5.0%. CDS Spreads on Italian banks continued to rise, however, ending August up 43 bps.

In August, despite the apparent effectiveness of the ECB’s intervention, CDS spreads on U.S., French, German, and Swiss SIFIs increased dramatically. CDS spreads on Spanish and UK SIFIs increased from already elevated levels. French banks, for example, entered August with CDS spreads of 168.6 bps. They ended September up over 100 bps, at 281.9.

During this time, risk assets were pummeled, with the S&P 500 dropping 14.2% in August and September. High yield spreads widened from 540 bps to over 800 bps. Since September, both stocks and high yield bonds have recovered significantly, though high yield spreads remain elevated. Importantly, while CDS spreads on SIFIs are below their peaks, they are still much higher than they were in July. This indicates that despite the recovery in risk assets, investors are still wary of global systemic risk.

In this environment, all risk assets are exposed to global event risk, likely emanating from the EU. For example, the wrong headline out of Greece or Italy could ripple through the global economy causing drops in U.S. stock and corporate bond prices. Financials remain high risk, with potentially high reward. As Jeffries showed, investors may sell first and ask questions later. Attractive opportunities to add risk may present themselves, as the baby gets thrown out with the bathwater.

The Purchasing Managers Index (“PMI”) attempts to gauge the health of the manufacturing sector in a given economy. As securities markets around the globe fluctuate wildly trying to predict the future path of global economies, this general economic indicator is flashing warning signs. A reading above 50 signals a manufacturing sector that is generally expanding, while a reading below 50 indicates a contraction in the manufacturing space. In October, the U.S. index reported a reading of 50.8, indicating very slight expansion in the manufacturing sector for the month. However, this number is part of an overall downtrend for the U.S. since a reading of 61.4 was logged in February, 2011. The Eurozone as a whole fell deeper into contraction during the month of October, with an index reading of 47.1 after first dropping below 50 in August of 2011. The picture isn’t much brighter for emerging economies, which are expected by many to drive global growth in the future. Brazil reported a PMI of 46.5 in October, and even China remains only slightly expansionary at 50.4. While the PMI is not the sole factor used to predict economic growth, these recent readings represent another headwind for sputtering economies.

Over Monday and Tuesday of this week the Nikkei 225 (major Japanese stock market index) fell 16.1% – dropping from 10,254.43 on March 13th to close at 8,605.15 on Tuesday. As this chart shows, this is the worst two-day drop for the Japanese market since the 1987 stock market crash and worse than any two-day period during the financial crisis, or during the deflating of the Japanese stock market bubble in the early 1990’s. This chart also shows that periods of extreme stock market performance in one direction are often followed by large stock market performance in the opposite direction. While the devastation in Japan is shocking and the future uncertain, if history is any guide a substantial rebound in the Japanese market over the next week would not be surprising.