Topic Tags: International Economy

The Greek Debt Drama and Guidance for Investors

July 2015 Investment Perspectives

With a history rich in theatre, Greece’s starring role in the “Grexit” drama has featured several rounds of inconclusive negotiations, the resignation of a finance minister, the closing of Greek banks, and a missed payment to the IMF. Finally, on July 13, Greece and its creditors reached an agreement on a third rescue package that likely ensures that Greece remains in the Eurozone. Key pension and tax reforms constitute some of the key austerity measures while Greek officials promised to set up a privatized fund by selling $50 billion in state owned assets. The funds will be devoted to the recapitalization of banks as well as debt servicing.

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Putting Greece in its Place

There has been much talk about a potential “Grexit”, as some believe it is inevitable and may be the best solution in the long run. Nonetheless, Greece is receiving its third bailout in five years to prevent such a thing.

There has been much talk about a potential “Grexit,” as some believe it is inevitable and may be the best solution in the long run. Nonetheless, Greece is receiving its third bailout in five years to prevent such a thing. The new bailout plan comes with some tough austerity measures in which Greece will have to make cuts to pensions and increase taxes in order to receive €86B ($96B) in new loans.

The fear of contagion has been cited as a reason for yet another Greek bailout. If Greece were to leave the Eurozone, a dangerous precedent may be set and other countries with high debt levels (such as Spain, Italy, and Portugal) may decide to follow. Even if these countries do stay, they may have difficulty finding investors to purchase their bonds. On the other hand, by continuing to bail out Greece, these countries may be less willing to make reforms and come to expect their own bailouts if their debt gets out of hand.

However, this week’s chart puts the Greece situation into perspective, particularly for U.S. investors. For all the attention Greece receives, it has a smaller economy than the state of Wisconsin and is less than half the size of Illinois. Even among the Eurozone, Greece contributes a mere 1.9% to the area’s GDP. Though there is the possibility of a domino effect, it seems unlikely that the events in Greece will have a large effect on the global economy.

Divergence of Unemployment Rates in Europe

The Maastricht Treaty mandates the European Central Bank (“ECB”) to target inflation. In contrast, the Federal Reserve targets maximum employment, appropriate inflation, and moderate long-term interest rates. When comparing unemployment rates between the world’s two largest currency blocks, the United States has seen a much stronger recovery with lower levels of dispersion between states.

The Maastricht Treaty mandates the European Central Bank to target inflation. In contrast, the Federal Reserve targets maximum employment, appropriate inflation, and moderate long-term interest rates. When comparing unemployment rates between the world’s two largest currency blocks, the United States has seen a much stronger recovery with lower levels of dispersion between states. The U.S. benefits from its ability to utilize fiscal stimulus, automatic stabilizers, and unconventional monetary policy.

On the other hand, the European Central Bank does not have the power or the authority to use automatic stabilizers on behalf of individual nations dealing with asymmetric shocks. It can only expand and contract its balance sheet by purchasing debt or issuing bonds as a third party. As this week’s chart shows, one of the direct consequences is that improving unemployment – among other economic challenges – is extremely difficult across a diverse set of countries. Thus, unlike the United States which has seen improvement in unemployment across all of its states, a notable divergence continues to exist across European nations and remains a challenge for future economic growth in select countries.

International Equity Returns vs. Strong Dollar

A major concern for investors over the last year has been the impact of a stronger dollar on international equity returns. Generally speaking, a stronger dollar translates to lower returns for international equity investments, and in 2014 the currency effect on the EAFE index was -10.9%, a sizable reduction to returns for U.S.-based investors.

A major concern for investors over the last year has been the impact of a stronger dollar on international equity returns. Generally speaking, a stronger dollar translates to lower returns for international equity investments, and in 2014 the currency effect on the EAFE index was -10.9%, a sizable reduction to returns for U.S.-based investors. On the other hand, valuations for international equities – especially those in Europe – appear far more attractive relative to levels in the U.S., and suggest higher upside potential, with the ECB’s asset purchase program offering further upside for European equities.

To date, how has this dynamic played out? Have the compelling valuations abroad been more than offset by the currency drag from the dollar’s strength? Our chart this week examines these very questions, looking at year-to-date performance for major markets and regions. Perhaps not surprisingly, Eurozone equities show the largest downward adjustment as a result of exchange rates, while Japan and China show little to no difference between local and dollar-denominated returns. After the first quarter, international equities have outperformed their U.S. counterparts in 2015 and rewarded investors who were patient with their non-U.S. equity allocations. Though it has only been one quarter, this is a theme that may persist for the better part of the year, as the dollar is still stronger than its historical average versus the Euro, and equity valuations are suppressed relative to those in the U.S.

Yield Compression in the Eurozone

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward-looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

On March 5th, Mario Draghi, President of the ECB, announced the details of the QE program and surprised markets by stating that purchases would include issues with maturities as far out as 30 years, causing a compression in yields (actual purchases by the ECB and various national banks began on March 9th). As the chart demonstrates, the largest yield compression has occurred in German bonds, where yields on 30-year maturities were 0.633% on Wednesday morning, down from 0.946% on March 5th. The spread between 2 and 30-year German bonds is currently 87 basis points. Yields for some of the riskiest longer-dated European debt (demonstrated here by Spanish and Italian bonds) have also seen compressions, though the spread between 2 and 30-year yields remains around 2%.

What does this mean for investors and the ECB bond buying program? Given the inverse relationship between bond yields and prices, the notable drop in yields has benefitted investors. However, reinvestment risk is a significant concern for investors should they sell their current holdings, as they would then have to purchase newer bonds that feature lower yields and coupons. Unless immediate cash is needed, bond investors will be loath to give up their higher yielding bonds in exchange for lower yields. Some wiggle room will be available as the front runners of QE look to cash in their profits, but others may hold out for a time since the ECB is a large, price indifferent buyer. Eventually, supply will normalize, possibly through a combination of profit taking and the ECB “nudging” those stubborn bondholders to sell.

Fragile Five Now Fragile Four?

In 2013, Brazil, India, Indonesia, South Africa, and Turkey were dubbed the “Fragile Five” due largely to high current account deficits and dependence on foreign capital flows. During the “Taper Tantrum”, these currencies were hardest hit recording double digit losses. This week’s chart provides an update on current account balances for each respective country.

In 2013, Brazil, India, Indonesia, South Africa, and Turkey were dubbed the “Fragile Five” due largely to high current account deficits and dependence on foreign capital flows. During the “Taper Tantrum,” these currencies were hardest hit recording double-digit losses. This week’s chart provides an update on current account balances for each respective country.

While the “Fragile Five” have been famously linked together, India has taken steps to distance itself from the group, improving its current account deficit from -5.1% in March 2013 to -1.3% in September of 2014. In addition, markets have praised the election of Narendra Modi as Prime Minister, given his focus on business confidence, economic growth, and structural reform. In sharp contrast, Brazil’s current account balance has declined and its political turmoil has heightened.

With the U.S. preparing to raise rates, emerging market participants are concerned about the possibility of a “Taper Tantrum” repeat. Relative to 2013, India is in a better position to handle such an environment. India’s contrasts with Brazil exemplify a growing trend of divergence within emerging markets, one that investors should expect to continue. Another tantrum will negatively impact the entire asset class, but some countries are better positioned to navigate the turbulence.

Europe’s QE: Better Late than Never?

The European Central Bank (ECB) announced Thursday it will begin a quantitative easing (QE) program in which it will buy €60 billion worth of assets a month. The program, which will commence in March and continue through September 2016, will purchase both government and private sector bonds as well as other institutional debt securities. This move comes after the U.S. and U.K. have ended their own QE programs following declining unemployment and modest GDP growth.

The European Central Bank (ECB) announced Thursday it will begin a quantitative easing (QE) program in which it will buy €60 billion worth of assets a month. The program, which will commence in March and continue through September 2016, will purchase both government and private sector bonds as well as other institutional debt securities. This move comes after the U.S. and U.K. have ended their own QE programs following declining unemployment and modest GDP growth.

Though there are a wide variety of opinions on the effectiveness — and consequences — of QE, the ECB hopes it will be the economic jump start that many of the countries in the Eurozone desperately need. The most recent GDP growth for the region was 0.8%, while unemployment was 11.5%. Additionally, the latest IMF forecast gave the Euro Area a 38% chance of falling into another recession. But the most troubling issue for the Eurozone is its inflation rate, which fell to -0.2% in December. Deflation can make it more difficult to pay back debt, which is especially worrisome for countries such as Greece, Italy, and Spain that have debt exceeding 100% of GDP. If the ECB is successful in achieving its 2% target inflation, this, in theory, would lead to further devaluation of the Euro, which has already fallen over 17% against the U.S. dollar since the start of last year.

How QE will affect the different parts of the Eurozone is difficult to predict. Unlike other QE programs, this one spans multiple countries and banking systems, some of which are opposed to this monetary policy. Stronger economies, such as Germany, warn that this shouldn’t be used as a method to avoid structural reforms while others feel the move was long overdue. Either way, with the threat of a third recession since 2008 looming, Europe appears to be left with little choice.

2015 Market Preview

January 2015

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2015 is no different: U.S. equities are at all-time highs, uncertainty reigns for international equities, and to everyone’s surprise, interest rates fell dramatically in 2014…but are poised to rise from historic lows over the next year. In the alternative space, real estate remains a solid contributor to portfolio returns, and private equity delivered on return expectations, though dry powder is on the rise. Hedge fund results were mixed, but have shown to add value in past rising interest rate environments. Further macroeconomic items that bear watching for their potential impact on capital markets include the precipitous fall in oil prices, the strengthening U.S. dollar, job growth, and international conflicts.

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Currency Effects on International Equity Returns

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities.

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities. In some instances, the impact of the stronger dollar has flipped positive returns denominated in local currency to negative returns when translated to U.S. dollars. In fact, this phenomenon has occurred year to date in 2014: the local currency return for a primary international equity index (MSCI EAFE) is positive (red bar; 4.2%), but becomes negative when denominated in dollars (blue bar; -2.4%).

In our Chart of the Week, we examine the retrospective returns of the MSCI index, denominated in both local currency and U.S. dollars. Based on the chart, two conclusions seem straightforward:

  • The “winner” each year will vary over time, which is not surprising since the U.S. dollar strengthens in some years and weakens in others.
  • Over the long term, the relative strengthening or weakening of the U.S. dollar is more or less balanced out, as the cumulative returns of each index – local and dollar – suggest, shown by the convergence of the two cumulative return streams.

If nothing else, this week’s chart should provide some comfort to investors whose returns have been negatively impacted by a stronger dollar: although the dollar acted as a drag on international returns this year, it is highly unlikely this will be a consistent pattern in the coming years, and should certainly not serve as a worry for long-term international equity investors.

Initial Results of the ECB’s Targeted Loan Operation Fall Below Expectations

This week’s chart examines the results from the first round of the European Central Bank’s (“ECB”) targeted long-term refinancing operation (“TLTRO”) which occurred on September 18th. The ECB announced this program in June 2014 with the goal of encouraging lending to small and mid-size companies in the region.

This week’s chart examines the results from the first round of the European Central Bank’s (“ECB”) targeted long-term refinancing operation (“TLTRO”) which occurred on September 18th. The ECB announced this program in June 2014 with the goal of encouraging lending to small and mid-size companies in the region. The TLTRO essentially provides a four-year loan to banks at a fixed low rate. This serves as one of several tools the ECB has utilized to address the low inflation and contracting credit conditions in the Eurozone.

With 400 billion euros available, only €82.6B were borrowed by banks, well below the €150B estimated by a Bloomberg survey. Considering the initial outcome, investors are starting to question the potential effectiveness of the program. However, it is important to note that in the month of October the ECB will announce the results of the Asset Quality Review (“AQR”), which is a comprehensive assessment of banks’ balance sheets. The Eurozone’s financial institutions may be more willing to participate in the TLTRO after the stress tests are complete. The second round of TLTRO is slated for December and will provide insight into loan demand in the region as well as essential feedback to the ECB about the effectiveness of its policies. Without stronger demand for loans from this program, strong growth in the Eurozone would seem dubious, and thus participation in later rounds of TLTRO bears watching.