Into the breach they go. Despite concerted efforts, Greece’s experiment with the euro zone stands perilously on the brink of collapse. On October 1, Greece released its draft budget for 2012 which outlined measures to rein in the country’s unsustainable public finances. On October 3, markets ostensibly dismissed deficit reduction plans and focused on the government’s admission that it will adjust its 2011 deficit projection upwards. US equity markets followed Europe, closing sharply lower. The S&P dropped below 1,100 for the first time in more than a year. Policy makers are running out of time as tension over the debt predicament continues to mount. Credit default swap spreads on Greek sovereign debt, a measure of how costly it is to buy insurance against their default, are at an all-time high (see chart). As of October 3, it costs 5,391 basis points or 53.91% per year to insure Greek bonds from default.
Figure 1. Sovereign Default Risk
Source: Bloomberg
Traveling through Europe this month solidified our belief that many American investors are too removed from the situation to fully appreciate the gravity of the crisis. The consensus among the European investors we spoke to is this: the Greeks recognize that they have no way out. “We must do within weeks and months what we have not done in months and decades,” said Evangelos Venizelos, the Greek Finance Minister, at a recent conference in Athens. Austerity talks may buy some breathing room, but in the end, many European investors believe a Greek default is only a matter of time.
The real question is what the fallout will be from a Greek default. The EU would move quickly to stabilize vulnerable euro zone nations committed to austerity. European banks, on the other hand, pose a less quantifiable risk. A liquidity crisis similar to the post-Lehman experience may ensue, although many Europeans believe its immediate impact would not reverberate to the US the way that the US crisis hit Europe.
If the financial crisis of 2007-8 had a silver lining, it served to remind investors that the return on one’s money means little in comparison to the return of one’s money. To that end, European investors remain underweight equities in general, with a specific aversion to the banking sector. That sentiment echoes Brown Advisory’s underweighting to developed international markets as well.
As for a Greek default’s long-term impact on the US, European investors find it hard to envision the US economy avoiding a double-dip recession. The possibility certainly exists. Headline GDP numbers in the US over the last few quarters point to sluggish growth. Further, rising deficits, persistently high unemployment and a debt-ridden American consumer add significant headwinds. But we don’t think another recession is likely. Current data surfacing from a range of American companies show reasons for cautious optimism. For example, domestic rail volumes, a barometer for economic activity, are indicating soft but reasonably stable demand, portending an extended period of below-average but still positive economic activity ahead.
Despite negative headlines, many US equities are priced to offer a favorable long-term opportunity. The S&P 500 currently trades for less than 13 times 2011 consensus earnings — a level very close to that reached in March 2009, the bear market’s low. Moreover, US corporations have staged an impressive earnings recovery by working operating margins back to pre-crisis levels despite the challenging economic landscape. Margin expansion, however, can only take valuations so far. Broad-based stock market appreciation must at some point
be driven by higher revenues. In the meantime, dividend-oriented stocks with stable cash flows offer a compelling, defensive option given today’s low-rate, low-growth environment.
So what will restart global growth? Rising emerging-market consumption for one. In the coming years, two billion people are projected to join the middle class, placing the region at the forefront of worldwide consumption. And looking longer-term, one would be remiss to discount the power of American innovation. Either way, what is needed, in our opinion, is time. And unlike Greece, we believe that for many US companies that generate surplus cash flows with conservative capital structures, time is on their side.
Paul Chew, CFA
Head of Investments
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