 The European tragicomedy is dragging on longer than bearable. That all actors know what needs to be done, but no one actually wants to do what’s necessary makes this show rather bizarre. Here in no particular order is the painful follow-up act the world is about to witness;
1. Debt restructuring: Returning the public finances of Greece to something that resembles sustainability probably requires a reduction in public debt outstanding of well over 50%. In other words, Greece’s public debt to GDP ratio needs to fall to no more than 60% of GDP from around 140% currently. Exactly what combination of principle reductions, maturity extensions, and cuts to coupon rates is required to achieve this is a second order issue. The important thing is that Greece’s public debt servicing burden has to be massively reduced.
2. Bank recapitalisation: In preparation for the Greek default, Europe’s banks (including the Greek banks) need to either raise capital from financial markets or from the European Financial Stability Facility (EFSF) or from their respective Governments directly. Needless to say, trying to raise capital after a Greek default will be tricky to say the least.
3. Austerity, public finance reform: Don’t think for a moment that default lets the Greeks off scot-free. A big part of the reason Greece got into this mess is that the tax system has been dysfunctional. The days when a substantial percentage of the Greek population treated paying tax as an option they would prefer not to exercise are long gone. The reform task is still enormous, but is significantly easier without such a massive debt servicing burden. Moreover, selling much needed reforms is easier when the population knows that the burden of adjustment is being shared – particularly with foreign bondholders.
4. Eurobonds: There has been much talk about how the Euro system has a number of serious flaws in its design that rendered a crisis such as the present one inevitable. One such flaw is the lack of a fiscal union to accompany monetary union. In other words, the system lacks a central borrowing authority to act on behalf of all member states. Why doesn’t it have one? In short, probably because the core countries, particularly Germany, were most reluctant to effectively subsidise the fiscal reprobates on the European periphery, whose commitment to sound public finances was shaky to begin with, and has now been shown to be non-existent. Now, in return for commitments and actions on public finance reform and austerity measures (albeit less severe) the German taxpayer is going to have to be convinced to provide just such a subsidy, because there is no chance of Greece returning to world markets as a credible stand-alone borrower any time soon.
5. Repeat 1-4 for Ireland and Portugal: Greece is the worst offender, but it is not alone. Rather than hope the problem will simply go away after dealing with Greece, the Europeans would be far better off (as would the world) if EU policy makers would just accept that they cannot only respond when there is a crisis. What is required is a pre-emptive approach. If they are prepared to address Greece, Ireland and Portugal in relatively quick succession, they stand a very good chance of preventing contagion to Spain and Italy.
Given this unsavoury sequence of events to follow, investors need to have protection built into their portfolios through both high quality equities and more importantly term deposits. Domestic equities are going to face headwinds in a world where aggregate demand falls due to questionable government lead austerity drives in most of Western Europe and the United States. Looking at the large diversified conglomerates, tourism and logistics dominate on the risk curve, followed closely by soft commodities and financials. Tourism is the highest risk sector on grounds that the Sri Lankan market is still dominated by high spending European tourists. While the luxury and top end will be spared pain, the vast bulk of the median will be negatively impacted as unemployment and austerity begin to bite in both Europe and UK. While absolute number of arrivals should trend higher, the lack of penetration in high spending Asian economies point to structural weakness for the sector over the short to medium term.
Tracking the fortunes of DHL, Federal Express and UPS over the past few weeks have confirmed doubts I’ve had about the outlook for global trade and demand growth. Potential weakness in logistics is caused by shrinking demand and uncertainties about China. Though Chinese economic growth rates have moderated to a level that is consistent with capacity growth and inflation pressures have eased a bit, credit growth in China remains high and concerning because growth and demand are coming from a leveraging up of the credit system, not from income growth as they did before. Second, credit creation is increasing bypassing the formal credit system. As China heads for a soft landing and consumption increasing at the expense of trade, earnings from logistics will come under renewed pressure. While India can replace some of this capacity, inflationary pressures there should stymie demand over the short term.
Soft commodities should see little pressure on prices as bulk Sri Lankan exports belong in the low risk category. The same cannot be said of currencies, which have had the most volatile run during September in over three years. It is currencies and more particularly the various treasury functions within the larger conglomerates that investors will need to pay particular attention over the next year. It is routine for management to annually decide on pricing strategies and currencies. A bad hedging decision or maturity re-profiling carries enough risk to wipe out an entire company. Investors must be happy to endure sideways price performance as long as dividends hold strong over the next twelve months. In the absence of a crystal ball, diversification is the only real investment strategy that will hold you in good stead during good times and bad.
(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at
kajangak@gmail.com)
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