Financial leverage has again emerged as a major concern for investors. This time, however, its not the world’s leading financial institutions causing the worry, its sovereign debt.
In the past, countries that faced the biggest fiscal challenges were emerging economies or those ravaged by war. That makes it somewhat strange to see the weakest government balance sheets in developed economies, during peacetime.
This is not to say that these sorts of issues are new to Greece. In fact, the first ever recorded default in history apparently occurred in Greece in the 4th century BC. The country has also spent more than half the last 200 years in default — more than any other country in Europe, according to a recent report by Citigroup.
The problematic balance sheets of countries like Greece, Portugal, Spain, Ireland make the fiscal positions of most emerging markets look strong by comparison. While there will likely be more contagion stemming for sovereign credit concerns, including a dampening of the recovery and a delay of the withdrawal of cheap money, the the global fallout should not be severe enough to drive a double-dip recession, according to Robert Buckland, global investment strategist with Citigroup.
“There are a number of resolutions for big fiscal deficits. Some are positive for equities, others are not,” he said, noting that cheap valuations should provide some protection against further disappointments for global stocks.
Nonetheless, Mr. Buckland recommends equity investors tilt away from areas where fiscal issues are most acute until the problems are seriously addressed.
Of the 45 countries in the MSCI All Country World Index, Citigroup economists forecast that four will have larger deficits than Greece in 2010 and that represent more than 10% of annual GDP. Japan, the United Kingdom and the United States have some of the most troubling positions. However, Japan and the United States are deemed less of a concern. While Japan has the highest gross debt to GDP, it is a creditor economy with a current account surplus. Greece is second. Meanwhile, the United Kingdom is an economy that looks to be experiencing rising inflation, which may put pressure on the cost of financing, Mr. Buckland noted.
He expects emerging markets – where governments have sound balance sheets and companies offer solid growth – will continue to benefit from cheap global liquidity.
From an equity investors’ perspective, the strategist feels the best way to resolve a sovereign debt problem is via rapid economic growth. That means higher tax revenues to relieve the government’s fiscal shortfall, but also requires strong company earnings supported by a solid macro backdrop.
“Equities benefit from rising corporate profitability and falling risk premiums,” he said. “The rapid economic expansion may generate inflation, which will be to the detriment of bond holders. A bailout is better for financial markets, but likely to help bond investors more than equity investors.”
Photo: Greece's Finance Minister George Papaconstantinou arrives for a press conference in the Finance Ministry in Athens on February 9, 2010. Papaconstantinou announced Greece's new tax policy, to help the country get out of its economic crisis. (LOUISA GOULIAMAKI/AFP/Getty Images)