The Great Divergence
Bill Hester, CFA
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For a brief period during the last decade the developed economies around the world became one. Countries shared similar fiscal policies, interest rate policies, and spending patterns which resulted in uncharacteristically similar economic performances. Investors took their cues from these trends and sent financial market securities converging in price and yield. The range of bond yields tightened, the level of valuations became closely aligned, and trailing stock returns were remarkably similar. As the developed economies continue to recover from the world-wide credit crisis, and now face new pressures of over-levered sovereign balance sheets and the prospects for below-average economic growth, investors should expect financial market performance among countries to continue to diverge.
The convergence of financial market performance that began in the second half of the 1990's – both in the bond and equity markets – was helped by three major forces. The first was the trailing effects of the period of The Great Moderation. Economic cycles stretched out and moderated during the 1990's and early 2000's, not only in the US but in most of the major European economies as well. Economic growth stabilized, inflation subsided, and exogenous shocks were fewer and came with less impact so investors pushed bond yields lower and stock prices higher on an expectation that the moderation would continue. The second trend fueling the convergence in financial market performance was very strong world-wide growth. World GDP grew at an average rate of nearly 5 percent in the three years through 2007, versus a longer-term average of 3.2 percent. More moderate economic cycles and investors' perceptions that world growth would remain strong helped countries with weaker structural characteristics converge in valuation with those with better characteristics.
The third event that supported the convergence was the adoption of the Euro by the countries in the European Union. The hope of the single currency was to introduce a viable alternative to the US Dollar as a world currency and to make trade and the economies of Europe more efficient by lowering financial transaction costs. As soon as the Maastricht Treaty was agreed upon, European countries began to focus on the hurdles to enter the union, including lowering deficits and debt levels. This brought an alignment among Euro members in leverage characteristics, which over time misled investors into thinking that a monetary union meant singular economic outcomes.
These three forces proved potent in diminishing investors' assessment in the differences in the characteristics of individual countries. The graph below shows the spread between the highest and lowest 6-month returns of the members of Morgan Stanley's index of developed countries (the spread is smoothed to highlight the medium-term cyclical fluctuations of the series).
The large spread around 1990 highlights the weakness in the Nordic countries during this period as their stock markets collapsed as they battled their domestic banking crises. The peak around 2000 coincides with the peak in the world-wide stock market bubble where a few indexes that were over-weighted in telecommunication and technology stocks fueled strong relative outperformance. But even outside of those peaks, the graph shows that during the 1970's and 1980's it was typical for there to be large divergences between the best and worst performing countries – 40 to 50 percentage points difference was typical. More recently through 2007 the divergence in stock market returns among developed countries collapsed. There was very little value in making distinctions at the country level when individual country returns were so tightly centered about broad benchmark return levels.
These trends have shifted the last couple of years and the recent spread between relative performances continues to widen. Year to date, Denmark's benchmark index is up 20 percent, while the Athens Stock Exchange index has dropped 33 percent. Country selection is beginning to matter again.
Bond Yield Divergences
One of the strongest benefits of the shared currency was that investors began to price government debt similarly across the Euro area. The countries of southern Europe and countries with smaller economies felt the greatest amount of benefit. Yields on Greek debt fell by more than half in less than 10 years. Ireland and Spain also directly benefited from a collapse in borrowing rates. This helped their economies prosper, fueled partly by lower bond yields and booming housing markets.
As the bottom right section of the graph above shows investors have returned to assessing individual country risk, and they are quickly re-pricing that risk. These trends are worth watching because they've mostly continued to deteriorate in the time since the ECB announced its $1 trillion rescue plan in May. Spreads between German bond yields and the debt of peripheral European countries have blown out to levels nearly as wide as immediately prior to the rescue. The spread between bonds issued by Portugal and Bunds are 8 times the longer-term average of the spread. Spanish bond spreads are trading at 13 times their longer-term average.
The widening spreads between the bonds of peripheral Europe and Germany are, of course, picking up both aspects of investors' reactions. Bond investors are demanding higher yields from the debt of countries with less attractive leverage profiles and seeking out the safer debt of countries like Germany, widening spreads.
The risk is that the cost of borrowing money from bond investors for the highly indebted countries will rise substantially, offsetting any improvements they can make in their budget outlook by way of higher taxes or pushing through austerity plans. One important threshold has already been surpassed. Over the last couple of years the cost of borrowing money for longer-periods for the peripheral European countries has been below the average coupon rate of their existing debt. This was a result of low inflation and low policy rates worldwide. Recently though, the 10-year note yield for many of these countries has risen above their historical average cost of issuing debt. The yields on Portugal debt are now more than full percentage point above the average cost of its debt currently outstanding. The yield on the debt of Ireland and Spain are now also trading at yields above their own historical cost of borrowing.
Diverging bond yields might be one of the more important risks to the relative valuation between countries. The convergence of bond yields was dramatic near the middle of this decade and fueled a convergence in stock market valuations. Investors have likely already begun to factor in new levels of long-term discount rates in valuing worldwide benchmarks.
Economic Growth Divergences
The divergence in discount rates will likely be only part of the valuation readjustment process. The other part that investors will be factoring into their analysis is the expectations of future cash flows. These expectations are also diverging. Returning to the Euro area, during the first decade of the monetary union economic growth was mostly aligned among member countries. Economic growth was faster in the smaller, peripheral countries. But as a group, growth was widespread and stable among Euro-area countries.
Countries within the union used these years of favorable tail winds in different ways, points out David Marsh in his new book The Euro . Measures put into place during this period – like a containment of worker incomes and domestic investment - has helped Germany become the best-managed of the larger Euro countries in his view. And German companies have emerged with increased competitiveness. According to the Organization of Economic Cooperation and Development, Germany improved its competitiveness against all other countries by more than 10 percent in the decade through 2007, based on labor costs per unit of output in industry. Over the same period, Italy's competitiveness position worsened by 34 percent.
It's also clear that the leaders of European countries plan on pursuing different strategies in tending to their violations of the Maastricht Treaty (which included limitations on deficits and debt loads when measured in relation to GDP). For one brief moment in May, European leaders came together with one voice to announce their bailout plan. Since that time, the rhetoric has reverted back to the more typical disparate tone. Countries like Greece, Portugal, and Germany have announced that they are pursuing mostly strategies of austerity (sending the US-based Keynesians who architected the American bailout plan into a frenzy). The French leaders have mostly balked at this strategy. France's Prime Minister Francois Fillon was quoted this week saying that “for the moment, we are trying to avoid austerity”.
The vastly different approaches to solving the sovereign debt problem in Europe are likely to produce a wide array of outcomes. And considering the amount of debt that has to be reigned in, across so many countries, leaves this as more of a hopeful experiment than a simple follow-through of a textbook economic theory. It's becoming clear that investors are moving from a period where they were mostly focused on the strengths of a single currency to a period where they are concerned about the inherent weaknesses of the union. As they do, the growth forecasts for individual countries will come into greater focus. Over the last decade there has typically been about a 2 percentage point spread between the rates at which the fastest growing countries expanded at versus the slowest countries. This spread will likely widen. The expectations for economic growth over the next couple of years are currently much wider. The graph below shows the expected GDP growth in 2010 across a range of countries.
There's almost 8 percentage points difference between the expectations for growth in Canada versus the expected contraction in Greece. And more than 3 percentage points difference in expected growth among Euro-area countries. The table also shows that the companies with the most challenging near-term debt loads – Italy, Portugal, Ireland, Spain, and Greece – also have the worst prospects for economic growth.
Benchmark Bank Weighting Divergences
The tremors that have been felt in US and European stock markets this year are less about sovereign debt risks then they are about the concentration of risks on European bank balance sheets. If Greece's debt – along with the debt of Spain and Portugal – was more diversified among governments and institutions, then a default of the debt might cause fewer problems as the pain of a write-down would be more widely distributed. Instead, European banks hold a big slug of this debt. The Economist magazine recently estimated that foreign banks' exposures to Greece, Portugal, and Spain combined comes to Euro 1.2 trillion and that most of this debt is being held by European Banks. German bank holdings alone account for almost a fifth of the total debt.
So investors are showing sensitivity to European bank stocks and indexes that have a large weighting of financials in their benchmark index. The graph below shows that there's been a rough correlation between the performance of country benchmarks and their weightings of financial stocks.
The riskiness of European bank balance sheets may not be an issue that is quietly swept under the rug. That's because the debt repayment schedules of the countries with the greatest amount of stress on their sovereign balance sheets are very much front-loaded. For the countries that are most often grouped together - Greece, Portugal, Italy, and Ireland, and Spain – about two-thirds of their total debt is due over the next three years. These aren't risks that sit far out on the horizon. These are risks that come due in the next few years.
In addition to monitoring country risk, investors will likely be assessing broad benchmark risk by measuring the weight of each index that is dedicated to financial companies and which banks hold the greatest amount of debt from the countries with the highest leverage ratios. These differences will also likely fuel future divergences in benchmark returns.
International stock markets are undergoing a new level of analysis at the country level. It's likely that investors are beginning to price in changes in their assumptions of futures cash flows and discount rates, informed by each country's growth prospects, debt levels, inflation risks, and fiscal battle plans. If the first decade of this century was about the convergence of economic performance, bond yields, and stock performance in developed countries, the next few years may be about the growing divergences in these characteristics. If so, country selection will begin to matter again.
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