Co-Authored By Luciano Siracusano, WisdomTree Chief Investment Strategist
Global equity markets plunged during the third quarter (“Q3”). A number of global market indexes such as the MSCI ACWI Index entered bear market declines (defined as a decline greater than 20%), while the S&P 500 Index fell into bear market territory briefly during the first week of October. Despite the sharp rally in global equities during October, we believe volatility is likely to hinge largely upon ongoing uncertainty stemming from Europe. If appropriate, investors may consider positioning equity portfolios to limit downside risk, while maximizing current income.
We believe the two primary risks facing global markets both emanate from overseas: the threat posed to the European banking system by the Euro debt crisis and the threat to emerging market economies and global Gross Domestic Product (GDP) growth should China’s economic growth materially slow.
In recent weeks, the world’s attention has centered on Europe. Shares of European bank stocks were down approximately 30% in Q3. In October, Fitch downgraded the credit ratings of Italy and Spain; also in October Dexia, a French-Belgian bank, required a multi-billion dollar government bailout. A statement by European leaders on October 27th indicated potential progress on a 50% Greek sovereign debt voluntary haircut program for the private holders of Greek debt, an avenue to potentially utilize leverage to increase the size of the European Financial Stability Fund (EFSF), and the initiation of a bank recapitalization requirement of 9% core tier 1 capital. The statement was greeted by markets with an initial sense of euphoria, but it has been followed by continued uncertainty, not the least of which is the back and forth discussions of a Greek voter referendum on whether the Greeks are willing to comply with the European demands for Greek austerity measures.
Of the countries within the Eurozone, it is clear that Greece is under the most pressure. Traditionally, countries only have four choices when faced with similarly high debt burdens: faster economic growth, currency devaluation, austerity or default. Currency devaluation is currently off the table for all countries in the European Monetary Union, which use the Euro as their currency. Greece’s unemployment is currently high and its prospects for a sudden pick-up in GDP growth are currently low, so the only two remaining options are austerity or default. Austerity does not seem to be working.
Greek officials declared recently that they will not be able to hit European Union (EU) targets for reducing fiscal deficits as a percent of GDP in 2011 or 2012 because of difficulty collecting enough tax revenue. Markets additionally have been skeptical that the proposed 50% haircut will be enough to get Greece’s debt to GDP ratio down from about 160% today to about 120% by 2020, the stated goal from the October 27th statement.
The banking crisis that became a sovereign debt crisis is threatening to morph once again into a banking crisis. While most global equity markets responded positively to the October 27th news initially, further details of the plan may prove sobering when both its costs and pitfalls come under greater scrutiny. In our opinion, a likely result will be dilution: dilution to the bond holders of Greek debt of 50% proposed in October or even more; dilution to the common shareholders of European banks that must buttress their core tier 1 capital to the proposed level of 9% while also facing write downs on the debt held on their balance sheets; dilution (downgrades) of sovereign credit ratings, as national debt burdens and interest costs rise with the assumption of new liabilities; and depending on the extent of the European Central Bank’s involvement, further dilution of the Euro itself. At present, the statement from European policymakers does not even address specific potential solutions for the issues of Italy and Spain, where unemployment rates are over 8% and 20% respectively.
Not surprisingly, the Euro has re-emerged as a focal point for the direction of global markets. The Euro, it can be argued, has become a kind of shorthand for European distress. The Euro exchange rate versus the U.S. Dollar fell 10% from its highs in May this year and most of that decline occurred in September. As the euro fell in the final weeks of the third quarter, the dollar rose, and riskier assets declined, with global equities, emerging market currencies and commodities retreating in tandem.
U.S. stocks, as represented by those within the S&P 500 Index, have been negatively correlated to both the U.S. dollar and to U.S. bonds over this period. On average, on days the Euro has risen in value, so have U.S. stocks, emerging market currencies and commodities.
With all the uncertainty surrounding Europe’s debt and deficits, European banks and the Euro, we suggest three areas for consideration, given the current environment:
1) Ex-financial strategies to help lower risk emanating from banks
2) U.S. dividend ETFs for their defensive sector positioning and income potential
3) Markets with the greatest declines in 2011 (the emerging markets) for their recovery potential.
We featured more in-depth research on each of these three topics in our quarterly investment commentary that can be read here (.pdf). The quarterly investment commentary was written as of 9/30/2011, prior to the formulation of many of the most recent policy details out of Europe. However, we believe that the 3 areas of consideration mentioned above remain relevant, even as these new details are released.
Jeremy Schwartz and Luciano Siracusano are registered representatives of ALPS Distributors, Inc.
 MSCI ACWI Index: A market capitalization-weighted Index meant to depict the equity performance of equity markets across both developed market and emerging market countries.
 S&P 500 Index: A market capitalization-weighted Index meant to depict the equity performance of 500 of the largest, most heavily traded equities within the United States. Widely cited as the performance of the “U.S. Stock Market.”
 A haircut on the bond is a write-down in its carrying value, likely on the balance sheet of the holder of that bond. For instance, if the holder of a bond was carrying the bond at 100 cents on the dollar on its balance sheet, a 50% haircut implies that the holder would only now carry the bond at 50 cents on the dollar on its balance sheet.
 Leverage: Use the currently held assets as collateral to borrow additional assets.
 Core tier 1 capital: Measure of a bank’s highest quality (most liquid and highest credit quality) capital on its balance sheet. Higher numbers indicate potentially increased ability to weather unexpected events.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.