In the November 2011 issue of bUSiness CHILE, fellow contributor Axel Christensen poetically described the crisis in Europe as a “true Greek drama”.
He wrote that “the drama seems to end (or is it just the beginning?) with a new leadership, chosen for its ability to contain, at least momentarily, the wrath of the gods.”
Unfortunately, it appears that the drama – more tragedy than comedy – was just beginning and, six months on, we are entering a potentially worse crisis, with Greece contemplating an exit from the Euro ahead of a critical election on June 17. Meanwhile, Italian and Spanish bond yields have returned to late 2011 levels, now pricing the greater risk of contagion.
Although the probability of a Greek exit – or ‘Grexit’ – has increased, we believe that the conclusion of Mr. Christensen’s article remains valid: there is too much at stake for European leaders to let Rome (or Athens) fall. Not only is the credibility of the European Union at stake, but it also appears that the vast majority of the Greek population favors remaining in the Euro, according to the latest poll by Athens newspaper Ta Nea, and pro-Euro political coalitions are gaining traction with voters. Meanwhile, even if Grexit occurs, there is a growing consensus that the European Central Bank will look to ring-fence the rest of Europe’s periphery in order to contain potential contagion effects. Ultimately, we are likely to see a more orderly process than during the Argentina default of 2001/2.
Despite the logical arguments for a more benign scenario, the outcome ultimately depends on politics, with markets likely to suffer in the interim as political wrangling continues. The focus will remain on the size of potential bailouts and sources of financing. In the latest battle, it appears that France and Germany are at odds over the issuance of Eurobonds, which could provide a key source of funding, but could also jeopardize Germany’s lofty credit rating. The debate is likely to intensify at the next Euro summit at the end of June.
In addition, more turmoil is likely to occur in both the near and medium term as tough austerity measures take their toll on European economies, as evidenced by sliding GDP growth and rising unemployment, primarily in the peripheral countries. Spain is currently in the crosshairs with the IMF estimating a GDP decline of close to 2% in 2012, with unemployment reaching 24%, while budget deficit estimates have been raised to 8.9%, triggering a Eurostat inspection. Populations will only be able to withstand austerity measures for a limited time, thus social unrest is likely to intensify, potentially reigniting political fires in a vicious cycle.
While uncertainty remains high and market volatility is likely to continue, we believe that Chile (and Latin America in general) remains relatively well positioned. In commercial terms, Chile depends less on Europe than other zones, especially since the economic and financial crisis of 2008 when exports to Europe represented 30% of the total. In the 12 months to April this year, exports to Europe represented just 19% of the total (albeit 7% to Italy, Spain and France, mainly copper) and reached an all-time monthly low of 15% in January. Given the already depressed levels of trade, the direct incremental impact of further economic turbulence would be less severe than in 2008/9.
Meanwhile, European periphery ownership in Chile remains rather limited. The most relevant holdings (by the likes of Enel, Telefónica, Santander and BBVA) are in relatively defensive domestic sectors and are operated independently. Therefore, a worst case scenario would be less capital expenditure, higher dividends and/or an outright sale of assets, none of which would be particularly detrimental for the underlying companies.
The real risk for Chile lies in the lower probability outcome of contagion beyond the bounds of Europe. However, continued public spending in the United States, which has helped boost corporate earnings despite consumer deleveraging, and plenty of policy firepower in China (helping to secure a soft landing) should provide stability, at least through the end of the year.
We will leave the 2013 tail risks related to broader European recession and eventual US government austerity for a later doomsday article.
Brian P. Chase is Portfolio Manager, Head of Andean Equities, at Itau Asset Management