The recent sell-off in global equity markets is in our view not justified by either economic or political fundamentals. We believe that the economic slowdowns in the U.S. and Europe will not last, though they do justify downward revisions to excessively optimistic economic and corporate-earnings forecasts. We are confident about the solvency of countries such as Italy and Spain and consider that their risk of sovereign default is close to zero. We do not doubt the political commitments of euro-area political leaders, even though we share the market’s frustration about how long it is taking to reform governance in the euro area. Lastly, Standard & Poor’s downgrade of U.S. credit, a landmark event in the modern history of sovereign debt, does not add anything to what we already knew: The 2008-2009 recession increased OECD governments’ debts by roughly 30 GDP points, thus making debt dynamics unsustainable in most of these countries, starting with the US.
In the second quarter of the year U.S. output growth all but stalled, and in the third quarter euro-area GDP growth may also be close to zero. Both economies are suffering from an excess of either private or public debts that were accumulated over the previous cycle. This indebtedness will not go away easily and, for that reason, we expect recoveries to remain sluggish in both regions over the next few years.
However, the global economy is still in an early stage of its recovery from the recession. China and other Asian economies are growing robustly, Japan is recovering faster than expected and Central and eastern Europe, the Middle East and Latin America are expanding. Last but not least, the nonfinancial corporate sectors in the U.S. and Europe are profitable, not excessively leveraged and eager to increase their investment spending. Against this backdrop, we expect the balance of strengths and weaknesses in the global economy to be positive for growth and earnings over the next year.
Based on euro-area policy makers’ most recent decisions, some investors may be drawing the conclusion that Italy will shortly need a bailout, and that Germany will block it. We do not share that view, for several reasons:
1. Although the weakness of Italy’s recovery raises legitimate questions about the government’s long-term solvency, Italy is more resilient than recent market developments imply. Not only is Italy running a primary budget surplus, forecast at 0.8% of GDP this year, but its net external debt is also limited, at 20% of GDP (compared to 100% for Greece). In any case, the weighted average life of Italy’s government debt is high at just over seven years, beyond that of many AAA-rated sovereigns. So Italy can withstand high bond yields for some time, though we do not expect its yields to remain at their current elevated level.
2. Italian banks have strong balance sheets. Provided that their investments in Italian sovereign debt are not impaired, which is our assumption, they are well capitalised. If and when their funding might become stressed, the European Central Bank is ready to plug the gap, as President Jean-Claude Trichet made clear during his most recent press conference.
3. We have not detected any sign that euro-area policy makersin Germany in particularhave a weakened commitment to the single currency. On the contrary, the decisions taken on July 21 to strengthen the euro-rescue fund, and the ECB’s subsequent decision to reopen its Securities Market Program, only provide further evidence of this commitment. We do note that Bundesbank President Jens Weidmann remains opposed in principle to the ECB buying sovereign bonds on the secondary market. But he does not oppose the ECB’s extension of full-allotment refinancing operations for banks, which was the more critical decision. We are convinced that, if liquidity shortages worsen dramatically for sovereign-debt and bank funding in the euro area, policy makers (including at the ECB) would react in an appropriate way.
On both sides of the Atlantic, markets have overreacted to the unfortunate coincidence of bad-but-temporary economic news and worrying-but-manageable fiscal challenges. Consider that inflation, which only six months ago was seen as the main risk factor for financial markets, is now receding thanks to declining commodity prices.
When markets become directional and are driven by rising risk-aversion, it is tempting to take the gloomy view and to follow the trend. It is precisely in these testing times that it is rewarding to focus on fundamentals that, in the end, will have the upper hand.
Mr. Chaney is chief economist and Mr. Sorasio is chief investment officer at French insurer AXA.
Source : AXA Press Release