Global contagion: Europe’s next export?

Posted by on May 25, 2012 @ 10:44 am in Economy & markets

In the summer at the beach as a boy, I used to dig in the sand and dream of finding pirate treasure. Old silver and gold coins from Spain and other parts of Europe that may have once washed upon our shores, waiting to be found by my yellow plastic shovel.

While I no longer dig for gold, I do spend time gazing across the Atlantic and worrying about the extent to which the ongoing European crisis—marked by related concerns over sovereign debt levels and bank capitalization—will worsen and spill over to American shores.

At present, the U.S. economy continues to expand modestly, while the economy of Europe as a whole has stalled. Such divergence or “decoupling” between U.S. and European economic growth is actually not unique by historical standards. As this chart illustrates, growth in U.S. real GDP often tends to lead or “drive” European real GDP growth, rather than vice versa.

Year-over-year real GDP growth_1980_2012

Sources: Vanguard calculations based on data from the U.S. Bureau of Economic Analysis, Eurostat, the International Monetary Fund, and Thomson Reuters Datastream. Year-over-year real GDP growth for the Eurozone from 1996Q1 through today provided by Eurostat. Before that, growth represents the GDP-weighted average of year-over-year real GDP growth of the 11 original Eurozone countries with available data from the IMF’s International Financial Statistics. The 11 countries include Austria (data available from 1980Q1–present), Belgium (1980Q2–present), Finland (1980Q1–present), France (1980Q1–present), Germany (1980Q1–present), Ireland (1997Q2–present), Italy (1980Q2–present), Luxembourg (1999Q2–present), Netherlands (1980Q1–present), Portugal (1980Q1–present), and Spain (1980Q1–present).

But can such decoupling last?

The chart shows that the deep global financial crisis of 2008-2009 engendered severe economic slowdowns in both the U.S. and Europe. The present worry is that events in Europe could produce the next systemic global shock. Most immediately, should conditions continue to deteriorate in Greece, political and social pressures could lead Greece to eventually exit the Eurozone, perhaps as early as this summer.

Can the U.S. economy hold up and avoid recession in the event of Greece’s exit?

My answer is a tentative “yes,” although this hinges critically on the euro hanging together. Here’s why. First, it’s important to recognize that the economies of the United States and Europe are linked through two primary channels: (1) trade, and (2) finance. These linkages vary from modest to significant.

On the sole basis of trade linkages, a deep European recession (caused by, say, fiscal austerity, but with the euro remaining intact) would likely have a moderate impact on the U.S. economy. At $320 billion, U.S. exports to Europe account for only about 15% of total U.S. exports, or about 2% of U.S. GDP.* This relative exposure is similar for U.S. corporations. According to our calculations, European markets represent approximately 14% of the total U.S. revenue of S&P 500 companies.

To me, the much more serious threat involves the health of the European banking system. Given its exposure to European sovereign debt and deteriorating loan performance (the latter driven in part by deepening recessions and home-price corrections in certain countries on the European periphery), the European banking sector (as a whole) is inadequately capitalized should sovereign debt dynamics deteriorate further. In Spain, bank balance sheets are especially vulnerable and may very well need additional public support. This is troubling, since approximately 70% of European credit comes from the banking sector, versus an estimated 30% in the United States (broadly, the capital markets provide the rest).

On this side of the Atlantic, the U.S. banking system is comparatively better capitalized based on a variety of metrics, including capital ratios and nonperforming loan metrics. According to calculations based on data from the Bank for International Settlements and the FDIC, U.S. bank exposure to the troubled periphery European economies of Greece, Portugal, Italy, Spain, and Ireland is similar (in relative percentage terms) to those above for trade. Of course, such risk exposures rise when you include the entire European Union, and even more so when you include the indirect exposure to the U.K., whose ties to Europe run much deeper.

So where does this leave the U.S.? Overall, I’d say that the U.S. economy should prove resilient enough to weather a potential Greek exit from the euro. But even the best locomotive can be derailed by hurricane-force winds. A full-fledged banking crisis and the dissolution of the euro would be such a hurricane, which is why this is so important for the European community to avoid.

Of course, even in the event that the euro survives in its current state, the wider E.U. crisis is likely to last for years (not months) as Europe finds its way through this trying period. We as investors should be prepared for Europe-related headlines and periodic spikes in market volatility for some time.

So what am I going to do about Europe? This summer, I plan to continue to focus on the big things that matter. For my portfolio, that means sticking to my asset allocation, contributing to my retirement accounts, minimizing costs, and, above all, ignoring the headlines the best that I can.

Most of all, I’m looking forward to my family’s week at the beach this summer. And this time, I plan to dig for old pirate treasure just like I did 30 years ago. A boy with his yellow shovel and not a care in the world.

I would like to thank several of my colleagues in Vanguard’s Investment Strategy Group for helpful comments and assistance, including (in alphabetical order): Roger Aliaga-Diaz, Andrew Patterson, Charles Thomas, and Joanne Yoon.

*In 2011, the U.S. exported $1.4 billion in goods to Greece, or less than $1 of every $1,000 in U.S. exports. (To put $1.4 billion into perspective, the monthly output of the smallest U.S. state economy [Vermont] is roughly $2 billion).

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