China's slowdown threatens the eurozone core more than the fragile South

AUG 3, 201510:29 PM

[LONDON] Few parts of the world will remain unscathed by the plunging stock markets and economic slowdown rocking China, but the companies of Europe's soft underbelly may weather it best.

Countries comprising the euro zone's periphery, such as Spain, Italy and Portugal, have relatively small exposure to the world's growth engine. Core countries like Germany, France and The Netherlands have much deeper links.

Strong demand from China has fueled the boom in Germany's German auto industry, the success of France's luxury and fashion empires and solid growth in the Dutch and Finnish chemicals and capital goods sectors. Investment by their companies has grown accordingly.

But that demand may be cooling. China's factory activity shrank in July at the fastest rate in two years, the country's stock markets have slumped 30 per cent since mid-June and growth could soon fall below 7 per cent for the first time since early 2009.

"Germany has products China wants. But we've got slowing global trade, slowing global growth, and Germany has already benefited from its currency weakness advantage," said Stewart Richardson, partner at RMG Wealth Management in London."

"Germany suffers if China suffers. So on European equities, the periphery outperforms Germany," he said.

European stocks have been the destination of choice for investors this year, with cash flowing in from emerging markets and the United States. A net US$80 billion has gone into European equity funds this year, according to Bank of America Merrill Lynch.

The difference between core and peripheral eurozone countries' exposure to China is clear from trade flows.

Around 8 per cent of Germany's exports go to China and about 5 per cent of both France and Finland's, according to Marc Chandler, head of global currency strategy at Brown Brothers Harriman in New York.

Compare that with the periphery: 3 per cent of Italy's overseas sales go to China, around 2.5 per cent of Spain and Ireland's, and only 2 per cent of Portugal's.

Of the top 37 European companies' exposed to China in a list drawn up by UBS, only 16 are from the euro zone. Of those, 15 are from core countries Germany, France, Finland and The Netherlands.

Spanish retailer Inditex is the only company from the so-called euro zone periphery to appear on the list. And it is near the bottom, with only 10 per cent of revenues coming from China.

German automaker Daimler posted a 54 per cent surge in second-quarter operating profit, to a record high of 3.8 billion euros, as sales of trucks and new luxury car model launches helped it defy a slowdown in China.

It remains to be seen how long it can defy gravity, though. Rival Audi last week lowered its global sales forecast because of slumping demand in China, the luxury-car brand's biggest market.

China's impact on European government bond markets has been muddied by the Greek crisis, which ultimately saw agreement between Athens and its creditors that should lead to a third multi-billion-euro aid programme for the cash-strapped nation.

July also saw the biggest monthly fall in Chinese stocks since the global financial crisis in late 2008.

In that roller-coaster month, the price of peripheral euro zone countries' bonds rose faster than Germany's, narrowing yield spreads. The premium demanded by investors to hold Spanish bonds over German bonds fell to 110 basis points from 165 basis points at the end of June.

And it's worth noting that the peripheral countries are also the principle direct beneficiaries of the European Central Bank's 1 trillion-euro bond-buying stimulus programme, which will run through September next year.

But to paraphrase the adage about the United States and the rest of the world, If China sneezes, won't everyone else catch a cold? And within Europe, if Germany sneezes, won't the rest of the continent catch a cold?

Fahd Rachidy, partner and chief investment officer at Sparrows Capital in London, played down the current economic relative outperformance of some peripheral countries like Spain and Ireland. Much of that just reflects their collapse in labour costs vis-à-vis the rest of the eurozone, he said.

"If Germany performs poorly because of the Chinese impact on international trade, then the periphery will follow as most of the intra-eurozone exchanges are with Germany," said "Extrapolating the Chinese situation to infer that investors favour the periphery over the core is a bit far-fetched," he said.

REUTERS

    

Puerto Rico defaults on bond payment, pays fraction of US$58m   

People walk past a closed store in San Juan, Puerto Rico, on July 31, 2015.

PHOTO: REUTERS

AUG 4, 20157:20 AM

[NEW YORK] Puerto Rico has defaulted on its debt by paying only a fraction of what was due on bonds due Aug 1, showing the depth of the island's economic and cashflow problems and potentially opening the door to litigation.

The commonwealth paid only US$628,000 of a US$58 million payment due on its Public Finance Corp bonds, the head of its Government Development Bank said in a statement on Monday. "Due to the lack of appropriated funds for this fiscal year, the entirety of the PFC payment was not made today," GDB head Melba Acosta said.

Puerto Rico Governor Alejandro Garcia Padilla shocked investors in June when he said the island's debt, totaling US$72 billion, was unpayable and required restructuring. The non-payment marks the first default by the commonwealth and is the most notable since Detroit defaulted on US$1.45 billion of insured pension bonds before filing for bankruptcy in 2013.

"(They are) telling investors they are serious about this debt adjustment," said Peter Hayes, head of asset manager BlackRock's Municipal Bonds Group. "It may be a precursor to how they make payments going forward if they can't reach amicable settlements with creditors groups."

A default could open the door to a fight with investors. Daniel Hanson, analyst at Height Securities, said in a research note last week that market participants would probably file suit in San Juan as soon as Tuesday.

While Puerto Rico has argued that missing a payment would not constitute default because its legislature is not legally bound to appropriate the funds for payment, credit agencies and investors saw it differently. "Moody's views this event as a default," said Moody's analyst Emily Raimes in a statement. "This is a first in what we believe will be broad defaults on commonwealth debt." PFC bonds have weaker protections than many other Puerto Rico bonds such as general obligation debt.

Mr Acosta said the decision reflected "serious concerns about the Commonwealth's liquidity in combination with the balance of obligations to our creditors and the equally important obligations to the people of Puerto Rico." Mr Acosta said that PFC made a partial payment of interest in respect from funds remaining from prior legislative appropriations. These funds of US$628,000 were applied to the Aug 1 payment.

"A government's primary responsibility is to provide services to citizens," said Mr Hayes.

"When you finally make the determination not to pay, you know you're effectively cutting yourself off from the capital markets, but from their standpoint they see it better of two evils."

REUTERS