First Greece, Now Italy, Who’s Next?: Analyzing The Sovereign Debt Default Chain

by: Nicholas Pardini
November 11, 2011

Starting in May of 2011, the extent of the global sovereign debt crisis began to hit the equity markets. Greece was first, then Portugal, then Ireland, and now Italy has become the focus of the financial markets and a source of macroeconomic weakness.

However, these countries are simply the first dominoes in a chain of fiscal crises that will either result in a series of defaults in the developed economies’ bond markets or high inflation generated by central bank intervention. The question now is who’s next? Countries with high debt/GDP ratios, high unemployment and lack high economic growth to sustain deficit spending are all about to face the consequences of reckless fiscal policies. Below I list the countries I believe to the most likely to enter sovereign debt crises of their own after Italy.

1) Spain: Spain has made some austerity reforms to address its problems, but the continued weakness of the Spanish economy will slide Spain back into fiscal trouble. Spanish 10-year yields have reached 5.9%, which is near its danger zone. The Spanish GDP has only grown at an annualized pace of 0.2% and is highly likely to slide back into recession. With a 21% unemployment rate (40% for those under 24), expect this to get worse with a return to recession. Continued high unemployment may also lead to civil unrest. The struggles of the eurozone will also diminish tourism to Spain which will compound the struggles of the Spanish economy. These signs are bad for the success of the austerity measures and will put the heat back onto Spanish bonds.

2) Belgium: The pending breakup of Dexia has confirmed Belgium as the newest member of the PIIG pen. Belgium has a debt to GDP ratio of over 100% and it does not help that the country has been without a government for 516 days. The country is going through a political crisis as this is the second time in four years when the country has been without a government for over six months. The French speaking Walloons and the Dutch speaking Flemish in the north are fundamentally divided and have more loyalty to ethnic identity than the Belgian nation. Slow growth and 3.55% stagflation does not help the situation.

3) France: Rumors of France’s loss of its AAA credit rating are eventually going to come to fruition as the market has begun to punish French bonds. Their spread versus the German bond is 1.69%, which is equivalent to the spread between Italy and Germany this time one year ago. France’s economy is growing faster than the PIIGs, but at 0.9% annually is still very slow and they have a high 81.7% debt to GDP ratio.

4) U.K.: The British economy is struggling through a stagflationary slowdown and the woes of continental Europe will put a strain on British exports. At just 0.5% GDP growth and 5.2% inflation before the Bank of England’s latest round of quantitative easing, it looks like the U.K. is already on its way toward inflating out of its debt (80% debt/GDP). The loss of North Sea oil and a lack of competitiveness outside of financial services leaves Britain in a vulnerable place economically. I expect the crisis in the U.K. to hit once the market is finished reacting to the debt problems of Italy and France. The best way for investors to play the possible British default (through honest means or inflation) is through shorting the British Pound.

5) Japan: At 220%, Japan has the highest debt to GDP ratio outside of Zimbabwe. Also demographic trends will significantly reduce local demand. As Japan’s largest generation is entering retirement, the smaller less economically successful younger generations of Japan will not be able to make up for the new shortfall of bond demand. Foreigners will demand much higher yields. Japan has been relying on near zero interest rates for 20 years to finance itself. Once yields rise, the market’s response to Japan’s struggles will dwarf Italy.

6) Germany: Germany is the wild card of the bunch. Its debt problems are not created by the faults of its own economy but its risk of being on the hook to finance the bailouts of the PIIGs. If Germany stopped supporting the weaker members of the EU and pulled out the eurozone, it could save itself from debt or inflationary crisis. Despite receiving objection from 75% of the German people, the political climate of Germany’s political elite is committed to preserving the euro at all costs. Going all in for the euro would sink Germany’s ship along with the rest of the continent. Even before any bailout of Italy, Germany’s debt to GDP ratio is already 83.2%, so time is running out for Germany to decide on its loyalty to the eurozone.

7) United States: The biggest domino in the sovereign debt crisis is right under our noses. It will also cause the most long term damage to the long term economy. The U.S. is the world’s largest debtor nation with (latest estimates) $14 trillion of debt (or 100% of GDP). Deficit spending is continuing at over $1 trillion of new debt per year. These numbers do not even include unfunded future liabilities related to social security, medicare and the bailouts of Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). Since U.S. tax receipts primarily come from income taxes over consumption taxes, tax revenue is more sensitive to economic fluctuations. As a result, persistently high unemployment will keep tax revenues down for the next several years. Half of U.S. borrowing is in short term T-bills. So once the Treasury has to refinance at higher rates, interest as a portion of the government budget will skyrocket. The U.S. Congress does not have the best record of making budgetary compromises or cutting spending, so expect the worst from any upcoming debt settlements. The solution they will ultimately use to solve this debt crisis will be through monetization. Once the euro mess resolves the best way for investors to hedge themselves will be through commodities, precious metals and equities that have pricing power.

8) Canada: Canada benefits from being a major exporter of raw materials, but weakness in U.S. (especially during its debt crisis) and Chinese economies will be devastating to Canada. In fact they may be even ahead of the U.S. on the path to a double dip recession with negative GDP growth for the second quarter of 2011. Canada’s debt/GDP is also high at 84%. Canada can print its way out of its debt problems, but bond holders will lose either way.