It's time to stress-test all of the companies in your portfolio. It's crucial to determine their geographic exposure right now, because a handful of major economies are possibly headed for a long-term unwinding.
I'm talking about four of the 12 largest economies in the world, which accounted for a combined $11 trillion in economic activity last year. That's 35 times larger than Greece, to put things in perspective. Simply put, U.S. companies with exposure to these economies will need to shrink their operations in these trouble spots, lest they see spiraling losses in coming years.
The four countries in question: Japan (the world's No. 3 economy), the U.K. (No. 6), Italy (No. 8), and Spain (No. 12). Let's take a closer look.
1. Japan
Roughly 18 months, I laid out the sobering challenges this country faces.
As this chart shows, the yen has rallied against the dollar, from $1.20 to a recent $0.81 during the past five years (meaning, one yen was worth $1.20, and is now worth $0.80).
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A strong currency always impacts trade flows. And Japan generated a trade deficit in 2011 for the first time since 1980, thanks to the rising yen. At this point, it's hard to see the country again becoming a net exporter as long as the yen stays strong, especially now that the country has decided to de-emphasize nuclear power rely on massive amounts of imported oil and natural gas.
In response to the strong yen, major Japanese exporters such as Toyota (NYSE: TM) and Canon (NYSE: CAJ) have begun the process of closing domestic factories and expanding capacity abroad. Japan has always been a nation of nearly full employment, with most citizens contributing to the tax base. Looking ahead, unemployment looks set to rise and income tax receipts may steadily fall without structural reform.
This comes right at a time that Japan is rapidly aging. As many citizens retire, they are creating a fiscal drag on the government as benefit spending surges. Adding insult, the government has been forced to spend billions on reconstruction in the area devastated by last year's tsunami.
Thanks to years of overspending on roads and bridges that were simply political pork, Japan already has the highest debt-to-GDP ratio of any country in the world, with its borrowings equaling close to 240% of annual GDP. The country has always benefited from a strong domestic savings rate, enabling the government to offer very low interest rates on the debt. But as more consumers head into retirement, Japan looks set to pay steadily higher rates to find new buyers of existing debt as it gets rolled over. Until this downward spiral is resolved, Japan's economy will get worse before it gets better.
2. The United Kingdom
A decision to cut spending in the face of a staggering debt load seemed like a wise move in the U.K., but it was done at a time when the economy was on very tenuous footing. As a result, sharply reduced government spending threatens to turn a weak economy into a shrinking economy as negative feedback loops spread across various sectors. For example, weaker consumer spending leads to reduced government tax receipts, which leads to even weaker government finances.
The International Monetary Fund (IMF) had been hopeful that the U.K. economy could grow a modest 0.6% in 2012, but that forecast was made before it was reported that it shrank 0.2% in the fourth quarter of 2011. The odds are rising that the economy will continue to contract, making it harder for the government to collect sufficient tax receipts to make a meaningful dent in the government's finances. And the U.K. can't export its way out of this mess: The country's industrial sector is largely uncompetitive, which explains why the U.K. has run trade deficits every year since 1997. This is a country that is wobbling now, but could easily enter into a downward spiral with a few bad breaks.
3. Italy and 4. Spain
These countries both suffer from aging populations, distressed consumer spending as a result of high unemployment (a stunning 23% in Spain), and look hard-pressed to reverse their debt woes as long as they are tied to the strong euro. More efficient economies such as Germany are simply too advanced for Spanish and Italian companies to gain a foothold in many European economies.
Italy has announced far-reaching austerity plans, which may create the scenario outlined in the U.K.. And concerns are rising that Spain's targeted budget cuts won't materialize, perhaps turning this country into Europe's next trouble spot. The Spanish economy is 450% larger than the Greek economy, and the risks of a financial mess are that much larger for the beleaguered European economic union.
Risks to Consider: It's hard to find "upside risks," meaning catalysts that will materially improve the fortunes for these countries.
Action to Take --> A wide range of companies in the S&P 500 relies on these countries for a decent chunk of their sales. Japan, in particular, is a huge market for the likes of Nike (NYSE: NKE), Coca-Cola (NYSE: KO), McDonald's (NYSE: MCD), and Tiffany & Co. (NYSE: TIF) and so many others.
The U.K., Italy and Spain account for roughly 35% of Europe's economic output, but key trading partners such as France and Germany would also feel the pain of deep economic retrenchment in these countries. You can find the degree of economic exposure to these countries by perusing the annual reports of the stocks you own (the 10-K filings sent to the Securities and Exchange Commission at the end of each fiscal year). If any of the stocks you own has considerable exposure to any of these countries, then you'll need to reassess whether it belongs in your portfolio.
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