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With strong words to support the Euro, Mario Draghi, the European Central Bank President, quelled fears over the future of the Eurozone. However, the bailout negotiations in Cyprus revealed cracks in this ‘floor’ supporting the region and markets. A ‘Banking Union’ has been undermined, imbalances within the region magnified and individual systematic risk returned. Divergences within the global banking sector will widen but with the Fed likely to remain accommodative, bullish market sentiment may continue to overshadow concerns elsewhere. Nevertheless, this recent turmoil has highlighted that we’re far from an end to the crisis.
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Cracks in the ‘Floor’
Draghi set a ‘floor’ under the markets with his assertion that he would do ‘whatever it takes’ to protect the euro. He launched a bond-buying programme back in the autumn of last year, named the Outright Monetary Transaction, to support this and investors took the news well. Since then, despite political deadlock in Italy, Greece remaining shaky and the growth outlook continually downgraded, markets have remained resilient. So what’s changed?
Troubles in Cyprus have shown that the crisis is far from over and there are key risks left unresolved. As succinctly put by economist Megan Greene, “bond-buying can’t mitigate a run on the banks”. Cyprus has revealed the cracks in the ‘floor’.
The Big Shock – Cash No Longer Safe
The biggest shock from the plans proposed to bailout Cyprus was the threat of loss on deposits, crucially all the way down to the smallest ones. In order to receive rescue funds, government officials wanted to reduce the amount of outstanding debt by charging a tax on deposits. This is a marked departure from the previously enforced strategy of forcing bond-holders to take a ‘haircut’, (loss on their holding), due to their more limited number and therefore the minimal revenue this would have created.
Why was this so strongly rejected and why has this caused such an outcry the world over? Because it could have violated deposit insurance offered to smaller depositors. It would have send out a message that even cash in a bank is no longer safe. The important point is that, rejected or not, officials can’t erase the fact it was proposed and to have even been considered concerns investors that it may return to the fore as a strategy in the future.
Interestingly, the Fed rejected a ‘Cyprus-style’ bailout package back in 1941 on the basis it would be undemocratic. People who have to store more of their money in bank deposits would be harder hit than the rich with more of their wealth elsewhere. Many Cypriot businessmen will have a substantial amount of their hard-earned money wiped out.
Banking Union Undermined
Crucially, the situation has undermined 3 key hopes investors held for the European region. Firstly that a Deposit Guarantee Scheme would at some point come back onto the agenda. This is vital for a return of confidence and support for banks, by encouraging depositors that their cash would be safe in any bank under the region’s banking union. Instead this deal threatened the exact opposite, a violation of deposit insurance with the potential to spark a ‘bank run’ of people moving their money to somewhere perceived to be safer.
Imbalances Magnified and Lending Threatened
Liquidity is therefore the next source of upset. Only since the autumn of last year have investors felt comfortable returning capital to Europe’s periphery country. To put this in context, after at outflow of around €400bn from the start of 2012 alone, the reversal seen in the latter few months of the year amounted to just €100bn. Therefore, a rebalancing of capital still has a way to go and this latest crisis may worsen the situation.
Vital for an eventual end to reliance on rescue funds, banks have looked to wean off ECB funding. Lending to each other would then be the next step towards maintaining adequate liquidity in the banking system. However, institutions can hardly be encouraged to deal in this way in periphery EU countries with the fear of loss so substantial.
Individual Systematic Risk
This leads to the third and final point. The close link between the health of a country and its banking system is being strengthened, when a banking union was hoped to create the opposite. When a country’s banking system is allowed to rock the stability of a country, borrowing costs can spike to unsustainable levels and exacerbate the problem. By uniting the banks so they can be dealt with regionally and separate from specific country risk, it is hoped that these spikes can be minimised. The crisis in Cyprus has shone a light on the lack of unity and individual systemic risk.
Divergences to Widen
So what does this mean for investing? Two interesting outcomes. Firstly, we may see a wider divergence within the banking sector as greater scrutiny over capital adequacy rewards some and punishes other. Funding costs within the periphery are unlikely to ease. Secondly, it casts a severe shadow over the value of stress tests to gauge the safety of investment in a bank. Cypriot banks passed tests in 2011, which raises doubts over the veracity of the Fed’s own investigations which led to 17 out of 18 US banks passing. Optimism in both cases could be argued as too high.
With the Fed likely to remain accommodative, bullish market sentiment may continue to overshadow concerns elsewhere. However, Cyprus has highlighted that we’re far from an end to the crisis.
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Political uncertainty in Italy could impact global markets, but provide a “fantastic buying opportunity.”
Like Jennifer Lawrence’s fall at the Oscars, unexpected but a chance to shine ‘comedically‘, Italy’s elections have shocked investors but provided attractive entry points to strong international firms, insulated from domestic woes (as well as offer up some funny one-liners from candidates). The possible loss of eagerly anticipated labour reforms, financial restrictions and market contagion provide shorter term sources of turmoil. However, existing reforms are likely to continue, market retrenchment is healthy and to be exploited for longer term opportunities.
3 Reasons to Be Worried
The biggest surprise of Italy’s election was the clear rejection of Mario Monti, former premier and instigator of many of the reforms pushed through government over the last few months. This has highlighted how far anti-austerity sentiment has risen. The rise of the reform averse Berlusconi, further complicates matters as new labour reforms, greatly anticipated by investors, were hoped to allow the economy to recapture a degree of competitiveness and crucially kickstart growth. Even Bersani, has announced he wishes to ease austerity. Without Monti, and with a possible coalition with Berlusconi instead, new reforms look less likely.
2. Financial Risk: Inability to Request Support to Tackle an Elevated Cost of Borrowing
Without a government to sign a Memorandum of Understanding, Italy is unable to request aid under OMT (the Outright Monetary Transaction). This means the European Central Bank cannot buy their sovereign bonds in an attempt to bring down bond yields which have risen on the back of this political uncertainty. Even aside from this, the ECB is at risk of removing support at any time, if they feel Italy is moving in the wrong direction. Again, highlighting the importance of reform, the ECB stopped buying Italian bonds in August 2011 when Italy was seen to renege on certain measures. However, this ultimately led to the resignation of Berlusconi as borrowing costs and the outlook for Italy became tenuous and therefore he may be more encouraged to keep to current reforms this time around.
3. Market Risk: Contagion
Driving markets globally, turmoil in Europe revived concerns over the sustainability of the region and survival of the euro. Outside of Italy, Spanish sovereign bond yields rose and the US stock market suffered their biggest single day decline in nearly four months. Unable to remain an isolated incident, political uncertainty has far reaching consequences.
But 3 Reasons This Is a Buying Opportunity
1. Status Quo will be Maintained
Although investor hopes for new labour reforms seems less certain, the continuation of reforms already in place is more likely. As mentioned before, Italian leaders have been victim to the withdrawal of support from the ECB previously and with measures already having progressed through government, their effect on the wider economy could still be palatable.
2. Shakeout Healthy
The markets saw huge swings during the election process, and short term traders cutting risk. Markets have been rattled from the combined effect of election disappointment, US spending cut negotiations, UK debt downgrade after a strong rally over the past few months. Retrenchment is healthy. This leaves room for longer term investors, desperate to put cash back to work, an entry point into markets and a more stable source of support going forward.
3. Profit-Taking to be Exploited – What to Buy:
Finally, although this is a chance to be opportunistic, the focus is on buying companies with strong long-term outlooks. International firms may be overpunished by the turmoil in the region where they are headquartered or the stock market on which they are listed, but generate a majority of revenues overseas, insulating them from pressure domestically. Furthermore, once a government is established, the possibility of assistance from the ECB provides a level of support. Companies are cash rich and can offer attractive opportunities over the longer term with any strengthening of global growth.
Published on the Front Page of Huffington Post Business
Markets have shrugged off improvement in the Eurozone because more is needed for stability. Rising demand for German goods, an improving business climate and stability in Spanish housing should have given markets cause for celebration. However, after the substantial rally we’ve seen, and the headwinds yet to be tackled within the region, caution has crept back into markets.
Absence of Growth and Currency Risk
There is deep concern over Europe’s ability to kickstart growth, as austerity measures dampen economic expansion and a strong euro stifles exports. The increase in demand for German factory goods interestingly was driven by demand within the euro area. Domestic demand was weak and the currency still source of concern abroad. Furthermore, despite an overall improving business climate, uncertainty in the political and economic landscape going forward is causing delay in hiring and investment.
Spain Precarious and Firepower Lacking
Once again hitting the headlines, Spain could derail European stability, as corruption charges are directed at the government while they continue to grapple with a large budget deficit. The latest data points to a possible floor in Spanish housing prices but defaults on bank loans due to the real estate bubble remains elevated and there is only limited further financial aid available directly from the rescue fund. In order to meet its main obligation of lending to struggling countries, additional direct bank aid has been rumoured to amount to less than €100bn, nowhere near enough to contain future turmoil!
Reform and Unity Needed
With France expected to have slipped back into recession, Draghi, the European Central Bank President, is right to warn that the region is not in the clear yet. What’s needed now are structural reform and closer fiscal and political unity. Only with a return of confidence, based on improving fundamentals, can stability return.
“The concern we have as investors is that there is a lot of risk out there that people aren’t really picking up on. The fact that this bond buying program (“Outright Monetary Transactions”) is conditional means that it’s actually hard to police. How can you give a country that asks for help support, and then withdraw it and not expect the market to implode as a result…
“A physics quip to link to is Heisenberg’s Uncertainty Principle… the more you understand about a particle’s momentum, the less you know about its location. And you can say that about Europe. The more we understand about how fast things are deteriorating, the less we understand the full extent of how big the problem is.”
Gemma Godfrey, Head of Investment Strategy at Brooks Macdonald and CNBC’s ‘go to’ expert on Europe and financial markets, on Squawk Box October 2012.
After disappointing economic growth within the UK fed fears of a ‘triple-dip’ recession, housing market data has added fuel to the fire. Stability is needed for consumers to feel more confident and comfortable spending but instead contraction continues. Outside of London and within the prime real estate market, demand has been driven by a low level of supply and foreign investment. However, outside of this insulated area, property is struggling and banks still have assets to offload which could further maintain downward pressure on prices.