As Eurozone turmoil resurfaces, Gemma Godfrey takes you through the under the radar risks and how to trade them.
The risk of Greece leaving the Euro is looming large over markets as a ‘snap’ election nears on Jan 25th. Threatening to reverse the austerity measures (spending cuts etc) required for bailout funds and remaining in the Eurozone, Syriza looks likely to lead any coalition government, if it does not win outright.
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.
[Click image below or this LINK to watch this as a TV Clip]
Huge strides forward in Europe and subsequent market rallies have raised hopes for the region. So is the road to recovery now clear or are significant risks still present? Crucially, what are the key areas of conflict we should be watching closely and which are ‘red herrings’?
A greater degree of oversight of the banking sector is needed for stability. Issues of experience and breadth of oversight to include smaller banks are somewhat misnomers but issues of authority, conflicts of interest, and deposit guarantees are not. Nevertheless, turmoil creates opportunities and the road will remain rocky for the shorter-term at least.
Resolution Remains Just Out of Reach
‘Tail risk’ in Europe has dramatically reduced over the past few months. This refers to the risk of a dramatic event which could drive an extreme change in portfolio values, i.e. a Greek exit from the Euro, having fallen substantially. Prompted by Draghi’s statement that he will do “whatever it takes” to save the euro, and solidified with his launch of an ‘Outright Monetary Transaction’, buying the bonds of countries that request help, markets have moved to reflect this reduction in perceived risk.
But does this mean the road to recovery is now clear? Unfortunately not. The risk of an immediate euro breakup may have eased but Europe still needs to integrate further before we can say unity has been strengthened sufficiently.
With the region rocked every time there is turmoil in one country’s banking sector, providing a level of oversight to spread, offset and protect from risk is a desperately needed move forwards. Agreement has been reached to progress this course of action, and the European Central Bank put in charge. So what are the key areas of conflict we should be watching closely to decipher how far risk has truly abated? What issues matter and which are ‘red herrings’?
Ready, Steady, Go….?
The ECB may have been the natural choice of supervisor but it has neither experienceof direct supervision, nor dedicated staff. However, this is probably the most easily remedied concern, with recruitment of a team with appropriate experience.
Of greater concern is the lack of authority with which the central bank would begin its ‘reign’. A ‘Banking Resolution Mechanism’, i.e. a process for the enforcement of support, rules and regulation, will only come into place at a later date. Threats without force are just words and the sustained support that could bring is doubtful.
Furthermore, the central bank’s original mandate of price stability could be compromised. It is unclear how a conflict of interest can be avoided when knowledge of bank positioning may affect its resolve to implement monetary policy. Knowing an interest rate move, for example, could destabilise a large bank and create a level of turmoil, may muddy the waters.
One for All and All for One
Germany has voiced its opposition to a broad-based level of oversight, focused not just on the largest banks but any that could pose a risk to the stability of the banking sector. As the country within the region with the largest number of ‘small’ banks as well as almost a third of the regions total number of banks, this has been a focal point in the press. The claim is that the administration costs to comply would be enormous, passed on customers and hit the local economy.
However, for two main reasons this again is more of a distraction than a nail in the coffin. Firstly, as in Spain, for example, it was issues in smaller banks which brought chaos to the country. Bankia, the ‘bailed-out’ bank, was constructed from several smaller struggling banks. Germany’s smaller banks together have total assets than exceed Deutsche Bank and are responsible for around 38% of both bank lending and deposits. Therefore, oversight should indeed include these banks.
Secondly, on a day-to-day basis, smaller banks may continue to receive oversight similar to national arrangements, minimising the feared disruption and cost. Rules were ‘softened’ when the European Parliament expressed the desire for the ECB to have the choice of delegating its supervision of smaller relevant lenders to national authorities. A feeling of loss of sovereignty is still tough to challenge but may be eased and outweighed by necessity.
Nevertheless, hostility from Germany continues in the form of opposition towards a single deposit guarantee scheme. A ‘run on banks’ was touted as a key risk as capital outflows from the periphery European countries gathered momentum last year. A lack of confidence in the safety of customer deposits drove exits and challenged the liquidity levels and stability of the targeted banks. A region-wide scheme to guarantee these deposits is hoped to bring some calm and reduce these fears.
This is a crucial part of the longer-term plan for a return of confidence to the region but has seemingly ‘dropped off the agenda’ according to Germany, resisting further discussion. The fear is the relative strength of one country will be used to offset weaknesses in another. Tax payers from one country could end up having to pay for the mistakes of a bank in another. Nevertheless, behind the headlines, it is understood that some form of transfer from Germany to the periphery is necessary for stability and this is certainly an issue to watch closely going forward.
A Rocky Road
Therefore, Europe has some crucial challenges to tackle over the next few months. Longer-term strategies must be embedded to protect the region. To complicate matters, politicians will continue to be distracted by ‘putting out fires’. For example, a request for help by Spain remains hotly debated and there is the potential for further civil unrest in reaction to growing opposition to austerity. The risk of further turmoil in Greece is high as it is tasked with completing bank recapitalisation and paying public sector debts, but a long-term solution to alleviate reliance on financial support remains illusive.
Turmoil creates opportunities and the road will remain rocky for the shorter-term at least. International firms that are merely headquartered in an area of weakness can provide an interesting opportunity as price moves, volatile in the shorter-term, more accurately reflect underlying value over the longer-term.
From Greek election elation to Spanish rescue concerns; a clear road to recovery has remained elusive. Greece continues to gamble with their euro membership with the misguided belief that they can soften demands for austerity, without threatening their bailout. Instead, it is the lack of a sufficient firewall, rather than a commitment to Greece remaining within the eurozone, which stands in the way of an exit. When banks are supported and other countries protected from a fallout, bailout payments to Greece and their membership within the eurozone could come to an end. Withdrawals from Greek banks could force the issue even earlier, as the desire to stay in the euro is offset with capital flows betting against it. For markets, it is clarity over the outlook going forward that is required for investor confidence and upward market momentum to return. We are not there yet, but time is running out.
Watch a 5 minute clip: Breaking the news about the outlook for Europe post Greek election
Greece Gambles With € Membership
New Democracy’s win in the Greek elections was a victory of fear over anger. Outrage over the harsh austerity terms that have pushed the country into a 5th year of recession was outweighed by the fear of an exit from the euro. Protest against the tough spending cuts and tax increases was overshadowed by alarm at potential isolation and banking collapse, if these measures were to be rejected and bailout funds halted. Thus, New Democracy, perceived as the ‘pro-euro’ party and as such the investors’ choice, won.
Crucially, however, although less willing to gamble their euro membership and expressing a commitment to staying in the eurozone, New Democracy also want to renegotiate the bailout terms. Dangerously, they believe it is possible to soften demands for austerity, without threatening their bailout. As a party seen as responsible for the crisis in the first place, their track record does not inspire confidence.
Odds Against Greece If Firewalls Strengthened
The Spanish rescue exacerbated the problem. Offering Spain a bailout without stringent terms was seen as a desperate move by European leaders, bending to pressure from a fear of further turmoil. Such a sign of perceived ‘weakness’ gave Greek leaders the confidence to believe their demands could likewise be met and the need for harsh austerity no longer mandatory.
This is misplaced. The possibility of a Greek exit is being discussed far more freely by European politicians. It is the lack of a sufficient firewall, rather than a continued resilient commitment to Greece remaining within the eurozone, which stands in the ways. This is especially the case while Greece’s membership continues to threaten the existence of the eurozone as a whole. When there are sufficient rescue funds in place to support the banks and protect other countries from the fallout, bailout payments to Greece and their membership within the eurozone could come to an end.
Depositors Could Dictate Greece’s Fate
With depositors withdrawing over €500m each day from Greek banks, decisions over the country’s future may be decided even sooner. European company exits have also gathered steam. Carrefour, Europe’s biggest retailer, has cut their losses and sold out of Greece. As sources of support dry up, the country stands on far shakier grounds. Voters may have moved in one direction but depositors have moved in another. A desire to stay in the euro offset with capital flows betting against it. As Bill Gross, founder and co-CIO of Pimco, said on CNBC’s Street Signs “Greece’s fate will be decided not at the ballot box but at the ATM”.
For markets, it is clarity over the outlook going forward that is required for investor confidence and upward market momentum to return. We are not there yet, but time is running out.
To note: Conviction for an exit from the euro has grown among The Investment Insight readers. From 40% of readers a month ago, to 72% on the latest poll (below), the belief that an exit is inevitable is building….
As French and Greek voters make their feeling about spending cuts loud and clear, we ask ourselves – why has there been such a strong swing to anti-austerity/pro-growth, how does this threaten the survival of the euro and is a Greek default still possible? The deepening slump has dampened deficit reduction, the Fiscal treaty hangs in the balance and patience is wearing thin. Crucially, according to voters and investors, time is running out.
Growth vs. Austerity: deepening slump is dampening deficit reduction
Francois Hollande’s victory in the French elections marks a significant change of focus in European politics. In contrast to the rhetoric delivered up to this point, Hollande wants emphasis of policy to be on growth instead of austerity. Why does he want this? Because the situation is deteriorating. Unless a country grows, their debt burden, as a percentage of a decreasing national output, grows and is therefore harder to manage. As iterated by French Socialist lawmaker Arnaud Montebourg, in an interview with BFMTV “Austerity is everywhere and it’s a complete shipwreck,”.
Portugal and Spain are prime examples. While the Portuguese economy is expected to contract by 3.3% this year, the deepening slump is dampening deficit reduction. In fact, the deficit almost tripled in the first couple of months of this year alone. Spain, similarly, is struggling with a deteriorating debt situation. As almost 1 in 4 are without jobs, unemployment is boosting defaults. Bad loan ratios have reached a 17 year high (see chart below on the right).
Survival of the Euro Threatened
However, such a drastic change of attitude could damage the Franco-German Alliance, political progress and the very survival of the euro. This is because for Hollande to promote growth, he is threatening the fiscal treaty, perceived as crucial for keeping the euro together in its current form. The Treaty would create closer consolidation within the European union. Handing over authority for National Budgets to a Supra-National entity could ensure the various moving parts of the region interact better as a whole. However, Hollande disagrees with the primary focus on debt and deficit limits, without any pro-growth measures.
Whilst the German Finance Minister Wolfgang Schaeuble is ready to discuss initiatives to boost economic growth Merkel has said she will not renegotiate the pact. As her spokesperson asserted, it “has already been signed by 25 out of 27 EU countries”. Instead the likelihood may be a growth pact attached to the fiscal pact. Nevertheless, the problems don’t end there. Firstly, Hollande will have his work cut out for him in an economy that is barely growing, with jobless claims at their highest in 12 years and a rising debt load that keeps France vulnerable. Secondly, can both sides agree what they mean by growth?
Growth by any other name…
France and Germany disagree strongly on how to achieve growth. Merkel maintains it is through structural reforms – making it easier to fire workers, which would encourage employers to hire, certainly a key aim for the Italian Government. However, Hollande is hesitant and instead wants growth via infrastructure spending. But Germany won’t agree to spending funded by borrowing – exactly opposite to their deficit reduction targets. Therefore, again although rhetoric can be applauded, practical plans remain elusive.
A Greece Default Still Possible
Uncertainty continues to be a key challenge for Greece as voters in a similar move to the French, overwhelmingly rejected mainstream candidates supporting spending cuts. Crucially, these cuts were aimed at securing bailouts and avoiding a default. Instead, 70 per cent of voters supported parties that promised to tear up the bailout and attempts may be made to negotiate a gradual ”disengagement” from the harshest austerity measures of Greece’s €130 billion ($168 billion) bailout. This keeps the possibility of a Greek default firmly in the picture and until a coalition is formed, a new election next month is possible.
As markets now price in a full default on 2 year loans, and the next tranche of the bailout hangs in the balance until political chaos abates, the question now seems to be – is an exit from the euro inevitable? The people of Greece are against it, but politicians are threatening it and firms are getting prepared for the possibility. Finally, there is a fear of a run on the banks as deposits fall and the risk other countries may join the ‘default’ bandwagon.
Greeks do not want to leave the Euro
Although 60% of the Greek population view the austerity terms set for them to receive the next tranche of their bailout negatively, more than 7 in every 10 favour staying in euro. The main benefit to the country in the reinstatement of their own currency would be its inevitable depreciation, enabling the economy to regain competitiveness with respect to the (cheaper) price of their goods and services. UBS estimates this would be a 60% change in valuation. However, the bank also estimates borrowing costs would rise by 7%, hitting balance sheets and costing each citizen €11,500 in the first year outside the euro (€4,000 in subsequent years).
A surprise and ultimately rejected call for a referendum and the ensuing political chaos put the next tranche of the bailout at risk. A last ditch attempt at appeasing the people, by putting the acceptance of the tough austerity measures they will have to endure to a vote, led to threats of expulsion from the euro. Subsequently, a coalition government has been formed until early elections can be called and the Prime Minister has stepped down from his position. The rumours that the leader of this new unity interim government, Papademos, wasn’t even in the country at that time doesn’t bode well for a new era of superior management!
Time is short as an €8bn bailout has now been withheld for over a month, until the situation is sorted out. 700,000 public sector employees and 2 million pensioners need to be paid at the end of the month and nearly €3bn for bonds maturing in December from the 19th onwards. However, Greece still has a bloated public sector, refuses to sell or lease more of their assets, misses out on what could amount to €30bn in tax avoidance each year and continues to generate a 10.5% deficit in terms of spending versus income. And with riots on the streets and wage and pension cuts already of 20% and upwards, flexibility to cut more is somewhat limited. Fundamentally of course, this won’t generate growth. With the resulting bailout a short term plug, and the economy still forecasted to shrink by 2.5% next year, the feeling of futility can be understood.
…and there are fears of a run on the banks
Worryingly, Greece deposits fell by €10bn, 6% of current deposits in October alone. And it’s no longer just the wealthy looking to relocate assets to the likes of Switzerland but by people needing the funds to survive. An audit of Greece’s largest banks could reveal in December €15bn of non-performing loans, whilst holding a disproportionally large amount of their own sovereign debt. Greek 2 year yields have risen above 100%, implying investors do not expect these loans to be repaid. It could take €30bn to recapitalise these banks.
… and the risk others may follow
If one country is allowed to renege on its debts, then there is the possibility of others demanding likewise. Ireland could follow suit and demand it is therefore unfair that they have to repay bond holders in full. However, although a possibility, it is not currently a probability. The stark austerity measures being imposed on Greece, and the scrutiny they are now under is enough to put other countries off that option for the moment. Ernst &Young Item Club estimate that a default by Portugal, Ireland & Spain would cause Eurozone output to fall by 6%, in a recessionary environment that’s not a number to take lightly!
The markets expect a Greek default and time is running out. However, banks still haven’t recognised enough of this loss, highlighting the pent-up risk in the sector. Deep-seated scepticism continues to drive market volatility and this will continue until a credible plan is on the table.
A Greek default due
Markets are pricing in a 93% probability Greece will default, with the country missing its deficit reduction targets, contracting greater than anticipated (-5.5% vs. -3.8%) and unable to meet salary and pension obligations within the next couple of weeks. However, there is still much uncertainty on what the next steps will be. Politicians are still clinging to the hope further bailouts will help and hinting they will demand private investors to bear a bigger part of the pain (“technical revisions” to allow greater haircut) but Finland is demanding collateral and time is running out.
“Time to move”
Despite ‘kicking the can down the road’ and delaying decisions over the next tranche of the Greek bailout, the markets are looking to the G20 meeting in Cannes on 3rd – 4th November as the final deadline for decisive action. Political pressure is high as Geitner demands it’s “time to move” and Obama issues some stark words accusing the EU of having a fiscal plan that is “scaring the world”.
Banks are not prepared
Dexia, one of Europe’s largest banks, hit the news with their need for some form of rescue. Their reliance on short term funding may be their current problem but the outlook is no more rosey. They have only reduced the value of their Greek bond debt exposure by 21%. If they, along with BNP Paribas and Soc Gen write-down these debts by 51%, that will cause massive losses amounting to E3bn. That’s of course assuming Greece doesn’t fully renege on all outstanding loans due.
Pent up risk
Therefore there are still many events that could shock the markets. Although so far market falls have been followed by short term rallies as investors use the opportunity to buy back into the markets. Crucially though, upside and downside moves are exhibiting a large amount of intra-day volatility. This highlights the deep seated scepticism that will only be removed once a credible and clear long-term plan is put into action. Until that time, the swings will continue.
Debate has been raging as to whether the Greek economy can avoid bankruptcy. Just how big is the problem, what are the options and how is this impacting financial markets?
Background to the Problem
Greece is around €300bn in debt. Putting that into context, its budget deficit is one of the highest in Europe and last year amounted to more than four times the Eurozone limit at 13.6% of GDP. This more than supports the country’s inclusion in the infamous ‘PIIGS’ acronym (Portugal, Ireland, Italy, Greece and Spain) used to refer to the areas of sovereign debt concern.
Despite the jobless rate reaching 16% (and a horrific 42.5% for youth), the Greek economy has seen only marginal deleveraging. Instead, people are depending on consumer credit to maintain their levels of expenditure and service their debts (i.e. paying credit card bills with other credit cards). Moreover, whilst many in the UK struggle to obtain loans from banks, the overall banking sector in Greece actually increased their credit availability, with the most significant increase going to the government itself.
Last Thursday, Jean-Claude Trichet, President of the European Central Bank, announced that they would lend Greece €45bn in new loans. However, this alone, they acknowledge, is not enough. The ECB wants to see structural reforms and a good deal of privatization, with the claim that €50bn could be generated over 3 to 5 years to reduce debt/GDP from 160% to 140%.
What are the Complications?
Loans to ‘bailout’ struggling countries are partially funded by taxpayers from different countries within the EU. Therefore, the problem is not an isolated one. Furthermore, even after this loan and the privatization contributions, there will be a financing gap of €170bn between 2012 -14 which will need filling. European banks have to refinance €1.3tn maturing debt by end 2012 and are owed over €200bn already by the PIIGs for refinancing ops.
Could a Good ‘Haircut’ Help?
With so much talk of a ‘restructuring’, i.e. bond holders sharing some of the pain, it is interesting to hear the views of Lorenzo Bini Smaghi, an ECB executive board member on the subject. He maintains that these are not the tools by which Greece can save its economy but could cause a “Depression” and “banking system collapse”. Furthermore, those pointing to a compromise of a voluntary or ‘soft’ restructuring appear to be fooling themselves. According to him, there is “no such thing as an ‘orderly’ or ‘soft’ re-structuring” since ‘haircuts’ (a percentage knocked off the par value of a bond) would have to be forced by governments. Crucially, any type of restructuring would cause a panic in the markets and cause credit events reducing the value of these investment vehicles either way.
Yield on a 10 year Greek Government Bond (Orange), 10 year German Government Bond (white) and the spread between the two (yellow) - showing the higher premium demanded by investors for holding Greek debt, near historical highs - highlighting a heightened risk perceived by the markets.
So, What Are the Options?
As previously mentioned, a default on some of its debts would have dire consequences but the prospects for sustainable financial solvency appear weak with such a substantial deficit and the habits of borrowers and lenders not much improved. Most worrying, from the perspective of European stability is the recent comments from a Greek EU Commissioner that “The scenario of removing Greece from the euro is now on the table”. Therefore, although in stark contrast to statements by Greece’s Prime Minister and with France and Germany still heavily exposed to EU laggards, which together make a break up of the euro unlikely in the short-term, it is a fear weighing on investors minds.
This has two consequences. Firstly, investors should be more cautious of an indiscriminate sell-off but secondly, this can be used as an opportunity to pick up high quality assets at a lower price. Be wary but remain opportunistic.
“United we stand; divided we fall” Aesop (Ancient Greek Fabulist and Author of a collection of Greek fables. 620 BC-560 BC)
The problem with the “EU” banner is that it links together economies that are quite different from each other. Much press has been dedicated to the fate of the PIIGS – Portugal, Italy, Ireland, Greece and Spain but it is interesting to compare journalistic exposure with economic impact. Greece Ireland and Portugal account for less than 5% of EU GDP. To save you shifting through pages of research – here are the key pertinent points for each economy… The structure follows that of my earlier assessment of the futility of EU bailout mechanisms–
FLAWED LOGIC – what are the real issues?
NOT SOLVING THE PROBLEM– will the economy in question be able to grow enough / will the debt burden be manageable enough so that it will fall as a % of GDP?
UNCERTAINTY – what are the political issues?
Source: "Belgium Joins The PIIGS: And Then They Were Six" - Gavan Nolan, Econotwist The Swapper - learning and understanding the increasingly complex financial world.
Portugal – A Disappointing Deficit, Dipping Back Into Recession
DISAPPOINTING DEFICIT and FOREIGN PRESSURE – Disappointed the market with its deficit reduction plan for this year, amounting to a value for the first 10 months of 2010 which was than for the whole of 2009 and forecasted to exceed the EU limit until at least 2012. Exposed to more foreign pressure with around 70% of its debt is held abroad
LOW GROWTH – estimated to only amount to 1.3% for 2010 for an economy expected to fall into recession next yr
POTENTIAL SOCIAL UNREST – planning to reduce its public workforce
Italy – Saved by its Savings, Economic Exposure but Debt Isolation
TOO BIG TO BAIL OUT – second largest debt burden after Greece (public debt equates to 120% of GDP)
HOWEVER: High savings rate, exposure to German and Emerging Market economies, less dependant on foreign creditors and therefore more flexible
Ireland – The Public Prefers a Default
HUGE BAILOUT – amounting to 60% of GDP vs. “only” 47% for Greece
POTENTIAL FOR DEFAULT – 57% of the public believe the country will not be able to support the annual interest payments involved with this debt burden (€5bn over 9 years) and would prefer the government to DEFAULT on its commitments
PROTEST and INTERNATIONAL IMPACT – 50,000 took to streets to protest against the Government’s plan to cut the budget deficit. The UK has £140bn exposure to Irish banks
SOLVENCY – It has been argued that the bailout package will only prevent Greece from insolvency for ~a year
CIVIL UNREST – has been seen in response to social program cutbacks
Spain – Pulling a “Sickie”
UNEMPLOYMENT and a potential for DEFAULT – the highest in the EU at around 20% of the population. A third of private sector debt (€0.6tn) was generated from the housing boom and liable to default.
INTEREST PAYMENTS HAVE JUMPED – Since Oct, yields have jumped from 4% to 5% leading to a larger debt burden as a percentage of GDP
SOCIAL UNREST – Just the other week we saw one of the largest “sickies” thrown by their air traffic workers
Hungary – The Government Can’t Win
Although not within the PIIGS acronym – it is important nonetheless to mention this economy at this point and a great example of the potential impacts to investment. It’s a case that highlights the Government can’t win – if it decides that instead of implementing austerity programs eliciting social unrest, it will instead employ more crowd-pleasing reforms, it will get punished nonetheless….
DOWNGRADED – Moody’s has downgraded its debt to the lowest investment grade status. One more downgrade and it changes classification and those restricted to investing in Investment Grade debt only will be forced to sell, regardless of any other factors. Great opportunity to pick up dent at a discount (whilst watching the quality of the issuer!)
REASON – Short term (less antagonistic) measures are not sustainable – special taxes and utilising private pension schemes to fill holes! The Government is relying on future growth to afford its pension liability in the future and anyone not transferring to a state pension by end Jan may lose 70% of their pension value.
Contrast with the Core
Just to contast these economies with the one seeming to be driving force behind the union – Germany’s deficit could potentially fall to the 3% EU limit next year
INVESTMENT INSIGHT: When investing in the EU – differentiate between countries!