Currency

Investors are calling this risk “Lehman Squared”

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.

(more…)

Advertisements

Reading Between The Lines: Why Eurozone Improvement is Being Ignored

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.

rafa-sanudo-euro-crisisstock market

Greece – an exit from the euro now a possibility…

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).

…But politicians point to the possibility

Nevertheless, politicians have begun pointing to the possibility of Greece leaving the euro. When faced with a potential referendum being held in Greece, subsequently called off, Sarkozy exclaimed that the “real question is whether Greece remains within Europe or not”. The Luxembourg Prime Minister tried a more diplomatic tact conceding it does not have to remain a member “at all costs”. Whereas Germany’s biggest newspaper far more brutally demanded “no more billions for the Greeks, Greece out of the euro!

…And firms are starting to prepare

And companies are starting to make preparations for Greece to return to their own currency. Tui, one of Europe’s largest travel companies see Greece leaving the euro as “more than a theoretical possibility” and have accordingly requested the freedom to pay bills in the new currency.

Lack of credibility puts the bailout at risk

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!

Gold may Glitter but can it Deliver?

The classic “safe-haven” investment has seen a strong uptrend in its value since the autumn of 2008. Risk aversioninflation fearsfalls in the dollar and demand from the east have all been credited as drivers of this move. But just how supportive are these factors going forward — what is the risk gold could lose its lustre?

A Hedge against Inflation

The fear of inflation is heating up as on Wednesday the Bank of England suggested that “there is a good chance” inflation will hit 5% later in the year, far above the target rate of 2%. Elsewhere, on the same day, Chinese inflation figures surprised on the upside. However, is gold an adequate hedge? It can be shown graphically that it is not. Charting the inflation rate (CPI change year on year) against the gold price, we can see that over the past decade the relationship breaks down. Indeed, if the gold price kept up with increases in general price levels, it would be valued at $2,600 an ounce instead of around the $1,500 level. How about if instead of actual inflation, we look at the market’s expectation of inflation? Even in this case, the relationship does not hold. Instead, there are other factors at play. As previously discussed, investors may be more focused on the sustainability of the economic growth rate and allow for some inflation. Inflation alone may not provide sufficient support.

The Gold Price (white) vs. CPI change year-on-year (orange). Source: Bloomberg

A Beneficiary of Risk Aversion

So — could upcoming economic, fiscal or political disappointments sufficiently boost the gold price? Here the case looks stronger. From sovereign debt crises in Europe, to the tragic tsunami in Japan and the turmoil in the Middle East, there has been enough newsflow to stoke fears and flows into gold (a “whopping” $679m of capital was invested in precious metals in one week alone at the beginning of April). Furthermore, a lack of confidence in the dollar further boosted investment for those looking for a more reliable base.

Demand from the East and Central Banks

In addition to jewellery demand, central bank purchases may provide much support for gold as we move forward. Russia needs to acquire more than 1,000 tons and China 3,000 tons to have a gold reserve ratio to outstanding currency on parity with the U.S. This is even likely to be an understatement with China stating publicly they would like to acquire at least 6,000 tons and there are unofficial rumors that this may go as high as 10,000 tons.

A bubble with no clear end

George Soros described gold as the “ultimate asset bubble” and with sentiment driving the price as much as fundamentals, it’s unclear when the trend will reverse. An increasing monetary base is looking for a home. As Marcus Grubb, MD of Investment at the World Gold Council was quoted as saying at a ‘WealthBriefing’ Breakfast on Thursday: “In the next 10 minutes the world’s gold producers will mine $3m of gold, while the US prints $15m.” However, an often-overlooked drawback in investing in gold is its lack of yield. With some stock offering attractive dividend yields and investors wanting their investments to provide attractive returns during the life of their investment, capital flows may wander.

The Investment Insight

Remain wary of relying on one driver of returns; it can often be overshadowed by another. Instead build a complete picture and continuously question your base case scenario. Gold is a more complex asset than many give it credit for and as always, it pays to be well diversified.


Currency Wars – What We Can Learn From Central Banks About Managing Our Wealth

Follow this link to read the article, as published in The Huffington Post.

What We Can Learn From Central Banks About Managing Our Wealth