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.
‘Grand’ gestures with minimal effects, Europe is doing the ‘Ice Bucket Challenge’ with a glass of water. Measures won’t measure up to much. Little movement in interest rates, not enough assets to buy and ultimately – you can put out as many cream cakes as you’d like, but if people aren’t hungry, they aren’t going to eat. The pressure is rising and more is needed. Europe has become a ‘binary trade’, and it is important to invest in those set to benefit regardless.
(Click on the image below for a quick video clip summary)
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]
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 withinthe 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.
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.
Bold words, high expectations and market rallies. We’ve seen steps in the right direction in Europe, but the 3 features that differentiate the latest bond buying program also highlight its flaws. It’s conditional but hard to police, transparent but uncertain, and unlimited but not long-term. The vicious circle is clear; a country will only get support if its economy deteriorates to the extent they will accept onerous conditions which will cause it to sink deeper into recession. With multiple significant flaws present in current plans, enough has been done to buoy markets but more is needed to support economic progress and bring sufficient confidence back to markets.
“Whatever it takes”
With bold statements come high expectations and Draghi, the European Central Bank President, has been acutely aware of this fact. After claiming he would do “whatever it takes” to save the euro, the pressure was on to support this with a decisive plan of action.
Earlier this month he seemed to do just that, promising to launch an unlimited bond-buying program to ease pressure on sovereign borrowing costs. Taken positively by the markets, the Eurostoxx closed up over 2% that day and periphery sovereign bond yields fell on the news alone.
However, the question remains: has this really marked the end of the Eurozone crisis? The rally has taken bank shares and CDSs back to where they stood in March, when markets similarly put faith in cheap 3-year ECB loans, only to be disappointed. Are markets at risk of a correction this time too?
Step in the right direction but we’ve a long way to go
Draghi identified at least 3 ways in which his latest plan would be different from previous bond-buying schemes. However, they also help identify flaws which could come to light if the situation in the Eurozone were to continue to deteriorate significantly:
1. Conditional but hard to police
To allay (German) worries of long-lasting and repeated requests for help, the support provided by the ECB will come with conditions. The ECB will buy bonds of countries that request help, as long as they conform to certain terms. Countries will be charged with specific requirements, e.g. spending cuts, to try and build fiscal discipline so assistance can wind down. The conditional nature of any offer to support a country’s government bonds could however also be cause for concern. It is hard to police. The resultant turmoil that would ensue from a country not only having identified themselves as in need of help, but now having that help withdrawn would extend beyond the country in question. This would therefore be mutually destructive. With investors fleeing from any asset perceived to be exposed to this country as they looked to de-risk portfolios, ECB assets could be damaged, lowering their resolve to enact this punishment.
Moreover, this unintentionally maps out the road to a euro exit. It highlights that once a country that has received a bailout no longer meets specific targets, the rug may be pulled out from underneath it and the resulting pressure could force it out of the euro.
2. Transparent but uncertain
The ECB will be transparent about which country’s bonds they are buying, reducing speculation and giving markets a clearer indication of what’s going on. However, this doesn’t mean the picture would be crystal clear. Uncertainty remains as to the exact level at which bond-buying could be triggered and the conditions that would be put in place.
3. Unlimited but not long term
There is no cap on the amount of bonds that can be bought and therefore it can provide some form of support long into the future. However, this does not equate to a long term solution. Buying bonds is not a substitute for reform or a strategy for economic growth, which Draghi himself stated has “risk to the downside”. Both of which are crucial for the health of Europe and an end to the crisis.
Finally, although not corresponding to anything stated as a benefit of the plan, it was not unanimous. The German Bundesbank President was not in favour of the plan and could still cause trouble. Indeed, it has since been ruled that Germany has the right to vote over every rescue programme. Considering the country’s fondness for austerity, bailout terms could be tougher and either rejected, damage the economy further, or accepted and failed to be followed. The vicious circle is clear; a country will only get support if its economy deteriorates to the extent they will accept onerous conditions which will cause it to sink deeper into recession.
With multiple significant flaws present in current plans, enough has been done to buoy markets but more is needed to support economic progress further down the line and bring sufficient confidence back to markets.
As U.S. stocks and the European equity index ended last week in positive territory, against a backdrop of disappointing data, market moves seems misplaced. Instead, Central Bank action is cosmetic not medicinal, a tool for reassurance not economic change. Developments from the recent EU Summit are either temporary or limited and capital remains restricted. However, economic deterioration heats up the pressure for action.Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.
Central bank action is being met with scepticism, and initial market rallies used as selling opportunities for profit taking. This is because moves are cosmetic and not medicinal, as in the short term they may reassure markets that measures are being taken, but they are of limited effectiveness at significantly boosting growth. Even Draghi himself, the President of the European Central Bank, argued “price signals (have) relatively limited immediate effect”. They won’t stimulate demand and, by potentially hurting bank profitability, could reduce the incentive to lend – the opposite of the target outcome.
Nevertheless, for the first time, we have seen the ECB cut the benchmark interest rate below 1%. In the same week, the Bank of England announced it will be increasing asset purchases by £50m. With weak US data and Bernanke already cautious, the pressure will be on to turn ‘Operation Twist’ into a more traditional waltz. Investors will be hoping the Fed will pump more liquidity into the system instead of ‘twisting’ or neutralising purchases by selling elsewhere along the yield curve.
Summit Moves Are Limited
The outcome of extensive talks at the EU Summit likewise fuelled a ‘false rally’. Spanish government bonds have since returned to hover around the unsustainable 7% level again despite developments. Instead, the 3 key ‘achievements’ are temporary or limited, as explained below…
1. Senior not guaranteed: Investors have been moved higher up the pecking order and will now be repaid for loans made to Spanish banks before the bailout fund. Being the ‘first’ in line to get money back is indeed an improvement but crucially the risk of loss is still there and may continue to worry the markets.
2. Wishful thinking? The government has been removed from the equation with bailout funds now able to offer loans to struggling Spanish banks directly. Removing government involvement in bank bailouts to protects sovereign bond yields ignores the possibility investors will continue to view the health of the banks as a driver of economic health.
3. Bond buying boost limited: Bailout funds may now buy debt directly from “solvent countries” (read: Italy). However, this is a limited source of demand and again short-sighted.
Capital Remains Restricted
The size of the problem remains a key concern and a crucial measure missing from the Summit was a substantial strengthening of the ‘firewalls’. At €500bn, the rescue fund is only 20% of the €2.4tn combined debt burden of Spain and Italy. The risk that a lack of funding will leave European leaders unable to stop the crisis spreading remains.
Economic Deterioration Heats up the Pressure for Action
With a backdrop of a deteriorating economic environment, Europe is far from able to ‘grow out of the problem’. German manufacturing deteriorated for 4th consecutive month. Relied upon as a rare source of growth, the outlook is dimming. European unemployment has reached its highest level since the creation euro. This is unlikely to spur spending and instead put the pressure back on Central Banks to do something to kick-start economic growth.
Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.
Note some of this article has been published by the Financial Times
There is still much to be decided before EU leaders can claim to have provided a comprehensive and credible plan to end the sovereign debt crisis. The rescue fund itself has met with significant obstacles, with demand in doubt and delays to capital raising leading to question marks over its ability to borrow on behalf of those that can’t. Instead of improving sentiment, it may cause it to deteriorate. Details, commitment, growth, structural reforms and greater consolidation of governance, fiscal policy and politics are needed. This has become a global issue.
Deutsche Bank, Germany’s biggest bank, and Credit Agricole, the largest retail banking group in France, rallied more than 19% over the last week in October after certain ‘positive’ news was announced at EU Summit. Measures included the leveraging of the rescue fund to €1tn, a voluntary default of Greek debt and bank recapitalisation. However, this may involve a dangerous derivative structure with insurance coverage not guaranteed and demands not going far enough.
Delays could hit sentiment, deadline looming
The European Financial Stability Fund (a.k.a. the ‘rescue fund’) was created to borrow on behalf of those countries that found themselves unable to borrow (read Greece, Ireland, Portugal etc). However, Wednesday’s attempt to raise capital met a substantial obstacle – limited demand, leaving the fund itself unable to borrow. The €3bn10-year bond offering had to be postponed, in the hope conditions would improve but a ‘red flag’ has been raised. If this fund is already having issues, at its current size with a lending capacity of €440bn, how will it manage with demands up to €1tn? Inadequate demand could cause sentiment to deteriorate, worsening the very situation it was meant to improve.
Demand from the East now in doubt
Plans to leverage the current fund to enable this €1tn of firepower seem to be heavily reliant on demand from the likes of China and Japan. This makes their apparent lack of interest in this recent bond offering most worrying. Investors have maintained the situation is too opaque and the risk/reward potential too skewed to the downside.
Dangerous derivative structure
The ‘Special Purpose Investment Vehicle’ which would allow this leveraging to occur has been likened to a CDO – collateralised debt obligation and the instrument that was at the heart of the subprime crisis, by insuring investors against loss. The bonds act as collateral so investors effectively buy junk sovereign debt with a certain level of guarantee from the fund.
The Greek ‘haircut’ has highlighted some of the risks. The ‘writedown’ of debt was structured as ‘voluntary’. It was agreed that private bond holders should offer to write off half of the amount Greece owed them versus a formal, official, enforced default. The latter would be classified as a credit event and trigger any insurers to pay up. However, the former doesn’t. Therefore investors who insured against losses paid a premium for cover but won’t get paid out to offset the losses suffered. The risk of a debt ‘default’ may not always be mitigated.
Doesn’t cover all that is needed
More details are needed to understand how bailout facilities will be implemented and hopes for the first signs of commitment from the IMF, China and Japan were dashed at the G20 Meeting last Thursday and Friday. Moreover, the recapitalisation of the banks, which was set at €140bn will need to be increased dramatically. The IMF already put the level at €200bn, with analysts advising a number nearer €275bn.
Finally, the fund does not compensate for what the EU really needs: growth, structural reforms and greater consolidation of governance, fiscal policy and politics. The EU’s jobless figures are the highest they’ve been since the launch of the euro. Draghi may have put the focus back on growth by cutting interest rates, in a move that surprised the markets, from 1.5% to 1.25% but admitted growth forecasts are likely to be downgraded so the EU economy will remain fragile for some time. Accounting for approximately 24% of global GDP and with lower demand hitting export-oriented Asian countries, as for example Taiwan expands at its slowest rate for 2 years.