As the Euro zone crisis intensifies and global markets reflect investor concerns, we ask ourselves, is a Greek exit from the euro on its way? Crucially, preparations have already begun to protect shareholder interest, companies are robust and policy in the US and China aims to maintain the upward momentum. To protect capital, proactively positioning portfolios has been key. International exposure and dividend yields offer attractive opportunities..
A ‘Grexit’ on its way?
All eyes once again are focused on Greece. An inability to form a government has led to a renewed fear that the country could exit the Euro and the wider European Union. Although only a small contributor to European economic output as a whole, contagion is the real risk. Concerns of further losses for external holders of Greek debt and a more widespread break-up of the euro have driven equity market weakness.
A self-perpetuating situation, investors are demanding more to lend to the likes of Spain and Portugal, driving their debt burdens to unsustainable levels. Furthermore, disappointing data from the US and China over the last few days have further added to the uncertainty.
…but preparations are underway
However, preparations have already begun to protect shareholder interest. German and French banks, which were the largest holders of Greek debt, have been aggressively reducing their positions. Some, for example, have cut periphery debt exposure by as much as half since 2010. Banks in the UK have been making provisions since at least November when the Financial Services Authority’s top regulator, Andrew Bailey, told banks: “We must not ignore the prospect of the disorderly departure of some countries from the eurozone.”
On the corporate side, interesting anecdotes have highlighted the proactive nature of company management in the face of this turmoil. Last year, for example, Tui, one of Europe’s largest travel companies, was reported to have requested to reserve the right to pay in a new Greek currency should the country exit from the euro. Corporate balance sheets are robust, holding more cash than long term averages, dividend yields and the potential for merger and acquisition activity once the macro outlook starts to improve can offer an attractive upside.
Finally, although wavering slightly, the US still successfully avoided falling back into recession. Keenly aware of both external and internal risks to growth, Chairman of the Federal Reserve, Ben Bernanke has made it clear he is not afraid to utilise further tools to protect economic growth. Especially with an election this year, policy is likely to remain accommodative. With respect to Emerging Markets, despite the recent wobble and an inevitable cooling of economic growth, with an estimated 1 billion of the population to join the consumer class by 2030, the long-term case remains strong.
Proactive portfolio positioning prudent
To protect capital, proactively positioning portfolios has been key. Reducing direct European exposure as Europe’s southern members showed severe signs of economic stress from an asset allocation perspective and via underlying fund managers has proved prudent. Fund managers have been able to maintain a zero weighting to Greece and a substantial underweight to the likes of Portugal and Spain relative to benchmark.
As equity markets reached new highs in the first quarter of this year, the substantial rally in share prices in the face of continued structural problems within the Euro zone, was a sign that the risk of a downward correction had increased in the short term. Caution was of course well-founded. A move to lock-in profits and redeploy capital to alternatives and property for a more attractive risk/return potential and hedge against inflation has been supported.
Assets which will help portfolio performance during these volatile market times are good quality companies with strong balance sheets paying an attractive level of dividends. Furthermore, in times of slow economic growth and persistent inflation, strong franchises with pricing power for protected market share and the ability to pass on increases in supply costs to the customer are very desirable attributes.
International exposure and dividend yields offer attractive opportunities
Looking forward, a resolution of key issues in Europe is required to gain confidence to add to equity exposure. Structural reform, greater fiscal consolidation, a focus on growth and long term support are required for stability in the region. At the same time, with a medium to long-term time horizon, it is more important to focus on the geographical location of a company’s revenue streams than where it is headquartered. Investor overreaction can offer buying opportunities with share price corrections providing attractive, cheaper entry points to high quality firms. Furthermore, the yield from dividends these companies pay out can provide a valuable income stream. With many investors holding back capital, the flow of money back into markets, buying into sell-offs at lower levels, could dampen these downward moves and provide a level of support. Therefore, although volatility could continue and market direction remains difficult to determine, it is possible to navigate the turmoil.
The problem with international meetings is politicians are often “more interested in their next job than the next generation” – Anonymous source via Anthony Hilton, Evening Standard
Political turmoil has hit the three largest European economies in recent days. Portugal’s Prime Minister resigned, Merkel’s party was ousted from the most prosperous state in Germany after an almost 58 year uninterrupted rule and at France’s recent election, abstention reached a new high at 54% of the population. What are the main issues to be watching, how are they affecting investments and why is the term ‘decoupling’ now being used to describe countries within the EU?
Berlusconi ‘Flirting’ With Protectionism
In reaction to recent French takeovers of Italian companies, Italy is threatening to draft a bill to curtail the trend. France maintains the bill will go beyond measures conceived by Paris and tensions look to worsen as the French EDF, the largest shareholder of Italian energy company Edison prepares to replace the Italian CEO with a French counterpart. Indeed with David Cameron concerned about maintaining an open and competitive continent, the issue is one to watch. Nevertheless, with a high savings rate and exposure to German and Emerging Market economies, the outlook for Italy remains strong. In a recent auction, the maximum amount of index-linked bonds targeted was sold on Tuesday, €6bn year to date. Domestic demand remains strong.
Spanish Growth Downgraded
Another European country with issues of its own and yet resilient market reaction is Spain. The Central Bank sees a growth outlook of 0.8% for this year, lower than the government’s expectation of 1.3% growth. Unemployment is still among the highest in Europe at ~20% and they are implementing some of the deepest austerity measures to bring their deficit inline with that of France. Nevertheless, markets are forward looking and are reacting well to the aggressive policy implementation. Spreads on Spanish bonds over the equivalent German versions continue to narrow.
Germany Facing a ‘Blocking Majority’
After another disappointing election result, the governing party of Germany could face a ‘blocking majority’ if they lose one more state in the September elections. Inner-party opposition is looking likely to intensify and after abstaining in the UN’s vote on the ‘no fly zone’ over Libya, fears of a return to isolationism have returned. Together this could compound the indecision that has dogged Merkel’s leadership so far. Nevertheless, the country’s deficit is set to fall as low as 2.5% of GDP.
A New ‘Decoupling’
Therefore, the markets are starting to differentiate between countries. Spanish and Italian equity markets are almost 9% higher than they were at the start of the year while others are still struggling. Most interesting is the lacklustre return of Germany’s equity market despite stronger fundamentals. Although this can be explained by the idea that markets move not by information on an absolute basis but relative to past performance and most crucially – expectations. With this in mind, Italian and Spanish economies are seen to be improving and doing well versus investor-set benchmarks.
The Investment Insight
There are many more hurdles along the way. The yield on Portugal’s 5-year notes surpassed 9% for the first time since Bloomberg records began (1997). The average yield across maturities lies at 4%, but the trend is upwards and once a 6% level is reached, it is argued it will become near impossible to reduce the countries debt-to-GDP ratio. In the immediate future, today’s results of Ireland’s banking stress tests will reveal the additional capital required for adequate solvency. As always, it is wise to maintain context, exploit contagion to your benefit and focus on quality for the longer-term.
Finance regulation is like airline security – defending against the last threat – Anthony Hilton, Evening Standard
When picking an investment focus on the ‘R’s… Regulation…. Ready for change…. Robust…. and then lets not forget Rotation…!
Regardless of the validity of the above quote, a higher level of regulation should be a serious consideration when picking stocks. Which sectors are most at risk? And what qualities should a company have to be able to flourish in this environment and provide an attractive vehicle in which to invest?
Let’s focus on the 3 ‘R’s which will help guide our way…
REGULATION – Within the financial sector, this may make banks more stable but less profitable….
READY FOR CHANGE – in contrast, those firms able to adapt will flourish (implementing new technologies, entering new economies (e.g. EM), exploiting niche opportunities)
ROBUST – whilst at the same time, the need for a strong balance sheet remains crucial in order to cope with, for example, the previously mentioned less predictable Emerging Markets. In addition, in this credit-starved environment, the firms with cash to burn are in a stronger position to buy cash-strapped competitors and build market share.
Note: The Economist this month published their 2011 themes, one of which summed up the latter 2 ‘R’s by coining a new term – forecasting of the dominance of “Multinationimbles” – combining multinational reach with nimbleness in strategy. Sited as an example was IBM, celebrating its 100 year anniversary this year, shifting its focus from hardware to selling services.
Another stock example: Nokia, originally a paper manufacturer back in the 19th century, with stints in rubber and electricity generation before entering the telecommunications industry. With products winning approval for sale in China, they are continuing to look for the next opportunity from which to profit.
Ok, before we end the article, there is one more ‘R’ to watch, on a shorter time horizon you should be aware of:
ROTATION – out of defensives and into more cyclical stocks as investors gain confidence and put risk back on the table….