Bad news out of Europe, Germany in particular, makes two potentially profitable outcomes significantly more likely. Firstly, the European Central Bank will be more flexible in its efforts to keep Greece in the Eurozone. Secondly, there are fewer roadblocks in the ECB’s way for announcing further QE. Policy is diverging. While the US contemplates tightening, Europe is exploring the opposite. Resulting currency moves could provide a welcomed boost to European exporters.
Bad news for Europe, good news for investors
Investor hopes for ‘government bond-buying’ QE were raised today as Germany came under renewed pressure.
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.
As an investor, misunderstandings and overreaction can offer some of the best opportunities to profit. Here 5 widely held beliefs are challenged and attractive investment strategies revealed: There is no need to fear deflation; The stock market trade has reversed; It’s not too late to join the (small cap) party; Central Bank action will not achieve its goal; Turmoil in Ukraine unlikely to directly impact earnings…
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.
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 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.