financials

Europe – Lacking a Long-Term Solution

Over the last few days we have seen a tremendous amount of volatility in the markets, epitomising the lack of clarity with which many investors have struggled. The contagion continues to spread as we hear rumours of a possible downgrade of French government debt although it is far more likely to occur for Italy first. Fundamentally, there is a lack of a long-term solution and the knee-jerk reaction by some EU countries to ban short selling not only misses the point, it may negatively impact the very stocks it is trying to protect. So as we see movement to safe havens, we also see room for opportunistic buying – as long as you invest with those with strong balance sheets unlikely to be hit in future earnings downgrades and have a long enough time horizon to withstand the volatility.

Italy and France to be downgraded? The Contagion Continues to Spread

The markets are already betting for the ratings agencies to downgrade France’s debt with credit default swap spreads widening to double their level at the beginning of July. A rising expense to insure against default implies the market believes it to be more likely. However, Italy is the more likely downgrade candidate in the short-term. The reasons given behind Portugal’s downgrade a few months back apply equally to Italy – an unsustainable debt burden (Italy has the third largest in the word at €1.8tn) and a low likelihood of being able to repay these obligations (as it dips back into recession). The European Financial Stability Fund is losing its credibility since even its increase to €440bn is not enough to cover future potential bailouts and would need to amount to at least €2tn. The crux of the problem, as I’ve iterated before, is that you can’t solve the problem of debt with debt and austerity does not foster growth. Instead debt burdens are increasing at a faster rate than GDP growth in many western economies so the situation is only getting worse.

Outlook for banks: Headwinds for banks remain

European banks remain highly correlated to the future of the periphery. German banks, for example, have exposure to the PIIGS (Portugal, Ireland, Italy and Spain) amounting to more than 18% of German GDP. Commerzbank revealed that a €760m write-down for Greek debt holdings wiped out their entire Q2 earnings. That’s before we look at France who have an even higher exposure and here in the UK, our banks have nearly £100bn exposed to struggling economies. Furthermore, these banks need to refinance maturing debt (at a rate of €5.4tn over the next 24 months) at higher rates and with demand shrinking.

Will the ban on short-selling help? No, it misses the point

The markets are concerned with government fiscal credibility not its regulatory might. Instead, the ban could increase volatility and negatively impact the very stocks it is trying to protect. ‘Shorting’ was acknowledged by the Committee for European Securities Regulators as beneficial for “price discovery, liquidity and risk management” just last year, so we may well see higher volatility than we would have without. Secondly, it limits fund ability to bet on financials going up. Hedge funds use shorts to remove market risk, buying shares in one bank and borrowing and selling shares in another. If they are forced to close these ‘borrowed’ positions, they will have to sell the other bank shares they have bought outright, causing further selling pressure and price falls. Most interesting was the timing of the implementation, just before an announcement was made that the Greek economy shrank by 7% in Q2 – fuelling fears the ban was needed since there’s more bad news to come.

How to trade these markets: Movement to safe haven offering opportunities

So how can you invest in these markets? A possible support to the stock markets is the ‘search for yield’. Sitting on cash can’t be satisfying for long, with rates as low as they are, and the dividend yield on the Eurostoxx is now double the 10 year German ‘bund’ yield. This means that even if markets go sideways, the return generated from holding European stocks could be more attractive than either if the other options. In addition, valuations are looking reasonable, at a near 8x forward earnings. Therefore we may see flows returning to the markets. However, be warned, we are starting to see earnings downgrades and volatility may remain. Therefore invest in companies with strong balance sheets and maintain a medium to longer-term time horizon.

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Strategic Stock Selection by Gemma Godfrey on CNBC

Follow this link: CNBC Clip for a 3-minute run down of where you should be investing and what to avoid.

Incl: headwinds facing the banks (a “Tale of Two Cities: Goldman Sachs and Credit Suisse); opportunities for firms ‘ready for change’ (Apple versus Nokia) and the inflationary pressure on consumers (Pepsi and Coca-Cola)

Bank Rules: Stability Up, Profitability Down  21 Apr 2011

“I’m a little bit cautious about the sector and it will be interesting to see how (banks) are reacting to the regulation,” Gemma Godfrey, head of research at Credo Capital said of the banking sector. She added there would be more stability with higher capital requirements, but profitability would be reduced, as in the case of Credit Suisse.

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