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.
As investors price into the markets only two options for Europe, politicians feel the pressure to avoid a break-up of the monetary union as we know and instead embark on the second scenario, full scale fiscal unity. European countries must share their budgets to share their burdens; fully unite or expect exits; go hard or go home. A Banking Union would form part of this strategy but would it be blinkered to significant risks? Nevertheless, caution can cloud ones vision and maintaining holdings in good quality companies, rather than raising cash levels is preferable. Progress is moving in the right direction and when confidence returns, so could market momentum.
A European Banking Union – an essential but flawed strategy
Ever since the fall of Lehman Brothers and the start of the ‘credit crisis’, a call for greater control over the banks has been hotly debated. Challenged with rising regulatory costs and lower trading volumes margins are being squeezed. Balance sheets are predicted to shrink by at least €1.5tn by the end of next year, even before taking account of an effect of a possible Greek exit.
A proposal that has won support in France is for a European Banking Union. This would involve a single regulator to oversee banks across Europe. Furthermore, it includes an EU-wide deposit guarantee scheme to protect savers in the event of a bank collapse. The European Central Bank has been hailed as the most appropriate candidate as supervisor, explicitly focusing the oversight to the euro area as opposed to the full European Union. This allays one of the UK’s concerns but reservations remain.
A mockery of the original mandate?
Firstly, it maymake a mockery of the ECB’s original mandate. Originally tasked with the challenge of controlling inflation, critics maintain this new role would conflict and weaken their ability to do so. Any move to print money (increasing the amount in circulation, reducing its value meaning more is required to make purchases), could increase inflation instead of maintain price level stability.
A ‘blinkered’ approach?
Secondly, focusing on only part of the problem is not a full solution. A supervisory body overseeing the banks will focus on the largest financial institutions but miss the risks stored up lower down the food chain. The most recent ‘crisis’ was kicked off by Bankia, Spain’s largest savings bank, suffering solvency issues. However, it was formed from 7 already troubled smaller banks and therefore the risks they posed would have gone unnoticed. Oversight is certainly warranted, but is the horse wearing blinkers?
Fiscal unity first
Finally, this is not a first step. Before such a move is considered, fiscal consolidation is required. To provide backing to support banks, greater control over national budgets is needed. Being so heavily affected by the economy in which they are located, unity must start from the top down. A ‘two speed’ Europe with pockets of growth versus widespread recession; a need for interest rate increases opposing desperation for further easing; and budget surpluses contrasting deficits highlighting the instability. European countries must share their budgets to share their burdens, fully unite or expect exits, go hard or go home.
But beware of de-risking
Caution can cloud ones vision and currently cash is not king. As prices rise faster than cash can appreciate in most savings accounts, the value of money is being eroded. Boosting cash levels is not prudent. Instead, maintaining a holding in good quality companies, with confidence they will grow in value over the long run, makes more sense. Progress is moving in the right direction and when confidence returns, so could market momentum.
With political pitfalls possible, eyes on Chinese easing, and a flight to quality by investors, policy is driving market direction. This week, the minutes from the latest Federal Reserve meeting will be scoured for signs of further fiscal support. Moreover, the Bank of England’s inflation report will be reviewed for changes to the outlook for growth and inflation. Central bank rhetoric will determine how investors trade. (Watch this as a slide show…)
Political Pitfalls Possible
France’s new President will meet German Chancellor Merkel today with opposing views on the fiscal treaty (see previous post). Furthermore, until a Greek coalition is formed, turmoil there will continue.
Eyes on China Easing
After data disappointed last week, the Bank of China cut the reserve requirement ratio by 50 basis points on Saturday. This is the equivalent to injecting around $64 billion into the banks. Investors remain watchful on Chinese policy, hoping it remains accommodative as the economy cools, to protect global growth.
Flight to Quality
Unsurprisingly, with the climate uncertain, investors have rushed into perceived safe havens. With much money still on the sidelines, a reversal of this trend could provide a hefty boost to markets. Appetite for risk is a crucial current driver.
QE3 Back on the Table?
The Federal Open Market Committee (FOMC) minutes will be scoured for signs of fiscal support. Housing market weakness and elevated unemployment has caused Bernanke to leave the door open for further stimulus. Any indication of inflation easing could put the possibility of QE3 back on the table. Although still unlikely, with elections due this year, the pressure is on for policy to remain accommodative.
A Worse Outlook for UK Inflation and Growth?
The Bank of England’s inflation report will give investors colour on the headwinds for consumption and the economy as a whole, as growth and inflation forecasts may be amended. Plunging purchasing power will keep consumer spending stifled. As rising inflation data calls an end to a 5 month easing trend and continues to surprise on the upside, investors will be watching for an increase in the inflation forecast. Higher energy prices and lending rates have kept the risk to the upside and as we dip back into recession, businesses are unlikely to boost hiring. Investors will therefore focus on whether the growth outlook is downgraded. Headwinds are severe and sentiment remains depressed.
As French and Greek voters make their feeling about spending cuts loud and clear, we ask ourselves – why has there been such a strong swing to anti-austerity/pro-growth, how does this threaten the survival of the euro and is a Greek default still possible? The deepening slump has dampened deficit reduction, the Fiscal treaty hangs in the balance and patience is wearing thin. Crucially, according to voters and investors, time is running out.
Growth vs. Austerity: deepening slump is dampening deficit reduction
Francois Hollande’s victory in the French elections marks a significant change of focus in European politics. In contrast to the rhetoric delivered up to this point, Hollande wants emphasis of policy to be on growth instead of austerity. Why does he want this? Because the situation is deteriorating. Unless a country grows, their debt burden, as a percentage of a decreasing national output, grows and is therefore harder to manage. As iterated by French Socialist lawmaker Arnaud Montebourg, in an interview with BFMTV “Austerity is everywhere and it’s a complete shipwreck,”.
Portugal and Spain are prime examples. While the Portuguese economy is expected to contract by 3.3% this year, the deepening slump is dampening deficit reduction. In fact, the deficit almost tripled in the first couple of months of this year alone. Spain, similarly, is struggling with a deteriorating debt situation. As almost 1 in 4 are without jobs, unemployment is boosting defaults. Bad loan ratios have reached a 17 year high (see chart below on the right).
Survival of the Euro Threatened
However, such a drastic change of attitude could damage the Franco-German Alliance, political progress and the very survival of the euro. This is because for Hollande to promote growth, he is threatening the fiscal treaty, perceived as crucial for keeping the euro together in its current form. The Treaty would create closer consolidation within the European union. Handing over authority for National Budgets to a Supra-National entity could ensure the various moving parts of the region interact better as a whole. However, Hollande disagrees with the primary focus on debt and deficit limits, without any pro-growth measures.
Whilst the German Finance Minister Wolfgang Schaeuble is ready to discuss initiatives to boost economic growth Merkel has said she will not renegotiate the pact. As her spokesperson asserted, it “has already been signed by 25 out of 27 EU countries”. Instead the likelihood may be a growth pact attached to the fiscal pact. Nevertheless, the problems don’t end there. Firstly, Hollande will have his work cut out for him in an economy that is barely growing, with jobless claims at their highest in 12 years and a rising debt load that keeps France vulnerable. Secondly, can both sides agree what they mean by growth?
Growth by any other name…
France and Germany disagree strongly on how to achieve growth. Merkel maintains it is through structural reforms – making it easier to fire workers, which would encourage employers to hire, certainly a key aim for the Italian Government. However, Hollande is hesitant and instead wants growth via infrastructure spending. But Germany won’t agree to spending funded by borrowing – exactly opposite to their deficit reduction targets. Therefore, again although rhetoric can be applauded, practical plans remain elusive.
A Greece Default Still Possible
Uncertainty continues to be a key challenge for Greece as voters in a similar move to the French, overwhelmingly rejected mainstream candidates supporting spending cuts. Crucially, these cuts were aimed at securing bailouts and avoiding a default. Instead, 70 per cent of voters supported parties that promised to tear up the bailout and attempts may be made to negotiate a gradual ”disengagement” from the harshest austerity measures of Greece’s €130 billion ($168 billion) bailout. This keeps the possibility of a Greek default firmly in the picture and until a coalition is formed, a new election next month is possible.
As banks all over the world slash jobs, we ask ourselves – will this produce more streamline firms ready to generate significant profits, or a sign of the poor outlook for the sector? Unfortunately, stifling regulation repressive and a false bubble has driven this move and severe headwinds remain through exposure to struggling economies and substantial funding needs.
The 50 largest banks around the world have announced almost 60,000 job cuts. UBS are laying off 5.3% of their workforce, blaming stricter capital requirements and slowdown in client trading activity; Credit Suisse cutting jobs by 4% to save SFr1bn and Lloyds a whopping 14%.
Restrictive regulation make banks more stable but less profitable
Stricter capital requirements were just the type of new regulatory measures the Chief Executive of Standard Chartered feared at Davos back in January, would “stifle growth”. At this time we saw banks such as Credit Suisse missing earnings targets and downgrade their expectations severely going forward (from above 18% return on equity to 15%, which turned out to still be too high).
UBS has seen costs in their investment banking division soar to 77% of income and net profit fall almost 50% from a year earlier. Stricter capital requirements mean banks have to hold a higher amount of capital in order to honour withdrawals if hit with operating losses. Furthermore, restrictions on bonuses led to increases in fixed salaries and an inflexible cost base.
Backtracking on a false bubble
Job cuts should also be set within the context of occurring after a ‘false bubble’. Post the 2008 financial crisis and bank bankruptcies and proprietary trading layoffs, the fixed income, currency and commodity business of the remaining players boomed as competition dropped. Banks began expanding. UBS’s proposed cuts of 3,500 jobs comes after an expansion of 1,700 to the workforce and incomparable to the 18,500 job losses experienced during the crisis.
Exposure to struggling economies is a key threat
Crucially, these cuts do nothing to solve the biggest problem these banks are struggling with. They have substantial exposure to struggling EU economies. In Germany, bank exposure to the PIIGS (Portugal, Italy, Ireland and Spain) amounts to more than 18% of the countries GDP. Just last month Commerzbank suffered a €760m write-down from holding debt that is unlikely to be repaid, which all but wiped out their entire earnings for the second quarter of the year. Further fuelling fear of the spread of the crisis from periphery to core is that French banks are among the largest holders of Greek debt.
Here in the UK we’re by no means immune. Our banks have £100bn connected to the fate of these periphery economies. RBS, 83% owned by the British taxpayer is so heavily exposed to Greek debt that it has written off £733m so far this year.
Severe funding needs and fear of lending exacerbate the problem
90 EU banks need to roll €5.4tn over the next 24 months. This will be funded at higher rates and with disappearing demand as investors become more wary, exacerbating the problem. In addition these banks need to raise an extra $100bn by the end of the year. An inability to borrow to satisfy current obligations, not withstanding any expansive moves, is a serious obstacle to profit generation.
Moreover, job cuts do nothing to boost confidence to encourage banks to lend. Just two weeks ago, EU banks deposited €107bn with the European Central Bank overnight than lend to each other. If banks are not even lending to each other, losing out on a valuable opportunity to make money, then how encouraged are we as investors to get involved?
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.
Debate has been raging as to whether the Greek economy can avoid bankruptcy. Just how big is the problem, what are the options and how is this impacting financial markets?
Background to the Problem
Greece is around €300bn in debt. Putting that into context, its budget deficit is one of the highest in Europe and last year amounted to more than four times the Eurozone limit at 13.6% of GDP. This more than supports the country’s inclusion in the infamous ‘PIIGS’ acronym (Portugal, Ireland, Italy, Greece and Spain) used to refer to the areas of sovereign debt concern.
Despite the jobless rate reaching 16% (and a horrific 42.5% for youth), the Greek economy has seen only marginal deleveraging. Instead, people are depending on consumer credit to maintain their levels of expenditure and service their debts (i.e. paying credit card bills with other credit cards). Moreover, whilst many in the UK struggle to obtain loans from banks, the overall banking sector in Greece actually increased their credit availability, with the most significant increase going to the government itself.
Last Thursday, Jean-Claude Trichet, President of the European Central Bank, announced that they would lend Greece €45bn in new loans. However, this alone, they acknowledge, is not enough. The ECB wants to see structural reforms and a good deal of privatization, with the claim that €50bn could be generated over 3 to 5 years to reduce debt/GDP from 160% to 140%.
What are the Complications?
Loans to ‘bailout’ struggling countries are partially funded by taxpayers from different countries within the EU. Therefore, the problem is not an isolated one. Furthermore, even after this loan and the privatization contributions, there will be a financing gap of €170bn between 2012 -14 which will need filling. European banks have to refinance €1.3tn maturing debt by end 2012 and are owed over €200bn already by the PIIGs for refinancing ops.
Could a Good ‘Haircut’ Help?
With so much talk of a ‘restructuring’, i.e. bond holders sharing some of the pain, it is interesting to hear the views of Lorenzo Bini Smaghi, an ECB executive board member on the subject. He maintains that these are not the tools by which Greece can save its economy but could cause a “Depression” and “banking system collapse”. Furthermore, those pointing to a compromise of a voluntary or ‘soft’ restructuring appear to be fooling themselves. According to him, there is “no such thing as an ‘orderly’ or ‘soft’ re-structuring” since ‘haircuts’ (a percentage knocked off the par value of a bond) would have to be forced by governments. Crucially, any type of restructuring would cause a panic in the markets and cause credit events reducing the value of these investment vehicles either way.
Yield on a 10 year Greek Government Bond (Orange), 10 year German Government Bond (white) and the spread between the two (yellow) - showing the higher premium demanded by investors for holding Greek debt, near historical highs - highlighting a heightened risk perceived by the markets.
So, What Are the Options?
As previously mentioned, a default on some of its debts would have dire consequences but the prospects for sustainable financial solvency appear weak with such a substantial deficit and the habits of borrowers and lenders not much improved. Most worrying, from the perspective of European stability is the recent comments from a Greek EU Commissioner that “The scenario of removing Greece from the euro is now on the table”. Therefore, although in stark contrast to statements by Greece’s Prime Minister and with France and Germany still heavily exposed to EU laggards, which together make a break up of the euro unlikely in the short-term, it is a fear weighing on investors minds.
This has two consequences. Firstly, investors should be more cautious of an indiscriminate sell-off but secondly, this can be used as an opportunity to pick up high quality assets at a lower price. Be wary but remain opportunistic.