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.
Investors are expecting an eventual reduction of support by the Fed, and Merkel winning the election this weekend. However, what stock markets have not priced in is the resurgence of Eurozone troubles into the headlines. So what are the options, why is this important and how will this effect markets?
[Click image below or this LINK to watch this as a TV Clip]
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.
Central banks are running out of steam as their measures to bring calm back to markets are no longer as effective as they once were. Germany too seems unable to keep up. Like a marathon runner caught in a sprint, their reluctance to move forward stands in stark contrast to market moves focused on the end game. But the road isn’t clear. Europe has three remaining hurdles in their race to recovery: funds, fiscal unity and reform. With Greece approaching the final whistle, doubts over its ability to stay within Europe are growing louder. The worry is investors are watching the referee not the striker, more focused on the search for safety than the rising risk elsewhere in the markets. False starts continue to drive market volatility and while investors ask whether it’s time to back the ‘underdog’, European stocks may provide diamonds in rough, but things could get rougher.
The vital relationship between central banks implementing stimulus and Spanish yields falling has broken down since April of this year. No longer is central bank action able to reassure the market and instead Spain and Italy’s borrowing costs remain at elevated levels. Investors are demanding more. Structural change is needed but markets are concerned that leaders could choke under the pressure.
Germany: A marathon runner caught in a sprint
Germany wants to progress towards greater unity at its own pace but the markets move faster. Indeed a backbencher delivered his dissatisfaction with the European Central Bank’s plans to their Constitutional Court! It will be tackled in September but investors and the economy won’t wait. Weak consumer confidence and rating agency scepticism highlight the urgency for action.
Europe: 3 Hurdles in Race to Recovery
The three key obstacles to be tackled to progress towards stability are: enough funds to contain the crisis; fiscal consolidation (share budgets in order to share debt burdens and be able to offer ‘eurobonds’); and finally structural reform to regain competitiveness & growth. All are vital for the future of the region and this realisation is starting to build within the markets. Europe did manage to overcome their concern that a Fed-Style straight bond buying programme would reduce the pressure on countries to reform, with a Memorandum of Understanding putting these measures on paper. The use of ‘MOU’s in order to accept ‘IOU’s to lend to countries within Europe may be a step forward, but this remains only part of the full picture needed for longer-lasting results.
Greece: Approaching the Final Whistle
S&P ratings agency has questioned whether Greece will be able to secure the next tranche of bailout funds as it downgraded the outlook for its credit rating to negative. Without such funding, the ‘death knell’ for Greece’s euro membership will be sounded. With the IMFsignalling payments to Greece will stop, the lack of funding fuels fears that without drastic action, the end could be near. Even beyond Greece, the Italian Prime Minister dared to publicise the possibility of a Eurozone breakup if borrowing costs did not fall.
Investors: Watching the Referee not the Striker
The rush to safety has been overshadowing rising risks. As investors pile in to perceived ‘safe haven’ assets, the yield on German government bonds has been falling. However, in a different market, the cost of insuring these bonds has risen as these investors see risk on the rise. The snapback in bond markets to better reflect this sentiment could shake the equity market as well and is therefore a significant concern.
Markets: False Starts
Markets have rallied in the face of disappointing data. Eurozone stocks reached a 4 monthhigh as manufacturing dropped to a 3 year low suggesting the slump is extending into Q3. This discrepancy has driven market volatility, exacerbated by the low volume of shares traded over the summer months. Greater clarity is required to see a more sustained upward momentum which will have to wait until leaders are back from their hols!
Investments: When to Back the Underdog?
European stocks may provide diamonds in rough, but things could get rougher. The overweight US / underweight EU trade is starting to look stretched, as the divergence in performance between the two regions continues to increase. This has been quite understandable, but there will come a time when this is overdone. Within Europe, there are international companies, with geographically diversified revenue streams so not dependent solely on domestic demand for their products or services. Furthermore, with effective management teams and strong fiscal positions, some may be starting to look cheap. However, cheap could get cheaper. Damage to sentiment could lead to market punishment regardless of fundamentals. Therefore waiting for decisive developments & clarity on road to recovery may be prudent.
From Greek election elation to Spanish rescue concerns; a clear road to recovery has remained elusive. Greece continues to gamble with their euro membership with the misguided belief that they can soften demands for austerity, without threatening their bailout. Instead, it is the lack of a sufficient firewall, rather than a commitment to Greece remaining within the eurozone, which stands in the way of an exit. When banks are supported and other countries protected from a fallout, bailout payments to Greece and their membership within the eurozone could come to an end. Withdrawals from Greek banks could force the issue even earlier, as the desire to stay in the euro is offset with capital flows betting against it. For markets, it is clarity over the outlook going forward that is required for investor confidence and upward market momentum to return. We are not there yet, but time is running out.
Watch a 5 minute clip: Breaking the news about the outlook for Europe post Greek election
Greece Gambles With € Membership
New Democracy’s win in the Greek elections was a victory of fear over anger. Outrage over the harsh austerity terms that have pushed the country into a 5th year of recession was outweighed by the fear of an exit from the euro. Protest against the tough spending cuts and tax increases was overshadowed by alarm at potential isolation and banking collapse, if these measures were to be rejected and bailout funds halted. Thus, New Democracy, perceived as the ‘pro-euro’ party and as such the investors’ choice, won.
Crucially, however, although less willing to gamble their euro membership and expressing a commitment to staying in the eurozone, New Democracy also want to renegotiate the bailout terms. Dangerously, they believe it is possible to soften demands for austerity, without threatening their bailout. As a party seen as responsible for the crisis in the first place, their track record does not inspire confidence.
Odds Against Greece If Firewalls Strengthened
The Spanish rescue exacerbated the problem. Offering Spain a bailout without stringent terms was seen as a desperate move by European leaders, bending to pressure from a fear of further turmoil. Such a sign of perceived ‘weakness’ gave Greek leaders the confidence to believe their demands could likewise be met and the need for harsh austerity no longer mandatory.
This is misplaced. The possibility of a Greek exit is being discussed far more freely by European politicians. It is the lack of a sufficient firewall, rather than a continued resilient commitment to Greece remaining within the eurozone, which stands in the ways. This is especially the case while Greece’s membership continues to threaten the existence of the eurozone as a whole. When there are sufficient rescue funds in place to support the banks and protect other countries from the fallout, bailout payments to Greece and their membership within the eurozone could come to an end.
Depositors Could Dictate Greece’s Fate
With depositors withdrawing over €500m each day from Greek banks, decisions over the country’s future may be decided even sooner. European company exits have also gathered steam. Carrefour, Europe’s biggest retailer, has cut their losses and sold out of Greece. As sources of support dry up, the country stands on far shakier grounds. Voters may have moved in one direction but depositors have moved in another. A desire to stay in the euro offset with capital flows betting against it. As Bill Gross, founder and co-CIO of Pimco, said on CNBC’s Street Signs “Greece’s fate will be decided not at the ballot box but at the ATM”.
For markets, it is clarity over the outlook going forward that is required for investor confidence and upward market momentum to return. We are not there yet, but time is running out.
To note: Conviction for an exit from the euro has grown among The Investment Insight readers. From 40% of readers a month ago, to 72% on the latest poll (below), the belief that an exit is inevitable is building….
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.
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.