Published in CityA.M.
The global recovery does not fully account for the rise in markets, and the growth that would justify these elevated price levels is not guaranteed. (more…)
As markets now price in a full default on 2 year loans, and the next tranche of the bailout hangs in the balance until political chaos abates, the question now seems to be – is an exit from the euro inevitable? The people of Greece are against it, but politicians are threatening it and firms are getting prepared for the possibility. Finally, there is a fear of a run on the banks as deposits fall and the risk other countries may join the ‘default’ bandwagon.
Greeks do not want to leave the Euro
Although 60% of the Greek population view the austerity terms set for them to receive the next tranche of their bailout negatively, more than 7 in every 10 favour staying in euro. The main benefit to the country in the reinstatement of their own currency would be its inevitable depreciation, enabling the economy to regain competitiveness with respect to the (cheaper) price of their goods and services. UBS estimates this would be a 60% change in valuation. However, the bank also estimates borrowing costs would rise by 7%, hitting balance sheets and costing each citizen €11,500 in the first year outside the euro (€4,000 in subsequent years).
…But politicians point to the possibility
Nevertheless, politicians have begun pointing to the possibility of Greece leaving the euro. When faced with a potential referendum being held in Greece, subsequently called off, Sarkozy exclaimed that the “real question is whether Greece remains within Europe or not”. The Luxembourg Prime Minister tried a more diplomatic tact conceding it does not have to remain a member “at all costs”. Whereas Germany’s biggest newspaper far more brutally demanded “no more billions for the Greeks, Greece out of the euro!”
…And firms are starting to prepare
And companies are starting to make preparations for Greece to return to their own currency. Tui, one of Europe’s largest travel companies see Greece leaving the euro as “more than a theoretical possibility” and have accordingly requested the freedom to pay bills in the new currency.
Lack of credibility puts the bailout at risk
A surprise and ultimately rejected call for a referendum and the ensuing political chaos put the next tranche of the bailout at risk. A last ditch attempt at appeasing the people, by putting the acceptance of the tough austerity measures they will have to endure to a vote, led to threats of expulsion from the euro. Subsequently, a coalition government has been formed until early elections can be called and the Prime Minister has stepped down from his position. The rumours that the leader of this new unity interim government, Papademos, wasn’t even in the country at that time doesn’t bode well for a new era of superior management!
Time is short as an €8bn bailout has now been withheld for over a month, until the situation is sorted out. 700,000 public sector employees and 2 million pensioners need to be paid at the end of the month and nearly €3bn for bonds maturing in December from the 19th onwards. However, Greece still has a bloated public sector, refuses to sell or lease more of their assets, misses out on what could amount to €30bn in tax avoidance each year and continues to generate a 10.5% deficit in terms of spending versus income. And with riots on the streets and wage and pension cuts already of 20% and upwards, flexibility to cut more is somewhat limited. Fundamentally of course, this won’t generate growth. With the resulting bailout a short term plug, and the economy still forecasted to shrink by 2.5% next year, the feeling of futility can be understood.
…and there are fears of a run on the banks
Worryingly, Greece deposits fell by €10bn, 6% of current deposits in October alone. And it’s no longer just the wealthy looking to relocate assets to the likes of Switzerland but by people needing the funds to survive. An audit of Greece’s largest banks could reveal in December €15bn of non-performing loans, whilst holding a disproportionally large amount of their own sovereign debt. Greek 2 year yields have risen above 100%, implying investors do not expect these loans to be repaid. It could take €30bn to recapitalise these banks.
… and the risk others may follow
If one country is allowed to renege on its debts, then there is the possibility of others demanding likewise. Ireland could follow suit and demand it is therefore unfair that they have to repay bond holders in full. However, although a possibility, it is not currently a probability. The stark austerity measures being imposed on Greece, and the scrutiny they are now under is enough to put other countries off that option for the moment. Ernst &Young Item Club estimate that a default by Portugal, Ireland & Spain would cause Eurozone output to fall by 6%, in a recessionary environment that’s not a number to take lightly!
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?
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?
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.
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.
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.
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.
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.
World unity is the wish of the hopeful, the goal of the idealist and the dream of the romantic. Yet it is folly to the realist and a lie to the innocent – Don Williams, Jr (American , b.1968)
There has been much in the news lately on the outlook for the European Union. In May, Greece was offered €120bn in EU government and IMF loans over 3 years to replace the need for new borrowing at exorbitant market rates – the “first bailout of a Eurozone country and the biggest bailout of any country”. Just last month Ireland joined the queue and received a €85bn injection plan. The flame of contagion was burning bright as investors worried Spain, Portugal and Italy were to follow suit quickly (The other members of the PIIGS acronym – and we’ve been advised what risks lie in an acronym!). Then just as markets calmed after the ECB staged their largest intervention and purchased mainly Portuguese and Irish bonds on Friday, the rating agency Moody’s announced it was downgrading Hungary’s debt by not one but two notches! This country isn’t even in the periphery of the EU, it’s outside of it entirely… and so the contagion spreads….
2. NOT SOLVING PROBLEM: without growth, the debt burden as a share of GDP will continue to rise. The latest European Financial Mechanism only covers maters until 2013, if Debt/GDP has not reduced significantly then bond holders start sharing the pain
3. UNCERTAINTY: ministers keep changing their minds! (“no bail out” to “bailout”, “no pain for creditors” to “sharing the burden”) – markets don’t like uncertainty!
What the ECB wants EU countries to do: Be prepared to increase the size of emergency bailouts, consolidate budgets and reform (implement austerity measures and assume national responsibility so the ECB can avoid being a bailout tool)
What EU country economies need: COMPETITIVENESS AND GROWTH
“Europe is difficult to understand for markets. They work in an irrational way sometimes,” Christine Lagarde, French economy minister