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.
‘Grand’ gestures with minimal effects, Europe is doing the ‘Ice Bucket Challenge’ with a glass of water. Measures won’t measure up to much. Little movement in interest rates, not enough assets to buy and ultimately – you can put out as many cream cakes as you’d like, but if people aren’t hungry, they aren’t going to eat. The pressure is rising and more is needed. Europe has become a ‘binary trade’, and it is important to invest in those set to benefit regardless.
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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…
‘Wind down’ is not withdrawal but watch negative news flow in the US; treading water is not growth so keep the champagne on ice for Europe; price is not value so beware investor sentiment; falling unemployment is not rising employment so watch the participation rate; and a hiccup is not a correction so keep an eye on an exit…
Political uncertainty in Italy could impact global markets, but provide a “fantastic buying opportunity.”
Like Jennifer Lawrence’s fall at the Oscars, unexpected but a chance to shine ‘comedically‘, Italy’s elections have shocked investors but provided attractive entry points to strong international firms, insulated from domestic woes (as well as offer up some funny one-liners from candidates). The possible loss of eagerly anticipated labour reforms, financial restrictions and market contagion provide shorter term sources of turmoil. However, existing reforms are likely to continue, market retrenchment is healthy and to be exploited for longer term opportunities.
Market elation has been a little bit too early, moved a little bit too far, and there are these potholes that actually could cause markets to stumble, at least in the shorter term. Markets do not like uncertainty, and the longer this continues, the longer the uncertainty is over the markets, the more likely is it will have a pullback.
The U.S. stock market is approaching 500 days since a 10 percent-plus correction, which she said was the tenth-longest time in history that such a bull run has occurred.
And it means when we’re looking at where valuations are , they’re no longer cheap with respect to the U.S. market, growth isn’t coming through as we thought it was going to come through, and you’ve got this level of uncertainty, meaning that it is more likely that these momentum followers – for example, the hedge funds are buying into financials – that they’re going to start to stumble.
But I do think that that means if we do see a correction, it could be muted because it’ll be a fantastic buying opportunity for those investors that are looking to rotate back into risk assets because over long-term, we’re actually more bullish about equities.
Low interest rates, credit spreads at multiyear lows and the prospects of a return to growth could still bode well for equities.
What the market needed was confidence and the return of depositors to put their money into European banks, something that hasn’t happened sufficiently.
All of that gives us slight cause for concern, meaning that we’re growing more cautious shorter-term, although, obviously, more bullish longer-term.”
And just a reminder of why Spain has been able to withstand bailout pressure and markets have shrugged off European woes until recently…
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.
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 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 European markets suffer the longest losing streak since November, the correction is a healthy one. The index is still up over 8% this year, despite many of the region’s problems remaining unsolved. The latest disappointment, a manufacturing industry contracting more than forecast, is merely the next knock in an overall shrinking group of countries. Just this month the European Central Bank reduced the outlook for growth this year to a 0.1% contraction, keeping the region in recession. As expressed by Tim Geitner in the US, Europe is “only at beginning of a very tough, very long, hard road”.
Italy struggles to free its labour market, essential to restore confidence and ease debt
Crucial for Italy to restore confidence in their markets and bring down hefty borrowing costs is the structural reform of its labour laws. The country’s growth has lagged the euro average for more than a decade and with unemployment at the highest level since 2001 (9.2%), the fear is they will be left further and further behind. Unfortunately, talks between government and union have failed to ease firing laws, which would stop older workers being protected to the detriment of the youth (suffering from a massive 30% unemployment rate) and encourage hiring. With elections early next year, the time for progress is running out.
Portuguese auction success shows investors convinced short term but long term concerns continue
Portugal, seen as the next card to fall after Greece, succeeded in auctioning 4 month bills at the lowest yield since late 2010. Demand for these bonds reached 7 times the amount on offer, implying investors were sufficiently confident on the short term outlook for the country. Nevertheless, long term bond yields remain elevated, with investors requiring 12.5% to lend to Italy for 10 years. With a 3.3% economic contraction expected this year, unemployment at 14.8% and strikes over pay, welfare cuts and tax hikes, the long-term outlook is yet to be rosy. The deepening slump has dampened deficit reduction, with the figures almost tripling in the first two months of this year.The fear is more rescue funds will eventually be needed.
ECB passing the baton: unwinding support for banks but had better move cautiously
Interestingly, despite the potential pitfalls, the ECB seems to be scaling back certain bond purchases. Prior to the recent Long-Term Refinancing Operations (LTRO), a measure to buy €40bn of bonds was set. Since then, only €9bn has been bought and the policy expected to last until autumn may be wound down sooner. This is understandable with LTRO, injecting a whopping €1tn of liquidity having made this ‘gesture’ obsolete. Furthermore, a member of the ECB has proclaimed that it “has done its part now governments must do theirs”. A move towards letting banks stand on their own two feet is the long-term strategy for stability, but with potential for risk to re-erupt, they had better step cautiously.