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?
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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.
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.
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).
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?
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.
Gemma Godfrey, Chairman of the Investment Committee and Head of Research at Credo Capital, and John Authers of the Financial Times on CNBC’s European Closing Bell. Discussing how you should invest your money.
Join Guy Johnson and Louisa Bojesen for a fast-paced, dynamic wrap up to the trading day. “European Closing Bell” gives an in-depth analysis of the day’s market action and includes expert analysis from the major players in the European business and financial world.
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.
Spanish Growth Downgraded
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.
Even more worrying is the 43% youth unemployment (as quoted in The Guardian), higher than both Egypt and Tunisia - leading Gregory White at The Business Insider to call Spain "The Next Egypt" http://read.bi/i7fKOu. Source of chart: Miguel Navascues, an economist who spent 30years for the Bank of Spain following a posting for the US http://bit.ly/fDGb6k
Germany Facing a ‘Blocking Majority’
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.
The Investment Insight
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.