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.
(Click on the image below for a quick video clip summary)
‘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…
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…
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.
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.