Wednesday, September 14, 2011

Keeping an eye on Europe

It’s been a big few days in the ongoing European sovereign debt saga. There have been heightened fears of an imminent default by Greece, a high profile resignation from the European Central Bank and both Italy and Greece have agreed to new austerity measures.

The impending departure of Jurgen Stark, who resigned last week as the Central Bank’s unofficial chief economist, was viewed negatively by the market. This can be mostly attributed to the fact that it underscores the lack of unanimity at the ECB about measures being taken to stabilise financial markets. Stark was not a supporter of recent actions taken by the ECB to purchase Italian and Spanish bonds which we believe were a helpful part of the stabilisation process.

Italy and Greece have confirmed Budget measures that will help them meet agreed budget targets. In the case of Greece, these measures will help close a significant Budget gap that was threatening to derail the payment of the next €8 billion tranche of the first Greek bailout.

It was during this process that rumours started circulating that Germany was preparing for a default by Greece. It seems prudent to us that Germany should be prepared for such an eventuality, in fact the only surprise to us in this news is that they weren’t already prepared for such an outcome!

You will recall it is our view that Greece will default at some point. The debt burden is simply too high and increasingly austere near-term budget measures are simply pushing the economy into an ever deeper recession. Deep and potentially protracted recession makes a long-term solution to Greece debt sustainability all the more difficult.

None of this means, however, that a Greek default is just around the corner. At the announcement of its most recent budget measures the Greek Prime Minister said his government remained committed to avoiding default.

It’s also not all about budget cuts: asset sales and a debt swap programme are also part of the plan. Asset sales will take time and it is questionable whether the target €50 b will be raised. September 9 was the deadline for banks and insurers to signal their participation in the debt swap programme whereby holders of Greek debt will swap bonds for longer dated ones. It’s unclear what the take-up is at this point. It’s unlikely these programmes will solve the problem, but at least they are moves in the right direction and deal with the fundamental problem of solvency.

There is little doubt a premature disorderly default would have serious contagion implications for other countries, particularly Portugal and Ireland. It would also have serious implications for currently undercapitalised banks. A more orderly process at a later date would allow Portugal and Ireland to demonstrate success in moving towards a more fiscally sustainable position and for banks to be better capitalised.

In the meantime, financial stability is important. There are two mechanisms for stability: the European Financial Stability Facility (EFSF) and the ECB’s balance sheet. First the EFSF. The July 21 Eurozone summit proposed increased powers for the EFSF. These proposals allowed the EFSF to use its funds to buy distressed sovereign bonds at a discount on the secondary market, issue precautionary liquidity loans to euro zone members and to ecapitalise banks in difficulty.

These proposals need to be ratified by the various Euro zone member parliaments. The French parliament passed the measures last week. In Germany, its constitutional court last week rejected challenges to the Euro zone financial packages that were agreed last year for Greece and other Euro zone countries. This has paved the way for the passing of the EFSF measures by the German parliament at the end of the month.

In the meantime, the ECB has been exercising its role as the lender of last resort. Through the Securities Market Programme (SMP) the ECB has purchased around €130b of peripheral Euro zone debt. With the ECB’s balance sheet already at €2 trillion, the inevitable question is: How far can the ECB’s balance sheet stretch? We think quite a bit. The ECB has considerable capacity to increase the size of its balance sheet by issuing non-interest bearing and non-redeemable debt. We are not concerned about the ECB’s ability to stand behind Euro zone sovereign members and banks, even in the face of a default by Greece.

In a more recent development, the BRIC economies are meeting in Washington next week to discuss how they can assist.

Ultimately we are waiting for the politicians to come up with the long term plan for the management and sustainability of Euro zone sovereign debt. We remain of the view that this involves a high degree of “fiscal federalism” in Europe i.e. a common fiscal policy. This inevitably leads to the issuance of Euro zone bonds. The creation of the European Stability Mechanism (ESM) to succeed the EFSF in 2013 will provide the institutional framework for such an outcome. Until that political reality dawns on Europe’s political leaders, we believe Europe has the capacity to muddle through.

As for the investment outlook, equity valuations remain at attractive levels. Over the longer-term this has historically meant a greater chance of positive returns, or at least a lower risk of negative returns. Our longer-term economic growth outlook is positive (in a “new normal” way), so the longer term return outlook for equities is positive.

But there is always a risk-return trade-off. The evolution of the European sovereign debt crisis has resulted in a higher awareness of tail risks, and it doesn’t take much thought-experiment to foresee an unhelpful turn of events. The question is the degree to which you look through this. For now we remain cautiously optimistic on the outlook for growth assets and retain out neutral growth vs. income asset allocation position. We will continue to closely monitor economic and financial market conditions, particularly in Europe.