Tuesday, October 11, 2011

Looking for a "durable" solution in Europe

Recent positive noises out of Europe have been, well, positive. Particularly pleasing has been French President Sarkozy’s commitment of France and Germany to “a global and durable solution to the Euro zone’s difficulties” before the G20 summit in Cannes in early November.

The key word for us in that commitment is “durable”. That’s the bit that has been missing thus far. The fundamental problem in Greece is solvency: its debt to GDP ratio at around 150% of GDP is simply too high and therefore unsustainable. Increasingly deep budget cuts that have pushed Greece into ever deeper recession are not a durable solution to a solvency problem by any definition.

There have been glimpses of a solvency solution. The July 21 Euro zone agreement included a “haircut” for private sector bondholders. However, it was never going to be large enough to bring Greek debt back to a sustainable level.

To meet the definition of durability, the next solution must include a couple of things. It must deal with the unsustainable level of Greek debt and it must prevent contagion by ring-fencing Greece form the other at-risk countries in Europe, particularly Italy and Spain.

It is quite likely we will see a deeper restructuring of Greek debt. The question then is whether the expanded €440 billion European Financial Stability Facility (EFSF) is sufficient to provide the necessary recapitalising of European financial institutions and further likely sovereign bond purchases. We think probably not, in which case we would also expect to see a further expansion of the EFSF, the use of leverage has been suggested, or an increase in the European Central Bank’s Securities Markets Program (SMP).

More broadly, we would also like to see the key principles of stronger governance at the European level, especially with regard to fiscal policy. No pressure!! The institutional framework for that solution, the European Monetary System, is already on the drawing board. Suggestions have been made recently that its implementation will be brought forward from 2013 to 2012. That’s a positive development.

The good news is we will start to see some detail perhaps as early as the next EU Summit which has been pushed out a week to October 23rd to allow more work to be done. The bad news is we think financial markets will treat anything less than a durable solution harshly. We think Europe’s politicians have got that message.

Even after we know what the plan is, there will still be considerable politics to play out. It will still have to be ratified by the various Euro zone parliaments. That could take some time. The Slovakian parliament is still debating the expanded power of the EFSF proposed back in July.

In the meantime business and consumer confidence in Europe (and indeed around the world) is suffering on the back of the ongoing uncertainty and political intransigence. Risk of recession in Europe is growing the longer this uncertainty goes on. We are expecting modest Europe GDP growth in Q3, but the outlook beyond that is less certain as firms delay hiring and investing.

Ongoing political uncertainty in Europe was a key driver of the de-risking of our portfolios in recent months. A genuinely durable solution to Europe’s debt issues and a more stable economic environment that will flow from that will take us a long way towards developing a more healthy risk appetite.