7 November 2011

 

Crunch time for Europe?

John Stopford, co-Head of Fixed Income and Portfolio Manager, Investec Asset Management

Euro-zone governments attempted to give the peripheral funding ‘can’ another hefty kick down the road at their summit on 26 October. The summit agreement addressed most of the market’s concerns. In particular, it was agreed that Greek debt should be subject to a larger write-down in exchange for additional funding, a decision was also made to leverage the fire power of the European Financial Stability Facility (EFSF) to over €1 trillion to help deal with an Italian or Spanish funding crisis, and EU banks were mandated to increase their capital to make them better able to withstand sovereign defaults. The initial market reaction suggested that investors were positively surprised by the outcome with credit, equities and the euro all rallying. The main exception was peripheral bond yield spreads over Germany, which stabilised briefly before continuing to widen. Unfortunately, this weakness has now pushed Italian spreads closer to the levels where Greece, Ireland and Portugal lost access to private sector financing and had to be bailed out.

 

Ironically, the agreement on Greece probably contributed to the sell-off in Italian government bonds because the apparent failure of sovereign CDS to protect against a ‘voluntary’ haircut torpedoed its role as a hedge, leaving investors in aggregate with more effective exposure to peripheral government debt than they had thought. The forced unwinding of positions at the failed MF Global, the derivatives brokerage, added to the selling pressure, as did political stalemate in Italy. Sadly, the now abandoned proposal by the Greek Prime Minister to call a referendum on the summit deal made matters worse. It was perhaps far-fetched to assume that the Greeks would readily accept an agreement which will leave their economy with a debt ratio of at least 120% of GDP after another 8 years of austerity. Although Greece remains a major source of contagion, in our view the future of the euro will be determined by how the authorities respond to the pressure on Italy and Spain.

 

In this regard, the summit package was relatively bold by past standards, but two elements lead us to be cautious. First, there is nothing in the plan to boost growth. Austerity without growth is likely to prove self-defeating. Survey data paint a pretty weak economic picture across Europe, especially in the periphery. Bank recapitalisation could also undermine growth if banks choose to deleverage rather than raise expensive new capital, though the plan makes an attempt to forestall this by proposing an extension of guarantees provided at the EU level to help banks roll over their existing debt.

 

Second, the proposal to leverage the EFSF assumes that investors will be willing to provide this leverage. Leverage is necessary because governments are unwilling to risk more money than they have already pledged. Financial engineering – akin to creating a CDO¹ – is required to turn the €250billion or so left in the EFSF in the event of a second bail-out of Greece into the more than €1 trillion needed as a credible backstop for Italy and Spain. Klaus Regling, CEO of the EFSF, has been in Beijing asking the Chinese to help fund the structure but it is unlikely in our view that they or other foreign governments will be prepared to invest more than a proportion of the necessary money. The flaw in this approach is that private sector investors probably will not want to buy large amounts of credit-enhanced debt mostly backed by Italian and Spanish government bond holdings if they are unwilling to lend to those countries directly. The decision to postpone the latest EFSF bond auction because of market conditions doesn’t bode well in this regard.

 

If Italy and Spain cannot fund themselves in the market at acceptable levels then the burden will fall on the ECB, suggesting significant bond market intervention will continue to be necessary for the foreseeable future. The role of lender of last resort to otherwise solvent governments is one we think the ECB will accept, albeit reluctantly. They are also likely to play more of a role in supporting growth. Fiscal austerity has pushed European purchasing manager surveys to levels which in the past resulted in rate cuts, allowing Mario Draghi to reduce the Repo rate by 25 basis points at his first meeting as President.

 

In the longer-term, we believe the euro can survive the current crisis largely because the costs of break-up for most countries are likely to continue to outweigh the costs of staying together. Encouragingly, the latest summit suggests that most policymakers understand this. Unfortunately, the market remains to be convinced and it may not be long before European governments and the ECB are once again required to demonstrate their resolve.

www.investecassetmanagement.com

ENDS

Notes to Editors

Investec Asset Management is an independently managed subsidiary of Investec Group. Investec Asset Management is a specialist investment manager, providing a premier range of products to institutional and individual investors. Established in 1991, the firm has been built from start-up into an international business managing approximately US $94bn* on behalf of third party clients. We have grown from domestic roots in Southern Africa and the UK to a position where we proudly serve a growing international client base from the Americas, Europe, Asia, Australia, the Middle East and Africa. We employ over 125 investment professionals. The firm seeks to create a profitable partnership between clients, shareholders and employees, and to exceed expectations for both client service and performance.

*As at end March 2011

 

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