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Europe: time to focus on quality

Nyhet   •   Maj 21, 2012 09:38 CEST

Europe is once again dominating the headlines and causing turbulence in global financial markets. Here, Dominic Rossi, Chief Investment Officer for Equities and Andrew Wells, Chief Investment Officer for Fixed Income, share their views on recent eurozone events, the broader impact of these developments and what we can expect in the weeks ahead. 

It is not altogether surprising we are where we are. It seems highly probable that Greece will leave the euro.
I expect to see a rise in risk premia in the sovereign markets.  Indeed, the reaction we are seeing in sovereign and equity markets is already beginning to price in the reality of a Greek exit. It seems likely that Spain will soon seek official assistance from the ECB and IMF in the recapitalisation of its banks. I am a little more sanguine about the Italian situation because the country is at least beginning to generate the primary surplus it requires to stabilise matters.

If and when – and I think it is more a case of when - Greece leaves, two possible situations arise. Typically in such a case, the first thing that happens is that the IMF moves into Athens for bilateral talks. They would then be able to talk directly with the central bank of Greece and with the government, something they haven't been able to do in the past because of the presence of the European legs of the troika. With the ECB taken out of the equation, we would have a purely bilateral relationship between the IMF and the Greek government and central bank.  The IMF would then present Greece with a loan, in large part so the country can buy energy as it is a net importer of oil. Greece would agree to an austerity programme, in order to access the IMF’s funds.  This is what has happened in most emerging markets during the crises of the late 1990s.

Unfortunately, this approach is only possible if the government is a fairly orthodox, middle of the road government. But if the polls are correct, this is not the sort of government Greece will have.  More likely is a government which will reject austerity.  In this case, it is possible that Greece would try and go it alone and impose capital controls, in the way that some emerging markets - in particular, Malaysia - did.  This is a very difficult situation for the Greeks.

Can the Greek situation be contained? Avoiding contagion is vital if the broader market impact of such an exit from the eurozone is to be limited. The key thing after any Greek exit is to look at the opinion polls in both Italy and Spain. The best outcome would be if we were to see a complete reversal in attitude in these countries, as they step back from the prospect of following the Greek example.  This would give greater legitimacy to the Spanish and Italian governments’ efforts to get on and do what they need to do.

The environment for equity investors is likely to be very difficult for the next 12 months. As we have seen during the crisis so far, policy initiatives will doubtless continue to have a positive impact on market sentiment but the effect will be short-lived, lasting one, or two, or three months. It is impossible to predict when those market rallies will happen or what their magnitude will be. At present, however, there are simply too many obstacles for the equity markets to make any long-term, meaningful progress. We have got the various eurozone issues to get through, a  deleveraging process for the European banks and this is all before we have even begun to consider the fiscal issues in the US, which have been parked ahead of the Presidential elections. 
Markets will continue to struggle over the coming months. We will continue to focus on high-quality companies which are well-financed and cash-flow rich. Capital preservation continues to be the most important consideration for investors. Equity income remains important and has been working well as a strategy.

There is universal agreement at the moment that we are in a risk-off environment. But because the influences are all so political in nature, it is very hard to analyse things on the basis of economic fundamentals. In this environment, people are taking risk off the table.

The interesting thing is that from a fixed income perspective, people aren't selling assets, and so total returns from bonds are still good - year-to-date returns are positive.

Liquidity is tight at the moment but credit fundamentals outside of the impacted governments have not deteriorated significantly. This has supported most fixed income valuations. Moreover, most of the opportunistic money left these markets in previous sell offs, so we are not seeing a disorderly market at the moment.

We are, however, seeing a few quite significant changes, in what we call the credit basis - the difference between cash and derivatives – which is widening. People are hedging their risk by buying protection, but not selling their cash ownership of instruments - so this is a market development that we need to watch carefully, because if the basis becomes too wide it will lead to even more volatility.

Generally speaking, there has to be a resolution of the Greek situation before real confidence can come back. We need to see Greece chipped off the side of Europe, and then a massive show of support – whether through the recapitalisation of the banks, or maybe a 5-year LTRO, or more economic support for the euro states that remain behind. 

Interestingly, not much has changed economically in the past couple of months. What markets have realised, however, is that you can't negotiate long-term refinancing with a government that doesn't exist, or one whose composition is highly uncertain. What's really driving Greece away from Europe then is the lack of long-term political stability. Greek politicians know that their negotiating position is poor but they should also know that if they leave the euro then the situation is more likely to get worse than better.

There clearly isn't really a desire to be risk-on at the moment. We haven’t seen a significant bounce-back from here in many of the risk assets. People are very nervous and concerned that this is just another chapter of a bad story.  We expect this to rumble on through the whole of the summer and there will be continued political noise as we approach autumn this year.

An improvement in GDP growth is needed badly, something we are not seeing at the moment. In the US all eyes are on the economic data, with the evidence suggesting that the recovery has weakened compared to the end of last year.

One an area of concern is that if equities drop substantially from this point, we could see problems in the credit markets as a consequence.
At the moment, we favour the US because of the dynamics in that market place and attractive corporate yields.
In terms of opportunities for investors, we have seen positive returns, year-to-date on investment grade fixed income. These positive returns are likely to continue. Especially those high-quality corporates that are well managed and which can continue to finance cheaply.



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