Strategy Monthly: Euro confusion

From

Equities appear to have recovered their poise after the four-week correction from mid February to the lows around the time of the terrible events in Japan mid March. Markets have taken the ECB raising interest rates in their stride, perhaps because expectations for rate hikes in the UK and US have been pushed further out into the future. One consequence of those moves has been to make the euro a strong currency in recent weeks.

First-quarter earnings have given more evidence of the rude health of corporations around the world ― profit margins are high, reported earnings are high and balance sheets strong.

Equities and credit remain attractive against government bonds and cash. Gold remains more attractive against cash than at any time in its history. Gold costs money to store and secure but cash basically yields zero (3-month US Treasury bills yield 0.025% to be precise). We have never had interest rates this low (data goes back to 1694 in the UK) so gold is as attractive as it has ever been on a relative basis.

Given this backdrop, it is justifiable for ‘risk assets’ to have performed reasonably well. That suits our core positioning. However, we remain concerned that there are too many structural hangovers from the Great Recession to make unalloyed bullishness the appropriate strategy.

One of those hangovers is the unresolved matter of dealing with the debt of Greece, Portugal, Ireland and potentially others in the eurozone periphery. Portugal has now agreed a €78bn three-year financial bailout involving the EU and the IMF.
x
Currency traders are looking through these issues and declaring that the ECB moving its refinancing rate to 1.25% is enough to make the euro the ‘bees-knees’ when it comes to global currencies.
x
In the short-term, we have some sympathy with the notion of looking through the periphery problems. That is exactly what policymakers in Europe want. We need to remind ourselves that there is a plan for dealing with the situation. That plan is simple.
x
The EU is trying to buy time to allow its banks to be in healthier shape before asking them to deal with the implications of a debt restructuring in Greece or any other periphery country. Hence, the ECB feels it can raise interest rates because it can focus on its inflation mandate and let the politicians deal with the periphery.
x
The context for that view is completely consistent with the longer-term thematic backdrop that must always be borne in mind when thinking about the EU and the single-currency. That is, to paraphrase Dr Friedman, the euro is always and everywhere a political phenomenon.
x
On the face of it, therefore, the threat to the euro comes if there is a loss of political will to support it. There is no indication that the ruling class has lost that commitment. Indeed, the setting up of the EFSF and ultimately the ESM are indications that the commitment remains wide and deep.
x
However, there is a lot of concern that the electorate in northern Europe in particular will do a Roberto Duran and declare “no mas”.
x
We completely agree that a political backlash in northern Europe is a critical risk for the euro. Political instability would undermine the single currency and, rather annoyingly for those ruling classes, the electorate get to vote now and again.
x
The Finnish election on April 17 was one such annoyance. It was an unusual Finnish election because it made the front pages of newspapers across the world. The rise of the populist True Finns party (which opposes EU bailouts) to a third place finish, stoked concerns that the northern European populace are indeed now revolting against the bailouts of the south.
x
The leader of the True Finns put it rather more colourfully: “The Finnish cow should be milked in Finland and the milk shouldn’t be sent abroad in charity.” Timo Soini deserves to be recognised for his wisdom.
x
However, in the remainder of 2011 there are few opportunities for European electorates to voice their concerns. There is a Portuguese election in June but nothing significant in northern Europe. We take the growing populist opposition to the bailouts in the euro area very seriously. However we suspect that its impact in 2011 will be limited.
x
But surely Greece has to restructure its debts given its 2-year government bond trades at a yield of 23%? At some point yes, and there are risks in the next month or so that events will push the story back onto the front page. On May 15, the Greek government presents its budget. In June, the IMF will report on the progress Greece has made since the original bailout.
x
We suspect there are three possibilities for ultimately resolving the problem. We see the probabilities of each to be rather different today than they may be in two or three years time.
x
  1. More assistance from the EU/IMF to avoid any restructuring. This is the most likely outcome in the near-term. There is no indication that the French or German ruling political class have any interest in jeopardising the euro project by forcing any debt restructuring on a member state until the broader financial sector, including French and German banks, are in better shape to deal with it. Probability of  happening this year: 60%. Probability of still being a tenable policy in 2013: 5%.
  2. Debt maturity is extended but no haircuts on principal. By not haircutting, financial institutions do not have to recognise any capital losses on their Greek debt. The question is whether this can be done without the market immediately thinking that it is just a stepping-stone to option three below. Probability of happening this year: 30%. Probability of being a tenable policy in 2013: 15%.
  3. Debt restructuring with haircuts for creditors. It would most likely be a soft version, along the lines of the Brady bonds issued in the 1980s to end the Latin American debt crisis. They involve some recognition of losses but give creditors a higher-grade bond to hold in place of the restructured original debt. This will likely be done on a voluntary basis by EU financial institutions. Probability of happening 10% this year; 80% by the end of 2013.
The critical thing to think about though is that the endgame for Greece will likely be some form of debt restructuring. It will involve losses for a lot of financial institutions in Europe. When this happens, it will almost certainly lead to renewed fears of contagion to the other ‘PIIGS” too. It is only a matter of time before this dominates the front pages again. Whether the euro will be quite such a strong currency when it is happening remains to be seen. But one suspects not. Has selling the euro become a plausible hedge against a core pro-risk portfolio?

Our asset allocation is overweight equities and fixed income; underweight property and cash.

x
This communication is directed only at investment professionals, and should not be distributed to, or relied upon by private investors. This document is not intended for retail distribution. AEGON Asset Management UK plc is authorised and regulated by the Financial Services Authority. The information in this report is based on our understanding of the current and historical positions of the markets. The views expressed should not be interpreted as recommendations or advice. Past performance is not a guide to future performance. The value of investments may fall as well as rise and is not guaranteed.

You must be logged in to post or view comments.