- Global markets enjoyed a more stable week with equities enjoying one of their best rallies for many months. The strong gains came on the back of increased optimism over the eurozone debt crisis even though some of the economic data was disappointing, such as unemployment increasing to over 2.5m in the UK.
- Whilst there has been no material change in the underlying eurozone debt issues, a firm statement from German chancellor Angela Merkel re-affirming EU support from Greece helped sentiment.
- However, political tensions are growing between the EU and the US, which blames the current turmoil on the inability of European leaders to get to grips with the crisis. A broadside from US Treasury secretary Tim Geithner on Friday didn’t go down well, leading to ECB head Jean-Claude Trichet commenting that Europe’s economic position was better than that of other major economies.
- With growing speculation that Greece may still default, the possible choices and implications for the eurozone as a whole are discussed this week including outright Greek default; full economic integration of all members and even Germany exiting the euro.
- The implications of a government defaulting on its debt is looked at and a parallel with Argentina is discussed.
- Amidst the recent volatility it is important not to lose sight of long term investment objectives and John Wood of JO Hambro briefly explains his views on UK equity investing.
A superficial glance at where global stock markets ended last week makes for encouraging reading. After the previous week’s volatility, investors switched into a ‘risk-on’ mode, snapping up equities which they believed to be oversold and so enabling Western share indices to enjoy one of their strongest rallies for many months. In London, the blue-chip FTSE100 advanced almost 3%, whilst on Wall Street the Dow Jones Industrial was up around 5%. However, over in Asia it was a different story with both Hong Kong and Shanghai slipping back following concerns over possible default by some of China’s regional authorities. The improved sentiment was not on the back of better economic news – here in the UK unemployment has risen above 2.5m according to the latest data from the Office of National Statistics, with the public sector hit hardest as spending cuts bite. Mid-week, Swiss banking giant UBS was in the limelight following news that one of its traders was arrested charged with fraud and false accounting, after the bank announced a loss of up to $2.3bn from a series of unauthorised trades. The loss has raised the spectre of thousands of job cuts or possibly even a break-up of UBS itself.
The reason that markets perked up was on raised hopes that the eurozone debt crisis might, somehow, be closer to resolution, although to the layman it might be hard to discern. The newsflow itself was not encouraging; President Obama led the way by criticising European leaders for failing to tackle the debt crisis, demanding “more effective, co-ordinated” fiscal policy. His comments reflect growing American anger over the current turmoil for which they blame European leaders. In France, two of the country’s largest banks – Societe Generale and Credit Agricole – were hit by credit rating downgrades by the agency Moody’s. The country’s embattled financial sector is struggling to convince the markets they can manage any Greek default but the downgrades were less severe than expected which enabled banking shares to rally, albeit temporarily.
Central Banks to the Rescue
Against this backdrop there were two key events that encouraged the markets. First, a robust defence of the eurozone and an attempt to stamp out talk about Greece defaulting from German chancellor Angela Merkel went down well. Second was the direct intervention of five of the world’s central banks – the ECB, US Federal Reserve, the Bank of England, the Swiss National Bank and Bank of Japan – to pump extra liquidity into Europe’s banking system to alleviate concerns that banks would be unable to borrow sufficient funds to fund short-term needs. The message from the ECB was very clear; no bank should go under because of a lack of liquidity and that it stood ready to offer them unlimited amounts of euros and now dollars too, following the intervention.
The action by the five central banks was unexpected and raised a number of questions for investors. Why did they do it and will it solve the funding problems in the markets? The ECB was concerned that eurozone banks were having difficulty in borrowing dollars which they needed to repay loans in the US currency. In normal market conditions US banks would happily lend dollars to the banks but heightened worries about French and German banks (because of their large exposure to Greek sovereign debt) meant they refused to do so. A key stress indicator is any change in the difference in the yield spread between the cost for banks to borrow overnight (considered the risk-free rate) and the rate they will be charged for loans over three months, measured by the euribor. Last week the euribor rate jumped to 84 basis points (bps), the highest since March 2009, but well below the 195bps seen at the height of the 2008 crisis. So in response the five banks offered to lend unlimited three-month dollar loans, so alleviating liquidity concerns.
Strategists believe the market is a long way off a systemic crisis such as the likes witnessed following the collapse of Lehman Brothers but, equally, do not think it has solved the core problem of the eurozone crisis, which is the vast public debt levels of the countries on the periphery of the eurozone. For example, while Greece owes around €384bn, Spain owes €657bn and Italy€1.7 trillion. This debt overhang problem can only be resolved by fiscal measures – such as austerity cuts by governments – and improving economic growth, both of which are in doubt. What the intervention by the central banks does do is to buy time, enabling European institutions that need dollars to meet their counterparty or loan obligations whilst policymakers find a solution. However, our view is that, whilst helping the banks through their liquidity problems, these measures do nothing to address the fundamental issue of Greece defaulting.
Chancellor’s Iron Fist
And, as we have stated several times over the last few weeks, it is the policymakers who have been causing anxiety in the markets – or rather their fragmented and sometimes contradictory messages. Not for the first time, mixed messages from different members of the German government spooked the markets, causing the euro to tumble sharply. This time it was the economy minister, Philip Rosler, who dared suggest that an “orderly default” by Greece should be on the agenda. Unsurprisingly, he was put firmly in his place by both Angela Merkel and her finance minister, Wolfgang Schauble, with the latter speaking scathingly of “idle gossip”. Following a conference call mid-week with Greek prime minister George Papandreou, France and Germany issued a statement to quell speculation that Greece could be forced out of the single currency, saying they were convinced that Greece’s future lay within the eurozone. This soothed nerves in the financial markets although some analysts and economists remain to be convinced that Greece will be able to meet its fiscal and structural reform targets following the foot-dragging evident to date.
The pressure on eurozone politicians should not be under estimated. At a meeting of EU members on Friday, Tim Geithner, US Treasury secretary – who attended by special invite – issued a blunt warning to the EU leaders to stop bickering and take control of the debt crisis that has brought “catastrophic risk” to financial markets, urging them to halt their months-long clash with the ECB. But despite the common need to find a solution, Europe’s finance ministers, led by Germany and the Netherlands, agreed to withhold an €8bn loan payment to Greece until the country could comply with the reforms agreed and meet again in a month’s time. Amidst signs of a deepening rift between Europe and America, Jean-Claude Trichet, head of the ECB, said after the summit on Friday that Europe’s [economic] position was quite encouraging if you compare it with other major advanced economies – the old adage ‘in the land of the blind the one-eyed man…..’ springs to mind.
The Euro Solution
Speculation regarding the future of the eurozone continues to gather momentum. Persistent imbalances in the economic health of the core and peripheral economies have raised serious questions regarding the sustainability of the single currency and have made it increasingly likely that one or more nations will leave the European Monetary Union. With the markets watching and waiting for positive action on the part of Europe’s policymakers it is worth considering again, in further detail, some of the choices they have and the ramifications for Europe and the rest of the world. The possible outcomes, from various schools of thought, seem to these: Greece defaults and exits from the euro; acceptance of the EU’s austerity programme; a shift to full fiscal union and finally the previously unthinkable step that Germany (and maybe others) leaves the eurozone. The legalities and mechanics of any of the above are fraught in themselves with difficulty. But as a starting point it is worth remembering that under the EU Treaty expulsion is impossible and there is no provision in the relevant European treaties for a country to exit the euro either. However, back in March last year Angela Merkel was quoted as saying “We have a Treaty under which there is no possibility of paying to bailout states in difficulty”. But under the July 21 agreement this year to bail Greece out for the second time, Germany will increase its commitment to the European stability fund to €211 billion, contrary to Ms Merkel’s previous assertions and opening the door to further changes.
So what are the realistic outcomes and which one will be least costly? In the unilateral default scenario the Greeks take matters into their own hands and default on their sovereign debt, unilaterally exit the euro and announce the issuance of a new currency with immediate effect. To prevent a massive flight of funds the authorities would impose a control – or ‘corralito’ – on all withdrawals and deposits. Whilst such action may violate external treaties, a quick exit would serve the interests of the Greek people far better than prolonged servitude. The cost of debt repayment to foreigners would depend on how far the drachma depreciated but the virtue of the strategy would be to help restore growth through a much more competitive currency. Alternatively, Greece could accept the EU’s austerity programme which many see as meaning a decade of pain with high unemployment, internal deflation and subjugation because without devaluation there is little hope of growth – the country’s labour costs have risen by about a third relative to the eurozone core. Based on history it is unlikely that the country could generate sufficient exports to repay the debt at current exchange rates.
What of a shift to full fiscal union? In this scenario the eurozone – effectively Germany and other core economies – assumes the outstanding debt of the Greek government as well as those of other eurozone participants, peripherals and core members combined. It implies a central eurozone Treasury, centralised administration of all government revenues and spending and the joint issuance of all sovereign debt issues – the so-called ‘eurobonds’. The obstacles to this path are mainly political and it would take a long time to accomplish and in the meantime the crisis in the eurozone will continue. Lastly, a number of observers including leading economists such as Martin Wolfe and Roger Bootle, are airing the possibility of Germany leaving the euro. Such a move would be populist but potentially damaging to the economy. The results of an exit would include a soaring exchange rate, a massive decline in the profitability of Germany’s exports, a huge financial shock and a sharp fall in GDP. For now the markets continue to wait and see, although in our view either a significant move to closer fiscal union or a limited Greek default seem increasingly inevitable.
One question asked is whether this has happened before? The answer is yes and a good example was provided by Argentina a decade ago. During the 1990s Argentina tied its currency, the peso, to the US dollar at a fixed rate, so giving itself the inflexibility evident in the euro. The country, like Greece, was not competitive in selling exports and bringing in foreign earnings so it resorted to borrowing and as the debts mounted it struggled to pay the interest. The result was spiralling public debt, unemployment rose and social tensions led to general strikes and finally the president quit and the country defaulted on $100bn of debts. Ultimately it broke the dollar peg, the peso collapsed, inflation went up but it made their goods much cheaper and since 2003 Argentina’s economy has grown by over 8% per year and tourism has boomed. In the run up to the peso collapsing, the IMF was very generous with Argentina to prevent an unavoidable default and devaluation but once that occurred it pulled the plug completely and provided no financial support. Economists, drawing parallels, are warning that the same mistakes should be avoided with Greece, that any debts be renegotiated and that any exit is done on an orderly basis.
Whilst the sovereign debt crisis continues it is important to understand what all this means to private investors who have money invested for the medium to long term. The recent volatility witnessed in global financial markets is disconcerting and unlikely to end anytime soon so our advice continues to be for investors to maintain their current strategy. The big picture – as seen by our fund managers – is more positive than it may appear at present and it is worth sharing some of these views. During recent weeks, global investors have favoured gold, the Swiss franc and particularly government bonds issues by Germany, the US and UK. However, as investors seek out quality, investment grade corporate bonds – issued by the likes of Vodafone, Tesco et al – have held their own and continue to pay attractive levels of income. So as part of a diversified portfolio they have an important part to play.
On the equity front, fund manager John Wood of JO Hambro comments “My strategy and views haven’t changed in the last twelve months. It’s about grinding out results and looking for growth in a low growth environment. There’s too much debt in the world, it needs to be written off, and then we might be able to move forward. The Greek bail-out is about bailing out the French and German banks, not the Greek people. Blue-chip investing is out of fashion yet these companies have deleveraged, have done what they should and are not going bust yet they are being sold and replaced with government bonds yielding 2%. The portfolio is focused on essential services and I own companies that can compound returns. It is currently yielding 4% with a free cash-flow of 9% which companies are able to re-invest. You will see that I hold the likes of Next, Tesco, Diageo, Compass and Sky – all quality businesses with good growth prospects”.
In these volatile times it is worth re-emphasising the potential benefits and peace of mind that can be achieved by investing into the markets on a regular basis, be that through ISAs, pensions and so on. The strategy of drip-feeding can help overcome concerns about the perceived dangers of investing at the wrong time. It also provides the scope to buy more units when prices are falling, and hence hold more units when prices recover.