Eurozone

Eurozone

Last year the focus of global financial markets was firmly fixed on the American economy.  Recent economic data suggests that the underlying American economy is now actually in reasonably good shape, with unemployment starting to fall, an expanding manufacturing sector, home sales growth and anecdotal evidence pointing to a strong start to holiday shopping.

The global problem child has now become Europe.  And unlike most economies in the world, the layers of bureaucracy that lace the European Union (EU) makes the process of agreeing and implementing sound action plans more difficult.

The intense media focus on the financial situation in the Eurozone has understandably made some investors nervous.  Markets will continue to speculate about possible outcomes to this crisis.  It is important to remember that all scenarios being discussed in the media – from the subtle to the extreme – are public knowledge.

In times of uncertainty, markets will always be volatile – as indeed they have been in recent months.   This paper provides a perspective on what is currently
happening in the Eurozone.

Background

The first stage of the global financial crisis – from 2007 to 2009 – focused attention on the plight of much of the developed world’s banking systems and the use of highly leveraged and opaque derivative instruments.

This second stage, dating from early 2010, has centred on the subsequent damage to many already stretched public sector balance sheets of bank bailouts and the consequences of extremely loose government fiscal policy in the preceding decade.

While the governments of the United States and Japan face major medium-term fiscal challenges, Europe has been the epicentre of market concerns. In the past year or so, Greece, Ireland and Portugal each have received financial assistance to cope with large debt loads. In more recent months, the concern has spread to Italy & Spain.  Gross government debt has ballooned as a percentage of the value of goods and services produced by countries each year (i.e. GDP), as shown below:

 

Many of the governments have agreed to austerity measures in return for promises from the European Union, the European Central Bank and the International Monetary Fund for continued short-term financing.

Policymakers, meanwhile, have approved changes to a special bailout fund to stem the risk of further contagion. Greece has won a new assistance package of up to 130 billion euros, but at the expense of a 50% discount for bond holders.

Recently, markets have expressed scepticism about the capacity of the Eurozone as a whole to deal with these liabilities. Even Germany – by far the biggest and strongest economy in the zone – has struggled in recent weeks to generate sufficient demand for a sovereign bond issue.

Last week, the world’s major central banks announced steps to prevent a credit crunch among the banks in Europe.  This news helped to calm global markets, and led to the Australian stockmarket rising by 7.6% over the week.

What will happen next?

No one can determine what will happen next, but below are some observations of what may happen in the coming weeks and months:

  • It will be a long road - it will be years before the Eurozone and other developed nations like the U.S can constructively escape from their straitjacket of debt.  But it is important to remember that there is no direct link between a country’s
    economic growth and the performance of its stockmarket, as we noted in a
    previous article: http://www.stewartpartners.com.au/do-budget-deficits-low-economic-growth-reduce-expected-investment-returns
  • Will Greece default? – the market has already effectively valued Greek sovereign debt as if it has defaulted.  Whilst the EU would like to avoid this outcome, the odds of it happening are high.
  • Who should pay? – bondholders who invested in Greek debt should bear the pain of default – this is how capitalism works.  However, this must be balanced
    against the need for financial stability and ensuring a properly functioning
    banking system.
  • How may the EU change? – one scenario which has been canvassed is that the euro currency may cease to exist.  If this occurred, this should not affect the ability of any governments to repay their loans. There will also likely be more oversight of budget spending in each member country.  The EU treaties already include sanctions if a country’s annual deficit exceeds 3% of its GDP, but in the past these penalties have never been enforced. Greece and Ireland have in recent years had annual deficits exceeding 10% of GDP.  The idea is that going forward, these penalties will be automatic and immediate.  The exact details of the process and penalties won’t be known until March 2012 at the earliest.Some countries will argue that ceding fiscal control will result in a loss of sovereignty, but it would appear a necessity for the EU.  One of the reasons many EU countries are in a mess has been due to central control for setting interest rates, whilst each country could still control their own budget spending.

In recent years, low interest rates in the EU were appropriate to help stimulate growth in the largest economies like Germany and France. However, in Ireland, where economic growth was already strong, the low interest rates encouraged unsustainable asset price rises – particularly in property. In Ireland, the economy really needed higher interest rates to keep inflation and spending in check. Subsequently, house prices have fallen dramatically and the country’s banks needed a financial bailout due to the large losses they were incurring.

  • What events does current market pricing anticipate? this is very difficult to answer.  Based on price to earnings ratios, the market has priced in the expectation of further bad news to some extent.  So there is a possibility that bad news reported in the media may actually result in stockmarkets rising if the news isn’t actually quite as bad as expected.However, it is important to understand that recent market volatility is not an indicator of lower expected returns in the future.  Simple economic theory tells us that the expected returns of stocks actually goes down in good times, and goes up in bad times.  That is why disciplined investors who remain patient when times are bad inevitably experience strong returns when markets recover – though we can never be certain when this will occur!

What am I invested in?

Clients of APW Partners should be reminded that their investment portfolios only invest in liquid securities including bonds and shares.  We do not recommend investments in complex derivatives such as structured products, hybrids, credit default swaps and other exotic instruments.

Conclusion

It is likely that uncertainty of outcomes will prevail at present.  Investors in stockmarkets must accept that markets go up and down.

On 25 November, newspapers in Sydney quoted the CEO of Commonwealth Bank saying that GFC 2 could be on the way. This headline may have caused some concerned investors to sell down their stock portfolios. However, over the next 6 days the stockmarket rose by 8.4%. This is a reminder that knee jerk reactions to headlines and opinions can cost investors dearly.

Rather than be apologists for the markets, we try to work with them. Our evidence based investment approach does help us target sectors of the market that offer higher expected returns. But whilst our clients are well positioned to receive higher investment returns relative to many other investors, we can never be certain what the absolute return of their portfolio will be on a year by year basis. To help counter against volatility, we seek to ensure our clients have targeted minimum amounts invested in cash and fixed interest securities to reduce the risk of needing to sell growth investments at distressed prices to meet expected cashflow needs.

For most investors, rather than worrying about events i.e. instability in Europe, which they have no control over, the focus of investing should be on generating cashflow over whatever the individual investors time horizon is to ensure they can enjoy the lifestyle they desire.

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.