Europe: The Tough Road Ahead

PART 3: Two experts question the eurozone’s response to the debt crisis and wonder whether it’s possible to repair the damage

Ben Johnson 13 March, 2012 | 1:53PM
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Ben Johnson is director of European ETF research with Morningstar. George Magnus is a senior economic advisor at UBS. Magnus was one of a handful of economists who warned of a pending global financial crisis as early as 2007. Edward Chancellor is a member of the Asset Allocation Team at GMO. Chancellor has written extensively on the topic of the current crisis, specifically examining the ways in which the eurozone’s predicament differs from historical sovereign defaults.

The Tough Road Ahead
Johnson: What’s the endgame here?

Magnus: I think it is really difficult to look much beyond the next few months at this point. But forced to choose, I think that there may still be enough political bonds between European countries, particularly between Germany and France. Politics was the driver of the project in the first place after World War II. Those political binds may be sufficiently strong to maintain some sort of eurozone in the future.

But I can’t possibly imagine a eurozone in which all 17 incumbent members will find it comfortable to stay. Bit by bit, I think the Europeans will probably change their governance structures and mechanisms with a view that makes it easier to leave the eurozone—well, as I say, “easier,” note that there is no provision for anybody to leave the eurozone. But I think that may change.

It’s also possible, of course, that countries could make a decision to leave and try to win the moral support of the rest of the eurozone countries to ensure that the departure is as orderly as possible, if it is possible.

Obviously, the extreme version is that there’s a complete implosion of the eurozone, which could occur as a consequence of some kind of dire economic backdrop—involving a really steep recession, together with the inability of countries to effectively stay the fiscal austerity course, and this might give rise to a banking crisis that we were so close to seeing back in November and early December.

Johnson: Edward, your vision of the endgame?

Chancellor: It depends on which side of the bed I get out of in the morning.

There is a nightmare scenario, which can come about in various different ways—a European banking crisis, as capital flows from the periphery to the core are not sufficiently replaced by the European Central Bank funding. The other is a more long, drawn-out deflationary bust—that is just too painful for countries like Ireland, Greece, Spain, and possibly at some stage, even Italy.

There’s a more optimistic outcome in which a credible solution is found and the yields in the periphery come down. The Germans agree to tide over with the necessary payments and transfers to the periphery. As I mentioned earlier, that probably requires a higher level of inflation in Germany and a pretty weak euro.

I think George’s idea that the eurozone would probably hold together but some members will leave is very troubling for investors, because the moment you start factoring that in, you start looking at the Italian yields and say, “Well, yeah, they’re pretty good if Italy doesn’t default, and who wants to let Italy default? But they’re not so good if Italy actually leaves the eurozone.” Once people start worrying about that, those high yields stay in place, and the problem becomes self-fulfilling.

So, it’s very important to find a credible solution. The longer there is no credible solution, then one tilts, I’m afraid, towards some of these more-dire outcomes.

Johnson: How should investors be positioning themselves in this environment?

Chancellor: I’m afraid it’s a really difficult problem because one is caught between greed and fear. Greed says that European equities, by and large, are cheap. In one of our recent seven-year forecasts, eurozone equities had an expected real return of about 8% annualised, which would be a pretty good return. In Italy, inflation-index bonds are trading north of 6% in real terms. If Italy doesn’t default, holding an inflation-index bond for 10 or 15 years yielding more than 6% is a pretty good investment.

In addition, you may have heard of European dividend swaps. European investment banks offer various investment products that leave them long European dividends, and they need to get them off their books, so there’s a market for European dividend swaps. Now, if the eurozone holds together, these will turn out to be very good investments. If the eurozone doesn’t hold together, and given that your counterparty for a European dividend swap is typically a French bank, that is more worrying.

There are some times in investment when you’re offered an opportunity that is a no-brainer, and you take it in as big a size as you can get. In Europe, you’re getting some reasonable investment opportunities. But given that we’ve sketched some very nasty scenarios that are quite plausible, you don’t really want to be taking overly large positions.

So, what seems to me to be a reasonably good portfolio for the current times is a core of U.S. quality—with a bit of eurozone or EAFE, if you want. I actually think that Japanese equities are probably a better buy today than Europe. Their valuations are in line with Europe’s, and Japan isn’t facing quite such dire problems.

Johnson: Sum up the next six to 12 months. What do you think will happen?

Magnus: When markets regroup early in 2012, there are a number of things that will attract attention. One of them may be fairly imminent, which is the downgrade of the French sovereign. One of the major rating agencies just put France on for a negative outlook. The review of sovereign ratings in Europe will happen during the first quarter, and I imagine that both the major rating agencies will probably confirm a downgrade of the sovereign. That is bad political timing, from the point of view of President Sarkozy, who is facing election on the 6th of May. And obviously, it’s not good anyway from the point of view of trying to strength of the European financial stability facility, which they’re still trying to do, because when France gets downgraded, that takes about EUR 150 billion of their guarantee value away from the agency. So, effectively, the proposals there will be pretty much confirmed as unrealisable.

Then, of course, we’ve got the resumption of heavy sovereign issuance early in the new year, including a EUR 15 billion redemption that the Greek government has to make in March, which, at the moment, looks like it may be the occasion for the long-awaited default, though the ECB’s recent announcement of these three-year lending facilities may defer that for a little while. We’ll have to wait and see. In any event, those are the major issues that I think will drive markets at the beginning of the year. As we go through the year, the idea that you can throw ECB and/or IMF money at this problem and resolve it will be seen to be a bit of a sham. The underlying fundamentals and the contraction in the European economy will continue to chip away at the credibility of the whole sovereign strategy.

So, “recurring crises” would be my bottom line. And we will never know which one of these crises might prove to be a game changer, or even terminal.

Chancellor: What can I add? If both George and I say “recurring crises,” we know whenever financial commentators are unanimous in their views they are almost invariably wrong. So, if I want to make the world a better place, I better agree with George and sacrifice my reputation.

Magnus: Maybe it will be all right, Edward. Maybe it will be all right.

Chancellor: I don’t want to be more depressing, but there is another area where we’ve done a lot of work, which is China. And China has been the source of global growth since the financial crisis of 2008. China looks to me in a very, very perilous state. It looks like Ireland 2008, but 300 times larger. China has just come off a huge property bubble, a huge credit boom, and a huge fixed-asset investment infrastructure boom. And that is very problematic.

I don’t know what the source of the global growth engine is. And frankly, I don’t know what the outcome is-other than a huge amount of volatility, I’m afraid, which means that by this time next year, I’ll probably be about as tired as I am today, because, it’s been an incredibly tiring year, I must say.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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