October 31st, 2011 | By Nick Sargen
At last week’s EU summit meeting, European policymakers reached agreement on three key issues:
For the most part, the package of measures announced was in line with market expectations; yet the announcement triggered a major rally in world equity markets and in other risk assets such as high yield bonds. Accordingly, many observers have been surprised by the response, and some have questioned whether it will be short-lived.
Criticisms of the plan include the following considerations:
My own take is that while these criticisms are valid, one should not to lose sight of what has been accomplished. During the summer, investors had lost confidence in European policymakers’ ability to deal with the underlying problems. Indeed, officials appeared to be in denial about the need to recapitalize the banks and to augment the ESFS, and the leaders of Germany and France were divided about how to handle Greece.
Heading into last week’s summit, a key issue was whether policymakers would be able to negotiate an “orderly” default of Greek debt, in which private bondholders would accept a bigger haircut than the 21% figure agreed to previously. Based on the markets’ response to the package, it is clear they have regained investor confidence: Instead of a run on European banks, their share prices fueled the rally in global equities and risk assets.
Accordingly, I believe European policymakers have bought time to implement these measures and also to begin the process of more fundamental reform of the European Monetary Union that will eventually transform it into a fiscal union.
In the meantime, we will be focusing on several issues:
Regarding implementation of the plan, it is easier to agree to a plan than to fulfill it. Indeed, since the Greek issue surfaced in early 2010, the problem has mushroomed into a test of the viability of the euro-zone, mainly because past efforts proved to be inadequate or unenforceable. Consequently, investors will be monitoring whether Greece is in compliance with the arrangements, as well as how other problem countries are faring. In this regard, there are growing concerns about Italy, as ten-year government bond yields have surged above 6.0%. This development reflects investor doubts about the government’s proposals to lessen its high debt burden and to embark on much-needed reforms.
Regarding economic prospects for Europe, Greece already is in severe recession and several countries in the periphery appear on the brink as the effects of austerity programs take hold. Thus far, Germany and other core countries show signs of growth, albeit at a subdued pace. An added uncertainty is how European banks will meet the increased capital requirements. To the extent they do so by shrinking their balance sheets, this would further undermine growth.
One encouraging development is that the global economy held up better-than-expected in the third quarter: The U.S. economy advanced by 2.5%, while China and Emerging Asia continue to be the pace-setters for the world. As long as debt problems in Europe can be limited to Greece, Portugal and Ireland, there is a diminished threat of financial contagion spreading to other parts of the world.
Amid the extraordinary turmoil in financial markets over the past three months, one of the most difficult issues to assess has been whether European policymakers would be able to regain market confidence. If so, investors could refocus attention on assessing fundamental developments around the world; if not, the focus would stay on Europe, and markets would continue to be subject to vagaries and rumors.
The plan European policymakers announced last week does not represent the permanent solution to Europe’s ills. However, the steps taken are the most comprehensive since the euro-zone crisis surfaced in early 2010. The most important accomplishment is that European leaders demonstrated resolve to keep the euro-zone a viable entity, and they were able to overcome differences for the sake of the Union. In this regard, I concur with the following assessment from JPMorgan Chase Bank:
“This summit defines the start of the end of the sovereign debt crisis, but the process will be drawn out (likely in years) and will have reversals, will not be obvious for some time, and will not prevent Europe from falling into recession again, as banks delever and austerity bites hard.”[i]
Our strategy throughout the market turmoil has been to maintain positions where we are confident there is long-term value, even if individual securities or asset classes suffered from the uncertainty. Now that markets have recouped most of their losses, we will continue to maintain our investment strategies (and asset allocations) while exploring new opportunities. In the United States, the key issues continue to be whether the economy will avert a double dip recession and whether corporate profits can continue to expand in a soft economic environment. Based on recent developments, we are more confident the stock market has registered its lows for the year. However, we do not foresee the market posting new highs this year in light of the many unresolved issues in Europe.
[i] Global Data Watch, October 28, 2011