December 9th, 2012 | By Nick SargenBy far, the most complex (and frustrating) issue investors have had to deal with recently is how to position portfolios when there is a threat of a meltdown in the euro-zone. As problems have spread from the periphery of Europe to countries such as Italy and Spain, funding costs for European governments have risen amid the prospect of widespread downgrades in their credit ratings. Strains within Europe’s banking system have also become apparent, necessitating a coordinated response by the Federal Reserve, European Central Bank (ECB) and other central banks to provide much-needed dollar funding. These developments, in turn, have spilled over to global markets, as market participants fear a replay of the 2008 financial crisis. The over-riding issue we consider, therefore, is what steps European leaders can take to avert such a dire outcome.
Amid these developments, European leaders met this past week to discuss the blueprint for a closer fiscal union to bolster the euro-zone. The deal that was announced included the following actions:
Prior to the EU summit, market participants were anticipating that the codification of a new fiscal compact would provide cover for the ECB to augment its bond purchase program. However, ECB President Mario Draghi downplayed such expectations in a press conference, as he indicated the ECB would not attempt to drive yields down to specified levels. This initially spurred a sell-off in equities, but it was reversed on Friday, as investors’ remained hopeful the ECB would play a greater role in bolstering government bond markets and the financial system.
Amid these developments, we are currently focusing on two issues related to Europe:
Heading into the European Summit, one of the principal objectives of Europe’s leaders was to create a firewall to keep problems in Italy and Spain from spreading to other countries. As yields on their ten-year government bonds surged above 6%, it had become increasingly apparent that both countries faced serious impediments in rolling-over their debt. According to Bloomberg, Euro-area governments will have to repay more than euro 1.1 trillion of long-and short-term debt in 2012, of which Italy and Spain account for more than 40%. In addition, European banks have about $665 billion of debt coming due.
It’s been clear for some time now that the temporary EFSF facility was not large enough to address the financing needs of larger European countries. Policymakers, therefore, have been looking for ways to augment the facility, including leveraging it. When that option was deemed unworkable, European leaders opted to bring the ESM forward and to augment the resources of the IMF.
Even with these expanded resources, however, it is not clear they will be sufficient to bolster investors’ confidence. Therefore, many continue to hope the ECB will ultimately provide governments with necessary financing. However, it is important to recognize that the ECB views its role as “lender of last resort” as providing necessary liquidity to the financial system, but not necessarily to governments. This distinction implies that the ECB will take action to help ease the financing strains of banks, but it does not want its mandate to be perceived as providing automatic funding for governments. Therefore, I believe, the ECB will continue to intervene in secondary government bond markets, but at its own time and choosing.
Where does this leave the prospects for the euro-zone?
In my opinion, the latest actions are sufficient to lessen the risk of an imminent crisis and associated “tail risk”. However, they are not decisive enough to eliminate this possibility altogether, and they will at the same time place greater pressure on European governments to undertake austerity programs.
With much of the periphery already in recession and the core economies including Germany and France slowing noticeably, I do not see how Europe can avoid recession in 2012. Indeed, the real issue is whether recession will prove to be moderate (along the lines of the ECB’s latest projections) or more severe and protracted, as some observers fear.
As we position investment portfolios for the coming year, we contemplate an environment where the U.S. economy is expanding at a moderate clip, and U.S. corporations are reaping record earnings while maintaining strong balance sheets. The principal risk we foresee is a recession in Europe that could become more severe, and which at some point could impact the U.S., Asia and other parts of the world.
In this context we are positioning fixed income portfolios for a low interest rate environment in which credit risks are not excessive. For those seeking to protect their portfolios against a crisis in the euro-zone, we believe the most effective ways are to short the euro versus the dollar and/or to hold longer-dated treasuries, as they are likely to rally in a crisis.