EuropeanApr 2 2012

Clarity needed in Europe

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The ECB’s decision to introduce the first tranche of the long-term refinancing operation (LTRO) in December has helped drive a steady rally in equities across Europe in the first quarter of 2012, as fears over a liquidity or banking crisis started to recede.

This year, the FTSE 100 has risen from 5699.91 in January to a high of 5965.58 on March 16, while the EuroStoxx 50 has seen a rally from 2389.91 to 2608.42 on March 18. However, the question is how long this apparent calm will last.

Ted Scott, director of global strategy at F&C, points out the eurozone debt crisis effectively began in May 2010 with the first Greek bailout, although markets were worried before then, but the amount of politics involved in the eurozone makes it difficult to predict how long the uncertainty will continue.

He points out: “We have short-term political risk in the eurozone at the moment as we’ve got an election both in Greece and France quite soon, and if more radical parties are voted into power, that could again disrupt the eurozone and act as the catalyst for the next leg in the crisis.”

Strategy

Currently the strategy for eurozone politicians has been to try and keep all 17 countries in the eurozone, but this depends both on economics and politics.

Mr Scott argues: “They will be able to manage this for maybe another six months or a year before Greece is forced to leave because the cost of staying in will exceed the cost of going out.

“It hasn’t reached that situation yet but I would imagine at least another year before we get one of the countries leaving and we might have the risk of a disorderly default. At the moment, the tactic is they can buy time: they’ve been doing that through the bailouts and also, crucially, the ECB’s action as well. The ECB is playing a major role in keeping the eurozone together.”

However, while the LTRO has temporarily boosted markets and helped the liquidity problems of banks, it hasn’t actually made the countries more solvent.

In addition, Frances Hudson, investment director and global thematic strategist at Standard Life Investments, points out that, although in general markets have rallied in Europe, there is still some discrimination between returns. Germany, for example, up approximately 20 per cent and Spain down 2.45 per cent.

“All of this seems to be a price movement as opposed to a solidly backed rally from people buying it, because volumes have stayed very, very low, which probably means that you can’t be that confident of its durability,” she adds.

Kevin Lilley, manager of the Old Mutual European Equity fund, suggests that, other than first-quarter company profits, the additional risks to the markets are potentially the results of the French election in late April early May, and economic data from both Europe and the US.

“At the moment we’re going through a transition phase because in the latter part of last year, growth expectations got too low for Europe in general and I think they’ve now been reset. We’ve seen the market moving up in the past couple of months and now we’re in a position where markets will probably move sideways for the next few weeks while we await confirmation of what’s happened with company profits in the first quarter.”

In terms of other monetary policy events such as interest rates and inflation concerns, the consensus appears to be that, like the US and UK, interest rates in Europe will stay lower for longer.

Ms Hudson says: “The ECB official headline rate is at 1 per cent and the next decision is on April 4. The futures are implying that the rate should come down further. Obviously they have room to cut because, in comparison, the Federal Reserve is at 0.25 per cent, the Bank of England is at 0.5 per cent and the Bank of Japan is at 0-0.1 per cent.

“But adjusting things when they’re at very, very low levels probably doesn’t have the same impact in terms of the economy, which is why most of them have resorted to the non-conventional measures.

“Although the ECB isn’t doing outright quantitative easing, because it is doing the LTRO, which is only providing funding for a certain channel, it does suggest a kind of recognition that altering the rate isn’t doing anything.”

Mr Lilley adds that with low growth expectations in the region, interest rates are unlikely to rise unless there is a significant pick up in inflation.

“The only threat, potentially, on the inflation rate is if the oil price moves up sharply from here, and I don’t really see that happening. For the oil price to go up sharply you would need positive growth shocks or a big geopolitical event, and I don’t see that happening either in the short term.”

In terms of the wider eurozone crisis and the possibility of a Greek default, Mr Lilley suggests Greece has lost its ability to shock the market and further destabilisation is only likely to occur “if something bad were to happen in Spain or Italy because they’re big enough to matter”.

“We’re worrying about a very, very small country which now has the facilities in place to keep it going for the next couple of years.

“Clearly it has to deliver against the benchmarks that have been set by the authorities, for the balance of money to be released, but I don’t think Greece is the game changer it was a few months ago.”

Pro-growth

Mr Scott suggests policymakers in the region will continue with their current strategy but suggests the target for Greece to reach a debt to GDP ratio of 120 per cent is likely to be missed and the country will require a third bailout.

“I also think in the next six months say, it will become evident that probably Portugal will need a second bailout as well. The question then is whether the policymakers will change tactics and say, “This strategy is not working, we need a strategy that is more pro-growth rather than implementing such severe austerity measures,” and I don’t think they will.

“I think they’ll also rely on the ECB to alleviate conditions by sort of pumping more money into the eurozone itself, which doesn’t really help solvency [in struggling countries].”

In the longer term, Mr Scott predicts the end result will either be full fiscal union, which will have to overcome significant political hurdles around countries giving up their economic and political sovereignty, or there will be some kind of fragmentation of the eurozone.

“I don’t think the euro project will be abandoned. We’ll still have the euro currency at the end of the day, but I think Greece and maybe one or two other peripheral countries will be forced to leave the eurozone, not only for their own good but also for the good of the currency union itself so that the remaining countries within there are able to co-exist. At the moment I don’t think it’s possible in the longer term.”

Nyree Stewart is deputy features editor at Investment Adviser