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From Special Report: Eurozone in Crisis - April 2012

What next for bailed out euro members?

Investors remain nervous over the outlook of bailed out nations, but some economies show signs of recovery

By Jenny Lowe | Published Apr 02, 2012 | comments

The economic prospects for much of the eurozone remain dire, with the European Commission forecasting recessions this year for Greece, Portugal, Spain, Italy and the Netherlands.

Dominic Rossi, global chief investment officer for equities at Fidelity Worldwide Investment, says: “The Greek default has been priced into equity markets but what is far less clear is the implications for other nations, particularly Portugal, Spain and Italy.

“While we appreciate progress has been made, particularly in Italy, in pursuing policies that ultimately worked in emerging markets 15 years ago, this remains a multi-year workout during which they will remain vulnerable to external shocks.”

A recent example of poor economic data was the eurozone purchasing managers’ index (PMI), which dropped for the second consecutive month in March, to 48.7, lower than the 49.6 that economists had forecast. A level below 50 indicates a contraction.

Stefan Angele, head of investment management at Swiss & Global Asset Management, says: “The fall appears to have been broad-based across the region. France and even Germany – the stabilising forces in the European Union (EU) – disappointed with a manufacturing PMI of 48.1.

“Austerity measures do not come without costs. The economic contraction in Europe is putting pressure on politicians to implement structural reform measures and will accelerate economic divergence. As France and Germany have also started to weaken, the market will question global growth expectations.”

Financial news in the monetary bloc also remains bleak. In February, Moody’s downgraded the credit rating of six eurozone sovereigns, including Italy, Portugal and Spain.

Azad Zangana, European economist at Schroders, explains: “Many will remember that European leaders decided not to increase the actual amount of money in the European Financial Stability Facility back in October, but instead opted to try to leverage up the funds that had remained. Since then, the plan has fallen flat as outsiders, like China, have declined to pay into the fund, while the scheme that was designed to insure against losses was deemed unattractive.”

Problems with Portugal

Following the recent massive restructuring of Greek debt, commentators are wondering whether Portugal in particular might be next.

Neil Dwane, chief investment officer for Europe at Allianz Global Investors, observes: “Clearly what we have seen, particularly dramatically, is that the market has decided that Portugal, too, is bust. Portugal will become a clear issue. [At the start of the year] they had only just started to implement their austerity measures and the structural difficulties are becoming very clear.

“The nuisance for Portugal is that unfortunately, unlike Greece, all their debt is under English international law. This means that the Portuguese government cannot change the rules as the Greek government can through a bill in parliament. The Portuguese will have to negotiate international law, which gives them absolutely no preferential treatment. This could potentially be the reason why the ECB [European Central Bank] stopped buying Portuguese debt [in February], because if there is a restructuring everybody will take a haircut, not just the people who the ECB and the EU say will take a haircut.”

In spite of being known for its financial troubles in the past decade, Ireland’s ability to begin reducing its deficit and restore growth has enabled it to distinguish itself economically from European countries with more troubled economies, such as Portugal and Greece.

According to Desmond Mac Intyre, chairman and chief executive of Standish Mellon Asset Management, Ireland’s government budget deficit, which was below 10 per cent of GDP in 2011, and the estimated expansion of its economy by 0.9 per cent in 2011 – the first growth since 2007 – are all reasons for optimism.

He says: “We expect this growth to continue, with medium to high expectations ranging from between negative 0.1 per cent to positive 1.0 per cent. While the country is clearly not yet firing on all cylinders, there is likely to be growth.”

Other positive signs include exports rising above previous peaks, a savings rate of approximately 8 per cent, and the success by government and business leaders in encouraging foreign investment.

While Mr Mac Intyre admits unemployment is too high and further reductions are necessary in the budget deficit, he remains optimistic that Ireland will overcome these challenges.

“It is our view that the Irish economy has the ability to grow out of recession.”

Undervalued equities

In spite of the fear surrounding the eurozone, Andrew Goodwin, investment manager of the SVG European Focus fund, argues that the crisis is now past its nadir following ECB intervention. In his view it is unlikely the eurozone will break up – political will is strong and this will aid its survival.

“Never has the argument for European equities looked so compelling,” he says. “Negative market sentiment surrounding the eurozone has created an attractive entry point for European equity investors, and there is currently ample opportunity for stock-pickers to acquire quality companies at significant discounts.”

According to Mr Goodwin, European equities are attractively valued, trading at multiples of their earnings that mirror the lows of the early 1980s. Yields on European equities are also offering the best of any asset class.

He adds: “While many investors remain defensive, investing in pharmaceuticals and food, looking through the market volatility and panic we see significant opportunities to invest in financials and peripheral Europe.

“Staying in defensive sectors is a missed opportunity, as we believe many financial and peripheral European stocks will re-rate aggressively. We have identified a number of companies across Portugal, Ireland, Italy, Greece and Spain with defensive cash flows, solid balance sheets and coveted market positions, and we remain bullish on European banks.”

The manager argues that the opportunity in European financials can be compared to the Asian financial crisis.

“Much the same as when banks traded on distressed valuations in Japan, they are now doing the same in Europe. While benchmark investors shunned Japanese banks, those who didn’t came out on top with four to five times returns. We believe the same opportunities exist in Europe.”

Jenny Lowe is features editor at Investment Adviser

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