What has been billed as the week to save the euro has already seen its share of highs and lows, from historic concessions struck between the leaders of Germany and France to rating agency Standard & Poor’s placing 15 eurozone members on negative credit watch.
In the build-up to the critical European Union summit tomorrow and Friday, AsianInvestor will publish a series of interviews with a cross-section of Asia’s asset management community on issues such as what constitutes a safe haven, likely crisis scenarios and the mechanics of a worst-case outcome.
We also take into account the opinions and forecasts of Dr Iwan Azis, head of the office of regional economic integration at the Asian Development Bank (ADB), who gave a presentation on the spillover effects of the crisis yesterday at the Foreign Correspondents Club in Hong Kong.
It appears that ground gained by positive pronouncements from German chancellor Angela Merkel and French president Nicolas Sarkozy was quickly lost by S&P’s move, with stock markets in Asia (and Europe at the time of writing) largely down across the board.
The rating agency put forward five factors that it argued affect the creditworthiness of all eurozone members: tightening credit conditions; higher premiums to invest in sovereign issuers; prolonged policymaking dispute; high indebtedness; and weakening growth prospects for 2012.
Certainly, weak demand for Berlin’s recent bond auction offered compelling evidence that investors are worried about contagion to core economies as well.
On the question of what constitutes a safe haven, Jim Cielinski, head of fixed income at Threadneedle, notes that core government bonds can hardly be seen as a source of attractive real income, given that yields are well below the rate of inflation in the US, UK and Germany.
He says what many investors have identified as “low risk” investments may merely turn out to be an efficient way of locking in negative real total returns. They are guilty of mistaking low volatility for low risk, he suggests.
Threadneedle has accepted it is no longer safe to assume there will always be demand for some countries’ bonds, and Cielinski suggests the next decade is likely to see the list of bond market pariahs lengthen unless policymakers step up their game.
But David Tan, fund manager for JP Morgan Global Bond Currency Fund and JP Morgan Global Government Bond (USD hedged) Fund, says his house is overweight core and benchmark neutral peripherals with the exception of Greece, where it has no exposure.
He remains unconcerned about the prospect of bunds trading like a credit, and names US Treasuries, UK gilts, bunds, and Canada and Australia as havens.
Germany also gets the vote of Arne Lindman, Asia-Pacific CEO of Fidelity Worldwide Investment, with the caveat that all debt, including AAA, will be in line for a ratings review.
Lindman reflects that uncertainty over safe-haven status has seen investors of all types return to the basics of investment – time in the market, and diversification – and argues that the imperative to consider the income-generating aspects of equities has never been greater.
He concedes that emerging markets will not be immune from eurozone-inspired volatility, but reckons their attractions will only become conspicuous in the final stage of the debt crisis.
He prefers to point to inflation as a significant tail-risk, given the likely outcomes of European quantitative easing and an increase in the money supply. “Right now inflation is being discounted in the bond market as inflationary expectations are still nascent,” he states.
Cielinski goes further, saying the likelihood of government bonds producing negative returns will be magnified if quantitative easing works and inflation takes hold.
“Inflation can quickly become a problem, especially in an era when the risk of policy error is high. Inflation scares may become a regular feature as the cycle matures in coming years. Should inflationary fears escalate, it will be an easy leap to higher yields, rising default risk and a buyers’ strike.”
But Tan believes now is not the time to worry about future inflation and is confident that the eurozone will move towards greater fiscal union, even though it could take years. He feels sure that European central banks will provide unlimited liquidity in a worst-case scenario.
“Central banks are aware of the big systemic institutions and will be prepared to save them or nationalise them,” he says in answer to a question on the implications of a messy break-up of the eurozone.
But Lindman suspects in this case the contagion would spread to the UK, US and beyond. “Funding conditions would weaken, the capacity of the ECB [European Central Bank] to purchase bonds quickly becomes exhausted, and the subsequent reduction in liquidity raises the prospect of a funding crisis in the global banking sector, which would lead to weaker economic conditions everywhere.”
The ADB has forecast a base case that the growth rate for emerging East Asia (Asean plus China, Korea, Hong Kong and Taiwan) will moderate from 7.5% in 2011 to 7.2% in 2012.
But Azis notes that while exposures of emerging East Asia to Portugal, Ireland, Italy, Greece and Spain (Piigs) are limited, a key consideration is that what is happening in Piigs will eventually affect core European countries, on which Asia relies in terms of demand for exports.
He points out that the spread on sovereign bond yields in emerging East Asia remained stable even after Greece was downgraded in June 2010. That was until September this year, when charts show evidence of a convergence. “The message is that no one will be spared what has happened in Europe, even East Asia,” he warns.
He was more positive when considering who will fill the funding gap in Asia as European banks pull back to meet 9% core tier-1 capital adequacy ratio requirements back home.
“If the banking sector is less willing to get involved in trade financing, then it may affect the export performance of some countries [in Asia],” he says. “But the good news is that many banks in Asia have ample liquidity, so the question is whether they are willing and able to take over the role of the European banks in terms of trade financing.”
On the question of which asset classes investors will turn to as they search for income without exposing themselves to excess risk, Cielinski says high-yield and emerging market bonds arguably offer greater transparency and a better risk/reward trade-off than government bonds.
He also expects shares in large-cap, high-yielding companies with strong balance sheets, robust cashflow generation and proven capital allocation strategies will be in demand. “Mirroring the multi-asset approach for total returns, investors will look for flexible products combining all of these sources of income,” Cielinski says.
He believes there are two possible end-games for the eurozone crisis, each carrying very different implications for markets. One is that the ECB stands firm in its view that quantitative easing is unacceptable.
The result of this, he notes, would be further contagion towards core European bond markets, a deep depression in the eurozone and probable departures from the euro as the region addresses its structural imbalances. “This would be a very difficult environment for risk assets.”
The other sees the ECB bowing to global pressure and beginning to print money, allowing it to guarantee all the bonds from troubled issuers. “This would lead to a much shallower downturn in the European economy and would also prompt a significant rally in risk assets,” says Cielinski. “At present, markets appear to be ascribing equal probability to these two outcomes.”
Lindman adopts a cautious stance on the understanding that the ECB’s delaying tactic to allow peripheral countries to make internal adjustments is becoming more difficult to persist with.
“Investors must give some weight to the possibility of a eurozone break-up as markets, and peripheral governments themselves, come to understand that the global funding situation, the weight of sovereign debts and economic contraction are working against them.”
Asked what these scenarios imply for Asian debt, both in US dollars and local currency, Cielinski points out that most Asian countries have built cushions against external shocks, while Asian policymakers have more room to ease fiscal and monetary policies than Western peers.
Still, given the lack of visibility over future developments in the eurozone crisis, Threadneedle remains cautious on currencies, favouring external debt which looks cheap. “However, we will like to have exposure to selected local rates markets, but hedge the currency exposure,” he notes.
Lindman acknowledges that while growth in emerging markets will be slower, it will be vastly in excess of the developed world. Lower growth, he points out, is a partial solution to inflationary pressures, allowing for more accommodative monetary policy in emerging markets. “However, when looking at scenarios like this, a black swan event could easily change this.”
He agrees that institutional investors are as perplexed as everyone else about the best route forward, with some taking this opportunity to increase their equity holdings.