Buyside sees Cyprus risks, but contagion unlikely

Asian investors dismiss the prospect of a eurozone spillover from the Cyprus bailout, but see penalising depositors as a dangerous precedent that could spark bank runs in the bloc.
Buyside sees Cyprus risks, but contagion unlikely

Asia’s buy-side has largely dismissed the prospect of eurozone contagion from Cyprus' fraught €10 billion ($13 billion) bailout, seeing a concerted global retreat from risk assets as highly unlikely and any sell-off as short-lived.

In fact, they believe the worst may be over already after early signs of an institutional retreat to safety (out of the euro, into gold and the dollar), and view the potential impact on global fund flows as limited.

After being quizzed by AsianInvestor on the risks of plunging the integrated bloc, and global markets, back into turmoil, generally they agree that Cyprus is an isolated case too small to contaminate the broader banking system. The fact is, developments in Italy are seen as far more significant – a point made by Western Asset Management.

However, investors acknowledge the dangerous precedent policymakers set by asking depositors to take a haircut on cash deposits, and see the biggest risk as a loss of confidence leading to runs on weaker banks elsewhere in Europe (particularly Spain and Italy).

Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management, says: “We doubt [Cyprus] will cause an immediate wholesale return to a risk-off environment. But these things have a habit of feeding on themselves, and the lack of concern by EU authorities on protecting the insured deposits of EU citizens has opened Pandora’s box, so to speak.”

He notes the risk that savers in southern Europe may start to fear for their own bank deposits. “If [bank runs] occurred it could culminate in further dislocation in eurozone money markets. EU policymakers need to emphasise how secure savers’ money is.”

Shane Oliver, chief economist and head of investment strategy at AMP Capital, says Cypriot governors made a huge miscalculation by drawing small depositors into the bailout. It comes as the Cypriot parliament rejected the bailout plan yesterday, so the government now has 24 hours to solve its funding gap before domestic banks reopen tomorrow.

Saying Cyprus was caught between a rock (eurozone policymakers) and a hard place (Russian depositors), he adds: “They need to remember the government will only remain in place if the polulace is happy.”

But he says the muted response to initial news of this crisis and to the stalemate in the recent Italian elections – underpinned by the determination of policymakers to keep the eurozone together at all costs – points to investor intransigence.

“The tendency of markets to overreact is becoming less,” he observes. “At the start of the eurozone crisis [2010] there were a lot of unknowns and no bailout fund. It was unclear what the central bank would do or what the cross-country exposures were.

“Now there is a lot more certainty, people know the size of the problem. It’s hard to see another slump [in markets] like the ones we've been used to. What we saw [on Monday] could well be it.”

Turner describes investors’ response to Cyprus as pragmatic, with European bank shares having only sold off by around 2% on Monday. However, he says the situation has brought the focus back to Europe and how politicians intend to move forward. “Markets having been supported by central banks were always vulnerable to policy moves (mistakes) by politicians,” he notes.

John Vail, head of global investment strategy for Nikko Asset Management, describes Cyprus as “a miniscule exception” to the eurozone project due to Russian involvement in its banking system. He points to stabilisation in the eurozone economy, supported by a huge increase in trade and current account surpluses, coupled with sturdy German demand.

On the question of global fund flows, he sees any initial reaction as knee-jerk and sees very little end-effect on flows ahead. “So many people globally seem to be waiting to buy on dips,” he adds.

Marie Lim, head of central dealing for UOB Asset Management in Singapore, says the trading signals appear mixed, and making a decision on when to cut or put on a position is not easy.

"It's still too early to tell, most Asian markets have been performing well, and a turnaround like [Monday] appeared to be a buying opportunity for many investors. We still have to wait and see, we're not out of the euro crisis yet."

Mark Konyn, CEO of Cathay Conning Asset Management, points out that flows to Asia have been trending down in recent weeks despite strong expectations that risk appetite is returning slowly.

He suggests confidence in equity markets will continue to build slowly and sees the great rotation (out of fixed income into equities) as unlikely. “The market rally has been fading of late and investors have been looking for a reason to pause,” he says.

Gary Dugan, Asia chief investment officer at Coutts, agrees, saying the Cyprus crisis gave investors an excuse to take profits on what had been a very strong run-up in risk assets such as equities in recent weeks. "However, within hours of a modest market correction the buyers were back, suggesting that the underlying trend remains a positive one for equity markets," he notes.

He says any escalation in the crisis would likely see international investors take profits, particularly on some Southeast Asian markets that have performed well over the past 18 months.

Andrew Cormack, London-based portfolio manager for Western Asset Management, said the firm was inclined to fade the initial “risk-off” move in core bunds by selling German duration in portfolios “as we expect the Italian risk premium that has been built into core yields to abate somewhat over the coming weeks”.

He retains the view that the ECB is committed to maintaining price stability and containing further volatility within the monetary union via outright monetary transactions.

“We expect volatility in the short term because the probability that the initial Cypriot vote is rejected is not negligible,” says Cormack. “We may see short-term spreads widening.”

If the situation deteriorates and there is a capital flight away from the periphery, this will push spreads wider, although all the flows since ECB president Mario Draghi told the market he would "do whatever it takes" have been constructive into periphery bonds, Cormack notes.

Dugan is most pessimistic of all: "The worry is the eurozone governments believe that raiding the deposit holders is seen as a legitimate way of resolving the situation. We doubt that the Cyprus crisis will derail the eurozone, but it is probably another staging post in its ultimate demise.”

He argues that investors will rightly be perturbed by events in Cyprus and are likely at the very least to become more anti-eurozone in their asset allocation. “Bond spreads will rise modestly and equities may remain cheap relative to their long-term valuations,” he tells AsianInvestor.

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