Eurozone splits opinion; Asia in firing line

Views are divided on whether Greece will exit the euro and the bloc will implode. Asia may be better placed than in 2008, but recovery would take longer.
Eurozone splits opinion; Asia in firing line

In the run-up to the potentially pivotal Greek election this Sunday, market opinions remain radically divided over whether the nation that brought democracy to the world will exit the euro.

The opinions stretch from Schroders, which expects an exit and is already debating drachma depreciation, to Bank Sarasin CIO Burkhard Varnholt, who sees such an eventuality as “extremely unlikely”.

Mostly investors are expected to keep to the sidelines, awaiting clarity and fearful of the consequences a eurozone break-up might bring. Even so, Marc Battallion of Lombard Odier Investment Management sees such inaction as “a massive mistake”.

In sanguine Swiss fashion, Varnholt warns that a Greek exit would lead to a vicious spiral and the greatest calamity – economically, politically and socially – in post-war history.

“It would be impossible to see one country exit without preventing others from suffering severe contagion and ultimately a full implosion,” he told a media briefing in Hong Kong last week. “It is important to understand that the idea of a clean break-up is a myth. It is fanciful thinking.”

He believes the eurozone will remain intact, having spoken to Syriza party leader Alex Tsiparas on a trip to Athens late last month. “He has every intention to keep Greece in the European Union and the eurozone,” Varnholt assures.

The CIO sees the eurozone problem as one of political fragmentation rather than debt, while the eurozone’s primary account deficit is not high and it is a net exporter.

But with an added sense of urgency to act ahead of Europe’s August holiday month, he says politicians will do the right thing. Varhnolt is expecting the introduction of a pan-European bank deposit to prevent further bank runs, which he says could accelerate unless Europe acts firmly.

“It’s not rocket science," he says. "All you need is balanced budget amendments [that perhaps don’t kick in until 2015] enshrined in the constitutions of all eurozone countries and a commitment towards mutualising national debt.”

Steve Walsh, CIO for Western Asset Management, similarly sees only two possible outcomes: eurozone breakup or fiscal union. His base case is for politicians to muddle through and he suggests the European Financial Stability Facility (EFSF) could be used to recapitalise banks.

But Varnholt dismisses this, comparing the EFSF as a solution to eurozone insolvency with two Friday night drunkards leaning against one another. “It can only be provided by a courageous step forward by all eurozone governments who put it up jointly to mutually guarantee bank deposits,” he says. “The power of such a guarantee is it will not have to be used.”

Western Asset's response to the crisis has been to reduce credit risk each time the market has turned more optimistic on the eurozone (in the spring of 2011 and in March this year). It expects to maintain overweight positions in countries with strong fundamentals – Singapore, the Philippines, Malaysia and South Korea – while adjusting interest-rate exposure selectively.

But Schroders is in no doubt that Greece will exit the euro, and expects the new drachma to depreciate between 30-70%, with the possibility of a euro peg being introduced. It says Greece may need to impose capital controls to stem the flow of money leaving the country, which would then force its exit from the union given this is against EU rules.

But the UK fund house does not expect other countries to follow Greece to the exit, although it does raise the issue of donor fatigue and says a complete break-up cannot be discounted.

On the question of whether investors should seek to capitalise on cheap European equities, Schroders notes that equities in the euro have lagged their neighbours over the past decade. It warns that a break-up has not been fully priced in, and the level at which this reversal in valuations takes place is likely below current prices, both in absolute and relative terms.

Threadneedle also sees Greece as increasingly likely to leave the euro, but says this is not a bad environment to pick stocks. Its equity portfolios are focused on defensive global growth stocks (exporters) and it is underweight value traps such as utilities and telecoms, and also financials.

As head of European equity long-only and long-short at Lombard Odier IM, Battallion sees European dislocation as the perfect environment to make money. “The crisis has created huge clarity for us,” he tells AsianInvestor.

He argues that every European country must go through austerity, meaning sales will decline for firms exposed to western Europe. “The direction of equity markets is clear over a multi-year period,” he says. “I think we will have some of the best years we have ever had because of these problems.”

Based in London, he and his three-strong team manage $330 million on the long-short side and $310 million on the long side. About 75% of its clients are high-net-worth individuals, with the remainder institutions. At least 80% of its investors are European, although it is targeting Asia increasingly.

Battallion does not really care if Greece exits, given that he is already hedged and is directionally short. As a rule he and his team do not invest in banks, insurance firms, oil and metals. Nor do they try to fathom human pharmaceuticals, gas and electrical utilities.

It maintains around 60-80 positions – evenly split between long-short and long-only – in a universe of 350 stocks, with a target annualised net return of 7-8% at today’s prices.

Rating agency S&P says there is now a one-in-three chance Greece could leave the eurozone. But it argues that an exit would likely strengthen the resolve of other countries to pursue reforms and avoid such economic consequences.

Rival agency Moody’s notes that if Greece exits, the chances are it will be disorderly and the financial ructions will spread globally. Asian financial markets would take a hit, with a knock-on effect for domestic demand, and portfolio flows into the region would likely slow and possibly reverse. Foreign investment into the region would also fall as firms pulled back on expansion.

It notes that Asia is better positioned than during the global recession in 2008-09 so the downturn should not be as severe, but adds that Asian manufacturers will likely have a longer road back to recovery, given the fiscal and monetary constraints that most Asian governments now face.

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