European politicians’ game of chicken has put the world at incredible risk. But investors that flee risk assets completely could be the biggest losers, warn portfolio managers in the US.
On the one hand, “The return of capital is more important than the return on capital,” says Jeffrey Schoenfeld, CIO at Brown Brothers Harriman in New York. He says many clients, including central banks, have been tightening investment guidelines to avoid credit risk, even via counterparties.
But he says that long-term investors face relatively low risks in many high-investment grade corporate bonds. “There are companies we favour that are high-quality, global companies whose debt is trading at 70 cents to the dollar,” he says.
He also advocates large-cap equities. “A lot of the gloom is already priced in.” Acknowledging that equity markets could yet suffer a nosedive if the European leadership fails to save the euro in the coming few weeks, Schoenfeld says, “There are great opportunities in equities over a three-to-five year period.”
Robert Tipp, chief investment strategist at Prudential Financial in Newark, New Jersey, says, “It’s important to take a long-run, balanced approach.” He notes that in the current environment, investors naturally rush to the safety of Treasury bonds and bills.
“But investors are losing yield in these instruments,” he argues. “There is an opportunity now in higher-growth markets, especially for investors whose natural exposure is to Asian debt, either in local currency or in hard currency.”
He adds that it is too late for investors to decide to try and short Treasuries or other ‘safe haven’ instruments now. Rather this is the time to enter well-researched opportunities in spread products and high-growth emerging-market currency exposures, he says.
The headlines are gripped with euro crisis fever. Most portfolio managers still expect Europe to get its act together and save the currency union. However, the danger of a political failure is rising in line with the game of chicken between German politics and market pressure.
European leaders have already fluffed previous chances to get ahead of the crisis. The European Financial Stability Fund could have been empowered with enough firepower to bail out funds, but it has been too small and has been further undermined by German court rulings that effectively tied its hands.
Other efforts to provide a joint and several pan-European guarantee for sovereign debt also came to naught. The way both sovereigns and pan-European institutions (such as the European Investment Bank) are trading suggests they have lost market confidence, say fund managers.
Behind these failures is a political drive in Germany and other creditor nations to push periphery governments as hard as possible on austerity measures, while doing the minimum to stave off market responses.
“Either the Germans are pushing others to the edge in order to extract structural reforms – or they’re mad,” quips Douglas Peebles, fixed-income CIO at AllianceBernstein in New York. “When you push the edge, you risk falling off.”
The last chance is for the European Central Bank to undertake a massive, unlimited buying programme of sovereign debt and perhaps of financial institutions.
As borrowing costs for countries such as Italy have soared from 3-4% to 8% in the past few weeks, it won’t take much more to get those borrowing costs up to 12%, should the December 8 summit of European leaders fail to come up with a credible plan.
Countries can afford such high interest rates, at least for a while, but banks cannot. Market pressures risk impairing many European banks, meaning they must reserve against capital charges, forcing them to raise more capital and shrink their balance sheets.
It is these very banks that are the main buyers of sovereign debt issues. So rising interest rates undermine European banks, in turn removing demand for European sovereign borrowing, creating a vicious circle. Only the ECB has the potential to break it.
Fund managers believe that if such support is not forthcoming (which means, in simple terms, getting German politicians behind it), the collapse of the European banking system will not only send Europe into a deep recession, but undermine America’s economic recovery and suck liquidity out of many emerging markets.
European banks are major lenders to Asian companies and Asian capital markets are not sufficiently developed to substitute for that lending activity.
Nor is there much faith in a ‘managed’ or ‘orderly’ exit of Greece or a handful of countries from the euro. It’s all or none, say fund managers, as depositors in other countries see the damage caused in Greece and also spark a run on banks. The contagion effect is too great to be stopped once it is sparked.
That’s the nightmare scenario keeping investors on the sidelines. But there is an optimistic scenario too, albeit one that requires a decade or more to realise. European governments are feeling their way to a solution of deeper integration, strict rules around debt-to-GDP levels, meaningful enforcement mechanisms and some form of European treasury.
“It seems like a leap of faith right now,” says Tipp, “but in 10 or 20 years, you could see a currency union that is in much stronger fiscal shape than the US.”
And in the short run? “Bunds are priced more attractively than Treasuries on a relative-value basis,” Tipp says. “Spreads are very wide and will compensate investors over the long run. If you are underweight the indices today, you will struggle to keep up in the future, because you will build in a huge yield gap in the portfolio versus market benchmarks.”