A business trip to the United Kingdom to see fund managers is asking for trouble these days.
“You should just get back on an aeroplane and go home to Hong Kong,” said one CIO, whose advice was based on the direness of the West’s economic problems.
Although there are plenty of things to concern investors these days, from America’s dysfunctional politics to emerging-market inflation, the biggest concern is the euro – perhaps no surprise for fund managers located just next door to the eurozone.
Other problems in the world are manageable, even if the underlying choices are difficult. The euro’s crisis, on the other hand, is not only nearing a critical point – meaning a default by Greece and the possibility of ending monetary union – but almost entirely unmanageable, in the sense that Europeans are damned if they do, and damned if they don’t.
Somehow they have to decide which particular depth of hell they would rather avoid, and their choices are going to affect the entire world.
Although ‘muddling through’ has been the preferred European tactic, almost no one believes this is viable. As is well known now, the eurozone has to choose between dissolution and fiscal and financial integration, the latter involving bailouts from Germany and other, sound northern members, which in turn would get to impose their will upon their neighbours in the south and periphery.
“It’s hard to manage assets in the world now because we face several binary outcomes,” says Alan Brown, CIO at Schroder Investment Managers in London. “We don’t face a neat distribution of outcomes, so our risk models can’t help. It’s a judgment call.”
While there are several such binary events on the horizon (including a ‘double-dip’ recession in the West and, less plausibly but as damaging, rebellion in Saudi Arabia) it’s the euro’s fate that is the most immediate and the least tractable. Fund managers have to make the call: will Greece default, and will that lead to the break-up of the euro?
The question of a default doesn’t need much explaining: the market expects this, pace Angela Merkel. Greece’s total debt stands at €328 billion, or 143% of its GDP. Without depreciation of its currency, Greece is insolvent as well as unable to become competitive, and the social and economic costs of the austerity required to pay its debts are too high.
This belies the underlying strength of the eurozone taken as a whole. On a consolidated level, Europe is fiscally strong and its aggregate debt-to-GDP level is moderate.
“Once you leap across the divide, you’re in a comfortable place,” says Mark Burgess, CIO at Threadneedle. “But how do you get there? How do you get a German taxpayer to underwrite it?”
He argues that a Greek default must take place, probably resulting in a depression there and in other periphery countries. He believes that if Greece alone exited from the euro, the inevitable run on its banks, bankruptcy of its companies with outstanding foreign debts, and damage to other European and American bank exposures to Greece would be manageable.
But not if there were contagion – and it’s hard to imagine that, once the taboo of expelling a member of the euro (and, legally, the European Union), the market would remain passive with regard to other countries with big debts, particularly Italy, with €1.8 trillion of outstanding bonds, or 119% of its GDP. A Spanish and Italian crisis would effectively end the euro and quite possibly the EU.
“German voters must save the euro or its banks will all go bust,” Burgess says.
Paul Brain, fixed-income head at Newton Investment Management, says the market would like to see a Eurobond, but German and French leaders have already ruled that out, at least for the time being. It would require treaty changes that their voters are not likely to support.
Finance ministers this summer approved an upgrade of the European Financial Stability Facility, a support mechanism operated by the European Central Bank set up in 2010 as a stop-gap for crisis countries. But adding firepower to the €440 billion rescue fund requires all 27 member parliaments to ratify a treaty change – and so far none has done so.
“Temporary measures by the ECB to buy Italian and Spanish bonds can’t last,” Brain says. “The EFSF can buy bonds, but the fund isn’t big enough; austerity measures aren’t being properly implemented; budget deficits aren’t improving.”
This reality has some fund managers expecting the euro to unravel. “Europe can’t manage fiscal and political union, so the eurozone will change,” says Schroders’ Brown, who notes that since World War II, the world has seen 69 other currency unions come and go.
He also believes that it’s best to end the charade now. Otherwise the status quo means the imbalances and debts will only grow, without resolving the problem of peripheral lack of competitiveness. The exposure to the financial system would be overwhelming.
Another fund executive, who asked to remain anonymous, says her business is preparing for “when Europe becomes a multi-currency area again”.
She says it will be Germany that quits, not Greece: “There will be a tipping point when a German politician wins an election based on a platform of leaving the euro.”
There are, believe it or not, some investment chiefs who think the euro will survive. Robert Parker, senior adviser at Credit Suisse, says the ECB and other European institutions took credible action in the dog days of August to ensure against a meltdown. He also believes recession fears are as overblown today as rosy forecasts in the spring were over-optimistic.
He notes that Italy’s primary budget is in surplus and, unlike Greece, it can put its total budget (including interest payments) into balance over the course of a few years.
Greece is a different story, and Parker estimates the market is discounting a 50% write-off of those assets, but is more upbeat about the banking system’s ability to manage this. Banks have learned a lot of lessons from Lehman Brothers’ collapse in 2008, and they have been busy deleveraging and de-risking.
Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management, says he expects the euro to survive. He, too, says summer fears over the euro have been too extreme, and notes the dedication of both the ECB and the US Federal Reserve to keep banks funded and offer nearly unlimited liquidity through their repo windows.
He does note the importance of governments ratifying the EFSF changes, which would see it become a bigger, more powerful buyer of bonds in place of the ECB. It may take a decade to work out the debts, but he believes bank risks can be contained.
Ian Kelson, head of global fixed income at T. Rowe Price International, says there are also ways around the legal challenges to a Eurobond. For example, the eurozone could issue project bonds, say to finance infrastructure. “It’s a piecemeal solution, but it avoids some of the legal problems,” Kelson says. “We’re still assuming the euro is going to make it.”
Those betting on the euro are also encouraged by (non-member) Iceland and (euro member) Ireland. Both countries have combined austerity, bank recapitalisations and other fiscal steps. Iceland was able to depreciate its currency, while Ireland used its low tax base, educated workforce and big US corporate presence to resume growth. Investors are just beginning to return to the shorter ends of their yield curves. There may be hope for the likes of Portugal (maybe), Spain and Italy (probably).
So which is right: the euro’s demise or Europe steps up and saves its currency?
My own view is that the euro can survive. The European Union has always been a political project achieved through economic means, not the other way around. In better times, the elites would be able to ensure solidarity to keep the EU on track. Today’s leaders, especially Germany’s chancellor, have failed to prepare their voters for the sacrifices at hand, or to educate them on the consequences of inaction. This stems from decades of technocrats going over the heads of electorates to create an integrated Europe; it’s a habit that has run its course.
Right now it is hard to imagine voters in Germany, Finland, Austria or other members of ‘strong Europe’ to accede to taxes to save the profligate Greeks. But that is what must happen.
The alternative is dire: recession or quite possibly a depression; the collapse of the banking systems of Germany and France, with serious damage to American and British banks; the loss of competitiveness of German exporters; the threat of a systematically important bank’s exposure to credit-default swap contracts; the possibility that the entire legal framework of the European Union would unravel and the destruction of both German and French geopolitical strategy.
In this light, the political costs of saving the euro are less, even if too few people in Europe appreciate this. Perhaps Europe isn’t ready to issue a Eurobond, but makeshift workarounds and a beefed up EFSF can buy the necessary time.
The hard work of constant rescues, arm-twisting of Greeks, treaty changes and bickering among both debtors and creditors is likely to go on for years. It’s a wearying prospect, and one reason why global investing is likely to remain fraught for quite a while. But my judgment call is: Greek default within the euro, and ultimately the trumping of the European project. The alternative is so frightening that I doubt real-money investors could ever hedge against it.