The EU Quandary and Investor Confidence
Market Commentary from CBIS Chief Investment Officer Frank Haines
Unfortunately, what the authorities in Europe can’t artificially support is investor trust and confidence, and events in the Eurozone during the first half of 2012 will sorely test those traits. By the end of March, in order for Greece to secure its next round of financing from the EU/IMF to pay off maturing debt of €15B, it must reach agreement with private investors on a discount in the value of existing debt (€200 B) by 50 percent or more. Discussions were supposed to be concluded in mid-January, but continue to drag on. Meanwhile the debt maturity in March approaches; either Greece receives its next bailout installment, or it defaults. There are related issues of whether or not credit default swaps are triggered, which may result in significant losses at counterparties (EU banks appear to be large sellers of CDS insurance).
By the end of March, the third rating agency – Moodys – will determine its downgrades of EU sovereign debt, following the previous actions of Fitch and S&P in January. While these may parallel the earlier downgrades, most significantly of France and the European Financial Stability Facility to AA, there is always the possibility of a negative surprise. As significant as the sovereign downgrades are, the potential downgrades to EU bank debt are equally troubling. The banks have become a leveraged option on sovereign debt by borrowing from the long-term refinancing operation (LTRO) and buying sovereign debt for the carry.
Finally, the first half of 2012 will see substantially larger auctions of government debt than in 2011, a test of investors’ willingness to purchase what is no longer “risk-free” issuance. There were some missteps during November of 2011, when even Germany, the strongest of the EU nations, couldn’t auction one third of a new issue of ten year securities. The ECB’s LTRO seemed to assuage sovereign debt investors over year-end, and subsequent auctions have proceeded at lower yield levels for a number of countries (with the exception of Portugal). It is estimated that €330B of sovereign debt must be refinanced in 2012, in addition to €600B of unsecured debt maturing for EU banks. Sovereign nations, as well as the banks, are scheduled to raise the majority of their financing needs within the first half of the year. Every one of those auctions will be a test of investor willingness to keep the Eurozone afloat.
Thus, by the end of June 2012, we expect greater clarity on Greece’s situation – whether exit from the Eurozone and Euro, or more time on life support. We will also know if the supply of new issuance will continue to be supported by institutional investors, as credit quality of EU debt further erodes. It is probable that European authorities will continue to muddle through. However, they must rely on the private markets to support their efforts. It is a test of the trust and confidence of investors, and with every passing month it is becoming clearer to many that the EU situation is untenable and insoluble under the existing EU framework. The likely events to which the markets will react are a bankruptcy/run on a major EU bank, or a failed sovereign debt auction prompting a substantial increase in yield. EU banks are under pressure due to their heavy sovereign debt holdings, and inability to access liquidity outside of the LTRO. As was recognized in November of 2011, once a sovereign’s interest rate reaches 7% or more, the likelihood of being able to support its debt load through the capital markets becomes remote.
Liquidity cannot solve what is essentially a solvency problem for a number of EU nations, and neither projected future economic growth nor strict austerity can meaningfully reduce the risk to debt holders of loss or default. It has become evident over recent months that governments such as Greece and Spain cannot even sell off public assets to raise capital, as investors are too worried about Euro currency risk, regulatory hurdles are often onerous and the governments won’t accept steep discounts. While the probability of default by Greece, or failure of a debt auction and resultant sharp yield increase is low, the effects would be severe. Equities worldwide would fall sharply, and high quality, long-dated bonds would rally further. Market response during 2011 demonstrated this as the EU situation worsened from May through September.
The EU situation remains quite complex, and unprecedented during our investing lifetimes. But certain investment fundamentals remain timeless.
CBIS expects that there will be far greater clarity on the resolution of the EU sovereign debt situation by mid-year 2012, particularly in regard to the Greek situation. That does not imply that Europe will be close to resolving its financial problems, but at least investors may have a better sense of where they stand. We will periodically keep our participants updated on this situation.
Please contact your CBIS Investment Adviser if you would like to discuss these issues in more detail.