- Scammell - Zangana

12 July 2011 – SH : European crisis deepens

– As concerns spread to Spain and Italy, and EU leaders debate how to deal with Greece, investors lose patience.
– Our central view is that the crisis is ultimately resolved – provided there is political commitment, growth, and investor confidence.
– We would argue that recent developments have been uncomfortable for Spanish markets but the situation is retrievable.
– In the short-term, though, expect volatility given investors’ current doubts. The crisis in the Eurozone is deepening by the day as concerns spread beyond Greece, Ireland and Portugal, and into Spain and, more worryingly, Italy. The latest sharp rise in peripheral bond spreads is occurring while European finance ministers have been meeting to discuss the next move for Greece

Azad Zangana – David Scammell

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    EU leaders managed to buy more time last month by placing pressure on the IMF to release the fifth tranche of funds to Greece, but only following a dramatic vote of confidence for the Greek government, and a close vote on a new tougher budget. Given that the IMF is still demanding a more long-term solution for Greece, EU leaders have another two to three months before Greece runs out of money again. And here lays the problem. EU leaders believe that their next deadline is two to three months away, and that they can spend the summer debating the merits of extending debt maturities for Greece, or imposin haircuts. The reality is that investors are quickly losing patience with the lack of clarity and leadership in dealing with this crisis.

    For some time now we have warned that should Spain come under pressure and is forced to follow Portugal, Ireland and Greece in seeking a bail out, then Italy, and potentially Belgium, would also be seen as targets by bond vigilantes. The European Commission forecasts Italian public debt as a share of GDP to hit 120% by the end of this year, while Belgian public debt is expected to reach 100% of GDP. These large outstanding stocks of debt make both Italy and Belgium more vulnerable to a sustained rise in the cost of borrowing, even if they are keeping current borrowing low.

    In our view, the cost of bailing out all the above-mentioned countries could exceed €3 trillion, which could prove to be the straw that breaks the camel’s back. However, this is not our central view as outlined in more detail below. Nevertheless, this is a very real threat to the current make-up of the currency union, which should serve as a powerful motivator for European politicians to make some progress on not only Greece, but the future direction of Europe.

    David Scammell, Head of European and UK Interest Rate Strategies:

    Our baseline scenario remains that the euro crisis is ultimately resolved and that spreads between the core and the peripheries narrow over time. Such an outcome will allow the ECB to continue on its tightening path and yields in core  Europe will subsequently rise from present levels. However, this will require three things: namely, political commitment, growth and investor confidence. The issue short-term is that the market has serious doubts on all three issues, and volatility is to be expected over the next few months.

    Growth is very dependent upon the global economy. We remain of the view that this is a “soft patch” within a subdued global recovery, but recent data would suggest that risks are now tilted to the downside. In particular, the US economy looks vulnerable, with the prospect of fiscal tightening next year. Whatever the outcome, Southern Europe seems set to underperform. Whilst  recent surveys suggest that the Spanish economy is holding up better than most, despite the larger drag from fiscal adjustment and from the ongoing housing adjustment, news elsewhere in the region has been disappointing. If growth disappoints, countries such as Greece will fail – already it is hard to see how this year’s objectives will be reached, even after the latest tightening measures – and countries such as Italy will get negative headlines.

    The political commitment to the euro remains for now, but investors increasingly fear that the politicians are getting it wrong. The discussion on debt restructuring and private sector involvement has been badly managed and is arguably misplaced. We are strongly supportive of the arguments put forward by Trichet – no credit event, no involuntary private-sector involvement. The politicians seem unaware of the dangers of going down the debt restructuring path – the way in which Greece is handled sets a roadmap for the rest of Europe. The markets will punish the peripheries if the politicians get it wrong.

    Investor confidence is deteriorating fast. The issue here is that the problem is not just Greece but it is a bigger story. Portugal and Ireland look destined for years of further support, whilst Spain remains clearly vulnerable to another downturn in the housing market and/or further banking sector losses. Meanwhile, Italy (which has a smaller budget deficit) is held back by structural problems in the economy. Investors are becoming increasingly divided into two camps – those who feel that the euro muddles along and those that believe that it cannot survive in its present form. The longer the politicians dither, the more ammunition for the latter group.

    We would argue that recent developments have been uncomfortable for Spanish markets but the situation is retrievable. The problem may become insurmountable if investors continue to push yields significantly higher. Given debt/GDP numbers, the situation with Italy starts to become problematic around 7% – given that the market is trading Spain and Italy as a bloc (within reason), this would imply a similar crisis level for Spain.

    Important Information:

    The views and opinions contained herein are those of Azad Zangana, European economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.

     Source: ETFWorld – Schroders

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