(April 17, 2013) — Keeping up with the latest views on the Eurozone is a bit like keeping on top of your favourite soap opera – one minute the headlines are screaming panic about contagion fears and the domino effect, the next, investors are happy to part with their money despite an Italian political stalemate.
European bond markets have shown only modest reactions to the events in Cyprus and Italy, and peripheral sovereign bonds have hardly lost any ground at all. If you look at current volatility levels compared to the five years prior to the 2008-crisis, they look expensive; the markets are saying the crisis is over.
But with high unemployment levels and poor productivity dogging many European countries, and France about to roll out another round of austerity measures – which are likely to stymie its already flagging economy – the question has to be asked: Why have investors relaxed about Europe?
There are two major drivers behind investors’ sudden period of calm – The European Central Bank’s head Mario Draghi’s now infamous “We’ll do whatever it takes to preserve the euro” speech, and the introduction of the Open Markets Transaction mechanism (OMT) which, despite not spending even a cent so far, has successfully halted a potential death spiral by promising help if countries suffer liquidity problems.
This has led to two reactions: one, investors feel calmed by the measures and are seeking higher yielding bonds in areas such as Italy and Spain or two, they’ve become complacent about contagion risk and are happy to go along for the ride.
“Investors have seen the euro area survive a number of potential tail events without imploding. This may have desensitized investors and made them more willing to look through adverse developments,” offered Darren Williams, European economist at AllianceBernstein.
“Contagion may now have been replaced by complacency. Nor is this only apparent on the part of investors. It is also evident in the actions of governments, with progress towards banking union and institutional reform having slowed markedly in recent months.”
Head in the sand
But complacency isn’t just leading investors to trundle through difficult conditions, it’s also led them to ignore the impact of Cyprus’s bail-in.
Before this development, markets assumed that no matter how bad the bank, they would always come away with their capital intact, former hedge fund manager Alan Miller, and now CIO at wealth manager SCM Private, told aiCIO, but this assumption has now been tarnished.
“Cyprus probably has an almost permanent contagion effect of increasing the necessary rate of interest for holding any form of bank debt and proving that cash is not risk-free. A considerable fear is that this last point is all too quickly and wrongly forgotten by investors.”
The issue is that cash is considered a risk-free asset by regulators, but, as the price of gold has recently demonstrated, perhaps risk should be seen in terms of the likelihood of not getting your money back.
“Paying too high a price for a low risk asset such as gold or government bonds is, in reality, high risk, not low risk,” he added.
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Olly Russ, fund manager at Argonaut Capital Partners, was also concerned about the knock-on effects of Cyprus’s bail-in being ignored by investors. “What the Troika has done is ensured that the next time a crisis flares up in a Eurozone country, the situation will move from bad to irrecoverable in moments.
“Any troubled banking system, as soon as a bailout is mentioned, will see massive deposit flight, as any rational depositor will seek to place capital outside of the domestic banking system. The result: massive capital flight, bank runs, complete systemic failure.”
Russ continued: “The Eurozone, not noted for its swift decision-making, will find its window for preventative action massively curtailed through its Cypriot response. In saving a few billion here, it could cost itself hundreds of billions in the future.”
And while it’s true the market has become more resilient to the sovereign stresses being applied, this and the new techniques used to circumvent traditional cash bailouts shouldn’t be celebrated, according to Jonathan Epstein, head of data operations at SuperDerivatives. He told aiCIO these two elements would have a detrimental effect on the Eurozone as the market is still missing the fundamentals; high unemployment, low growth and antiquated fiscal policies.
Silver Linings Playbook
Not everyone’s so bearish however – many asset managers have taken pro-Europe stances. Scott Thiel, deputy chief investment officer of fixed income for fundamental portfolios at Blackrock, told reporters on Tuesday that as investors move cash into equities and fixed income, many were searching for higher yielding products in the bond space – leading him to take positions in Italian bonds.
Blackrock isn’t alone – Momentum Global Investors’ CIO Glyn Owen told aiCIO there was a “pretty good case” for buying Italian bonds, especially when you compare it to traditional safe havens such as UK gilts, which would currently lock you into negative yields.
“Major problems such as a disorderly breakup of the euro or a collapse of economies – there’s enough evidence now to show that’s not going to happen,” he said.
“Draghi’s speech and the OMT policy has seen peripheral bond yields fall dramatically – Spanish bonds were yielding 7.5% before and are around 4.5% today. That move effectively underpins the euro, the banking system and peripheral bond markets.”
That’s not to say Owen’s bullish on all of the Eurozone countries – like many of his peers he has grave concerns about France’s future productivity, given the ongoing austerity measures implemented by France’s President Hollande.
In addition, the Bank of Japan‘s latest round of quantitative easing will lead to increased liquidity, and that money will have to be invested somewhere. Henderson Global Investors’ head of global equities Matthew Beesley believes that place will be European government debt.
“Since the announcement of detailed plans for QE in Japan on the 4th April, notice the sharp declines in peripheral bond yields,” he told aiCIO.
“Many European assets are cheap. As such the region is primed for asset allocators to re-assess their weightings, having for so long been underweight.”
As with many opportunities, if you’ve got the resources and knowledge to chase after outliers, there are openings out there. A European systemic banking crisis might be off the cards for now, but investors must be vigilant to other potential coughs (and constantly check its heartbeat and blood pressure) as Europe recovers from its recent bout of flu.