The European sovereign debt crisis is a bit like a complicated chess match, where the ending is necessarily very uncertain. Governments are discussing various options, e.g. at the next summit on 21 July, but the problem is they are still trying to address a short-term lack of liquidity, not the problem of insolvency (in some countries, debt levels are too high and economic growth too low). Ultimately, €2 trillion solutions may be needed.
How does the European sovereign debt crisis affect investors?
There are positive and negative investment conclusions: sell the euro and certain bonds, buy certain equities, and prepare portfolios for considerable volatility.
The problem for investors with the European sovereign debt crisis is that there are multiple games of chess taking place across Europe, and new ones opening up each day. Which grand master will win?
What are the solutions to the current difficulties facing the Euro-zone?
The first point to make is that there are no easy answers. The European sovereign debt crisis crisis has lasted, off and on, for well over a year. Opportunities to nip it in the bud are long past. The key words are ‘burden sharing’. What combination of current and future taxpayers, private and public money and support will be required, across 17 different economies?
Burden sharing is easier if there are strong shoulders to share the pain. One of the difficulties for European policymakers has been that it took so long to work out how strong the private sector contribution could be. The stress test failure of 2010 has come home to roost in 2011. Even after the European Banking Authority (EBA) report on 15 July, investors clearly have their suspicions about certain banks in Spain, France and Germany – especially those where investors have carried out their own in depth credit ratings, as Standard Life have done.
Current options
Each of the various options has a severe downside for someone.
a) extending the maturity of Greek debt. Advantages – this helps costs for Greece, and no money is needed from German taxpayers. Disadvantages – it damages the balance sheet of the private sector owning such bonds. European pensioners and savers suffer. If the bonds have been extended could they be extended again? Clearly a default occurs as far as the credit rating agencies (CRAs) are concerned, with effects, for example, on the European Central Bank’s ability to provide liquidity to weak banks.
b) the French form of Brady bonds, a cleverer idea as there was theoretically more certainty that a bond might ultimately be repaid. However, again it would crystallise losses for European bond holders, and the CRAs would call it at least a selective default.
All such proposals are fine in ‘round one’ but how can the Euro-zone ensure that investors do not run for cover thinking that a package for one country could be extended to another? NB: Greece has €340 billion of debt, but Italy has €1,600 billion.
c) buying back debt in the secondary market, debt which is priced at a significant discount to face value, say 50-60 cents in the euro. Losses are crystallised for bond holders, but the sell-off could be manageable if the package was large enough to impress the markets. However, ‘he who pays the piper calls the tune’. Will the European Financial Stability Facility (EFSF) be granted authority to do so? If so, that is a call on future taxpayers to fund the interest and repayment bill. The sums involved could become very large.
In this European sovereign debt crisis, the total debt of Greece, Portugal, Ireland, Spain and Italy is about €3.1 trillion. Additionally, the EFSF would issue its own high-quality debt, backed by all Euro-zone members, to fund its purchases of cheap low quality peripheral debt. That means German debt no longer becomes the European benchmark. Do German debt servicing costs rise? Why should German taxpayers pay for the profligacy of Greek or Spanish politicians?
d) the European Central Bank could carry out debt purchases, building on its Securities Markets Programme (SMP) which has already bought about €70 billion. There are two objections. First, the ECB’s balance sheet deteriorates in quality. Any losses are shared pro rata among the central banks of all the Euro-system – again higher taxes for future voters.
Secondly, is ‘SMP’ seen as an alternative abbreviation for Quantitative Easing (QE)? If QE goes ahead, and inflation appears, then future European households suffer.
Analysing the options
The drawback with all four proposals is they are not the end game. At best, they are a way of postponing it. Options a) and b) do not address the solvency issue, but continue to treat the problems as a liquidity crisis. Investors must be very clear about differentiating between attempts to delay a resolution and a resolution itself.
In that regard, options c) and d) are potentially better, probably working as part of a package. However, they would have to be carried out in large scale rather than as a token gesture . They would also have to be carried out quickly; otherwise a significant rally would quickly reduce the effectiveness of the policy leaving the still problematic level of debt fully in the official sector.
At the end of the day, the solvency aspects are key. It must be remembered that none of these options remove the need for Greece to continue its reforms and eventually stop running a primary deficit.
Default ahead?
With no easy solutions, does default ensue in this European sovereign debt crisis? We must emphasise that too many people bandy the term ‘default’ about without a precise definition. What sort of default is being considered? Is it voluntary or involuntary, orderly or disorderly, temporary or long-lasting?
The first default option would be a temporary default. If plans for extending debt maturities ever see the light of day, the credit rating agencies could announce a short-term selective default for a few weeks or months, before renewing a credit rating on the basis of the new arrangements. A similar scenario happened to Uruguay back in 2003.
The second would be the expected orderly rescheduling of Greek debt to lower its burden considerably. When will it happen? When the banks are strong enough and can cope with serious losses. The 2011 stress test results need to be examined in detail, but so far they suggest a long tail of weak banks which need to raise capital and retain earnings, suggesting no such default before 2012.
The third form of default would be a disorderly one, namely that Greece becomes unable to adhere to the austerity measures within the EU/IMF programme, resulting in a political and banking crisis. The negative effects of such a ‘default’ on the currency and banking system would be large, as global investors pull out of euro assets.
More important, though, would be the extent of second-round effects, which in turn would depend on how successful the ECB, and the other Euro-zone institutions, would be in ring-fencing the problems surrounding Greece. The ECB, for example, could initiate its own form of QE, while G7 currency intervention would be very possible.
What might politicians do?
May 2010 was an important weekend when the Euro-zone took the initiative with ‘shock and awe’ – €850 billion of support for markets. At some point, politicians will do the same, but the timing remains very uncertain. As with our analysis at that time, we advise looking beyond the size of the package to see whether it addresses the clear solvency issues at the heart of the European sovereign debt crisis.
Investment conclusions
First, the euro currency will survive in some form or other, but clearly it will not be the same form of currency which we all thought it was. It is evolving already in front of our eyes. More analysis needs to be paid to the other key aspect of debt servicing, the ability to pay, or in this sense the future growth rate of an economy and therefore its tax revenues. Individual countries are being forced to catch up after years of uncompetitive behaviour, when they lost up to 20% versus their German competitors. Investors can look for the most successful examples of such restructuring, at a country or company level.
Secondly, the euro currency looks a one-way bet. Many of the ultimate solutions will either involve expanding Europe’s money supply, or worrying overseas investors over the quality of European assets. A lower euro reflects the adjustment process. Quality European exporters are well positioned to take advantage of this extra boost. Buy German small cap firms.
Should investors be Light in peripheral debt during this European sovereign debt crisis? Yes, but not too much. The short-term benefits of being Light need to be offset against the risk that at some moment in time there will be a major short covering squeeze as Europe responds to he building pressures. Yes, be Heavy in German bonds, but again only until it is clear whether or not a large part of the burden will ultimately fall on German taxpayers.
Conclusion
Investors need to monitor the European sovereign debt crisis closely. In their portfolios, they must differentiate between interim holding operations and ‘solutions’ or ‘end games’ — the ultimate check mate would be a fiscal union or a disbandment of the euro – all other outcomes would be messy stalemates.
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