Waiting for Clarity and Action in the Euro Zone
Allianz Global InvestorsInvestors
By Neil Dwane, Stefan Hofrichter
June 8, 2012
- Poor economic data and the collapse of a Spanish bank have kept the pressure on Europe and the financial markets.
- We believe Greece will stay in the euro and the EU. Europe wants Greece to stay; Greece will only leave if the Greeks want to—and they appear to want to stay in.
- Germany is pro-Europe and recognizes the need for growth, not just fiscal austerity.
- ECB policy has been supportive. We expect them to step in with more activity, but they don’t want to do the government’s job.
- U.S. investors should look to high-quality dividend-paying stocks in this uncertain environment, and should be prepared for potential market dissonance ahead of the presidential election and talk of a “fiscal cliff.”
What happened in the recent euro-zone summit?
Neil: Not a lot. They talked about how they could expand and develop the role of the European investment bank, and looked at using European Union (EU) structural funds to increase investment in Europe, much in the same way the Obama stimulus package was supposed to kick start the U.S. economy in 2009 with shovel-ready projects. Most expected that this informal summit would be mostly talk, and that real decisions would be made in June at the full EU summit meeting—by which time we will know the results of upcoming referenda and elections in France, Ireland and Greece.
Still, the small amount of news from the informal summit was overshadowed by poor economic data coming out of Europe, and by news about the collapse and rescue of one of the major Spanish banks, Bankia. This has kept the pressure on Europe and the financial markets in particular. Two to three weeks ago, when new management was put into place at Bankia, the impression was that the bank needed an additional €4-€5 billion in capital to withstand the bad debt of its property-lending business. Instead, they are now saying the number is more like €24 billion, but that’s without any close examination of the balance sheets.
It’s clear that the scale of Spain’s leverage and bad lending, much like the situation in Ireland a few years ago, is truly extraordinary. Recent European Central Bank (ECB) data show that €31 billion have been taken out of Spain’s deposit base, which is 2% of their deposits. As we learned in the U.K. in 2008, when citizens begin to lose faith in their banking system, it has very traumatic effects on the banking sector and the health of the economy, and places great strain on government financing.
Is Germany moving more toward supporting growth as opposed to austerity?
Stefan: I think Germany is all for growth if it doesn’t cost anything. The proposals they continue to push—which are gaining traction—is that the southern European countries should implement additional structural reforms. But Germany does recognize that Europe needs growth in addition to fiscal austerity to get out of the crisis. Keep in mind that the current center-right government is losing voters, so there is an increasing probability that the more pro-growth-oriented Social Democratic Party will make gains in the 2013 election. This could soften the austerity movement and add to calls for growth measures. The Social Democrats are more supportive of proposals made by the new French president, Francois Hollande. They are in favor of a German version of the euro bond—which is limited in time (up to 25 years) and only open for fiscally strong countries—and in favor of asking the ECB to do more to encourage growth.
Neil: It’s important for the U.S. to understand that there is no serious anti-Europe party in Germany. There may be in Spain and other countries, but more than 90% of the members of the German parliament are pro-Europe. Their differences are more about their approaches to solving the crisis.
Where does the euro-bond proposal stand?
Stefan: The euro-bond proposal, which states that all involved countries would share the burden in case of a default, is not perceived by the markets to be likely in the near term. And it will not gain support from Germany, from the Bundesbank or from other core European countries that fear moral hazard. There is, however, another proposal being discussed in Germany, which is that all debts above 60% of gross domestic product (GDP) should be shared, and that there should be a shared commitment to reducing debt to GDP levels to less than 60% over the next 20-25 years. This position, which is supported by the opposition in Germany, could gain traction.
What’s your outlook for Greece?
Neil: Our base case is that Greece will remain in the euro and in the EU. We believe there will be a scenario that reflects the need for continuing austerity, better tax collection and increasing restructuring of the Greek economy, and we may see the EU and Germany soften the targets they have set for the Greek economy. We may also see additional forgiveness of debt to lighten the load that the Greek financial system is carrying. Europe wants Greece to stay in. Greece will only leave if the Greeks want to—and they seem to want it. Keep in mind, however, that the cost of them leaving would be far higher than the cost of them staying on board.
Investors should note that there will soon be a blackout on official polls in Greece between now and the June election, so we shouldn’t see the kind of market swings we saw during recent weeks.
What about the Irish elections?
Neil: Ireland is holding a referendum on the new fiscal compact. While a “no” vote will not make any difference to the fiscal compact, it will highlight how well Irish politicians are advocating the current economic process and a resolution of the banking crisis in Ireland. The referendum will be seen as a vote on whether austerity and EU policy are being approved by the electorates of Europe.
Are there other euro-zone countries to worry about?
Stefan: Spain is clearly an important country, not only because it has problems with its banking system, but because it is definitely too big to be bailed out. If something goes really wrong in Spain, there are legitimate questions about whether or not the euro zone could continue.
Because of their ongoing real estate problems, the Spanish banking system is facing major writedowns. They began with €100 billion in writedowns, then added another €50 billion in February and €30-€40 even more recently—and if stressed, they could need to write down another €70-€80 billion. That means new capital must come from somewhere, so if the private sector doesn’t come through, it will have to come from the government. That’s why the Spanish bond market is coming down, and why Spanish savers are withdrawing deposits. It is a serious development. Spain is facing a liquidity problem, but it could be stopped if Spain gets financing from the European Financial Stability Facility and the European Stability Mechanism.
Portugal is another weak country. It’s already getting EU funds, but it’s not like Greece. Politicians in Lisbon are playing by rules of the troika—the ECB, the European Commission and the International Monetary Fund. They are implementing structural reforms and austerity measures. Cohesion in the country is quite strong, and funds will continue to be provided. The key hotspots today are Greece and Spain.
What can be done to fix Europe’s banking system?
Neil: My view of the banking system globally is that the level of balance-sheet disclosure is woefully poor. Regulators and investors have generally failed to convince banks to give them the disclosure they need. For Europe, as a whole, the greater the clarity there is on the scale of the problem, the easier it will be to attract external investors who are currently scared of Europe. This is something the EU has been very poor at so far. The frustration is that Europe as a whole has less net debt than the U.S., U.K. or Japan, but there are strong and weak hands in Europe that make the problem hard to solve quickly.
What is the ECB doing? Can they do more?
Stefan: ECB policy is more supportive than you might think, but they operate differently than the U.S. Federal Reserve. The ECB continues to provide an unlimited amount of liquidity to the European financial system—including the long-term refinancing operation (LTRO) of December and February. The ECB has also lowered collateral requirements, so there is ample liquidity being provided. What the ECB does not want is to do government’s job via the back door; they have refused, for example, to finance Bankia’s efforts to raise equity by using repos to its mother company. So while we expect the ECB to step in with more activity, they don’t want to take over the government’s job. And while they support growth initiatives, they haven’t been precise on what they want aside from pushing for structural reforms.
Neil: One frustration for the ECB, having used nearly €1 trillion in the LTRO, is that €750 billion is on deposit with banks, generating no income. Weaker banks are borrowing, but strong banks have no desire to put this money to work. One can anticipate the ECB will try to get this money off the sidelines and into the economy and markets. The Fed previously struggled with a similar problem, but the ECB has not yet found a way to get this money into the economy.
Stefan: Lending standards actually eased after the LTRO was implemented, but demand for credit remains quite weak. So the ECB is pushing on a string.
What are the prospects for Italy?
Stefan: Italy’s debt level is high, at 120%, but it has generated a primary surplus each year, on average, for two decades. So the situation there is less of a problem than widely perceived, but much depends on how much growth they can generate. The technocrat government has put reforms into place that should help, and there’s a good chance the country could win back some of the competitiveness of a decade ago. There are plenty of mid-size companies with products that are interesting for international trade. I am much more relaxed about Italy than I am about Spain.
Neil: I was recently in Milan and asked people I spoke with about their commitment to austerity. I was left with a very strong sense that the Italians were up to this. They know they need to change and know the country has been drifting. Some don’t like the tax-raising austerity measures, but they recognize that the sleepwalking Italian economy needs to shape up and they are ready for the challenge. I also got the impression that a wealth tax would be welcomed. They recognize it’s their turn to give back—unlike Greece, where they take money out. Italy doesn’t have a housing bubble or excessive consumer or corporate debt—just high government debt. So there is still the potential will in Italy to change and support the government. Italy doesn’t have Spain’s handicaps, and I was left with a strong feeling that they were committed to improving their situation going forward.
What about the euro? Is it a failed currency?
Neil: No, it is not a failed currency. However, there is a need for a closer fiscal union. That’s what the EU fiscal compact is intended to achieve.
What are the implications for U.S. investors?
Stefan: The current environment will remain uncertain, which means investors should look to find stable growth and stable current income. We advise looking to high-quality dividend-paying stocks.
Neil: Investors should keep an eye on the run-up to the November presidential election. The U.S. has debt to GDP levels of over 100% and a budget deficit of 8% of GDP—which sounds like Italy—and the markets might start challenging the U.S. government to live more within its means. There’s talk about a “fiscal cliff” for the U.S. in 2013, so if we don’t see clearer policy in the second half of this year, we may see the same dissonance in markets as we did last summer. Things are bad in Europe, but it may get bad elsewhere if politicians don’t start showing clear leadership.
Neil Dwane, CFA, Chief Investment Officer, Europe and Stefan Hofrichter, CFA, Chief Economist.
For more insights, visit the Allianz Global Investors Euro-Zone Crisis Resource Center: www.allianzinvestors.com/euro
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