Who Benefits from Eurozone Progress? Hint: Look North, Not South
By Russ Koesterich
October 26, 2011
“If there is real progress toward a solution to the European sovereign debt crisis, which countries would benefit the most?” Many investors are asking this question as speculation increases that policy makers may be moving closer to containing the crisis. While you might assume the answer would be Italy, Spain or Greece, I have a different take.
In short, look to the north, not the south: Perhaps somewhat surprisingly, countries in Northern Europe not directly involved in the sovereign debt crisis will likely benefit disproportionately from any credible progress.
Risk has become an increasingly important driver of valuations in the past year, particularly for developed European countries. We gauge riskiness by looking at credit default swap (CDS) spreads, which measure how costly it is to insure against the possibility that a country will default. They essentially show the market’s current perception of a country’s sovereign riskiness.
At the same time that country valuations have become more sensitive to risk, investors have becomeincreasingly pessimistic about all of Europe, including European countries not directly linked to the crisis. Negative investor sentiment has considerably driven up CDS spreads and the perceived riskiness of countries in Northern Europe, hurting valuations.
Overall, the importance of sentiment as a driver of risk has increased recently, and the safer developed European countries now exhibit sensitivity to financial markets strain similar to that of emerging markets countries in Europe in the past.
The valuations of Sweden, Norway and Switzerland seem to have suffered disproportionately, given that these countries are not even in the eurozone. Within the eurozone, the valuations of the AAA-rated Austria and the Netherlands have also been hammered, with investors concerned that these countries will have to ultimately pick up the bill for the peripheral countries’ sovereign debt problems.
To the extent investor sentiment improves with any progress toward solving Europe’s problems, I would expect such countries to benefit. Their perceived riskiness would likely go down, sending valuations up.
If Northern Europe is poised to benefit from any progress, you may be wondering how I define progress. While the exact shape of the solution is still up for grabs, I’m looking for a credible and coordinated strategy that addresses the major threats facing Europe. In general, I’d like to see an orderly restructuring of Greek debt, a European banking sector recapitalization and a plan for how to ring-fence Spain and Italy from further financial contagion.
I’m also looking for a fully functional European Financial Stability Facility (EFSF). While an expanded EFSF was approved, solving Europe’s problems is going to take more than the 440 billion euros already approved. Such progress would improve investor sentiment and help Northern Europe’s valuations.
If a disorderly Greek default happens, however, all bets are off.
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