Eurozone Slowly Inching Forward
By Investment Strategy Group
July 6, 2012
No End in Sight
After three years, the European debt crisis continues to roil markets. At the heart of the problem is the issue of unbalanced growth, manifested through unsustainable budget deficits and failing banks. The lack of monetary flexibility for countries within the European Monetary Union (EMU) means that tools normally available to ease pressures (e.g. interest and exchange rates) have been diminished, and governments have to rely heavily on fiscal policies. Five bailouts and many discharged leaders later, the euro area is back in contraction territory, as austerity measures and uncertainties impact growth and confidence.
DIVERGING UNEMPLOYMENT FIGURES HIGHLIGHT THE IMPACT OF FISCAL AUSTERITY
Forecasts by economists and experts on the next chapter of this drama run the gamut of possible scenarios. One significant concern is that the absence of a holistic strategy to address longer-term questions means that an expiration of short-term measures might eventually pave the way for a return to volatility as issues resurface.
Furthermore, the unresolved questions that loom in the near horizon mean that EU leaders will quickly need to refocus on some outstanding decisions. For example, in the process of drafting a new budget, Greece’s new coalition government will still have to convince the Troika, consisting of the European Central Bank (ECB), European Union (EU) and the International Monetary Fund (IMF), to agree to a less aggressive timetable for austerity measures before the next injection of capital. In Italy, Prime Minister Mario Monti needs to continue driving market reforms in the face of a slowing economy and a skeptical public to bring down funding costs and debt levels.
In short, the outlook remains murky with many possible outcomes. Notwithstanding this fact, we highlight below some of the plausible and more discussed scenarios for how this crisis could eventually play out.
1. No countries exit the EMU and the region muddles through the crisis. We believe this is the highest probability scenario which, in our opinion, is largely priced into the markets. In this scenario, Europe would stagger through efforts to increase fiscal integration in the euro area and make structural adjustments to support the currency union. Countries and central banks may drag their feet on implementing structural changes but act when issues become dire. Greece would likely continue to receive funding and remain in the EMU but the lack of clarity and fiscal retrenchment in affected countries would likely weigh on economic growth. The euro area may go through a mild recession followed by a slow recovery. Under this scenario we believe the performance of risk assets would be lackluster and endure frequent bouts of volatility—not unlike what we have experienced recently.
2. Managed Greek exit. In this scenario, Greece would exit only after the EMU had the opportunity to build up necessary firewalls to stem a systemic crisis. The ECB would likely intervene to ensure that liquidity is provided to countries such as Spain and Italy to avoid contagion. Contraction in the euro area may deepen but a meltdown caused by liquidity events, such as a run on the banking sector, would likely be avoided. Leaders would continue to work toward a solution for greater integration and a Greek exit might even speed up the process. Under this scenario we believe risk assets would be adversely impacted initially but if policy makers provide clarity and are forceful to implement changes, confidence might return.
3. Disorderly exit by Greece or another EMU member. We believe this is the worst-case but least likely scenario. Many economists consider the probability of this scenario to be no more than the low teens, and after the recent summit, the likelihood has diminished further. In this scenario, Greece and possibly other European countries, i.e. Spain, may exit the EMU. The sudden departure would have a sizeable adverse impact on economic growth as contagion fears would likely increase. The viability of the euro might be in question and if policy makers were slow to act, a Lehman-like liquidity event could occur. GDP in the euro area would likely contract and this would reverberate throughout the global economy. Under this scenario we believe risk assets would sell-off dramatically and safe haven assets would rally.
As of June 29, 2012, the prediction market, Intrade, projected a 25% and 49% chance that more than one member country will exit the EMU by end of 2012 and 2013, respectively. We clearly recognize that risks are skewed to the downside and that view is reflected in many recent downgrades in growth expectations for the region. The scenarios we have presented aren’t optimistic, and a more bullish scenario where European leaders act quickly to implement confidence-inspiring changes (e.g., Eurobonds, pan-European deposit guarantees) remain possible. Despite near-term optimism, we expect this to be a rolling crisis, with EU leaders gradually inching forward to much needed solutions.
Even though uncertainty has given rise to opportunities in the region, as seen in the low valuations in certain European equity markets, we believe substantial risks remain. Therefore, we continue to recommend a cautious positioning in the region. But for those who would like access to these opportunities, active management might be a good way to navigate through this environment as the drama continues to unfold.
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