Last week’s panic in financial markets finally forced European policy-makers into taking decisive action. Convinced that inertia would potentially lead to the collapse of the euro itself, European Union (EU) leaders effectively threw the kitchen sink and whatever else they could at the issue. The outcome was a new financial stabilisation package of up to euro 750 billion. There are three pieces to the package: First, opening up the EU balance of payments facility to all euro area countries and increasing its ceiling from euro 60 billion to euro 110 billion. Secondly, a new European stabilisation fund, which will provide guarantees worth up to euro 440 billion. Finally, an additional International Monetary Fund (IMF) facility of up to euro 250 billion. In addition, ECB has announced that it will intervene directly in public and private debt markets, and in conjunction with the Fed has re-opened USD swap lines, allowing European banks to obtain USD funding against euro collateral.
These measures have been accompanied by a strong commitment from the respective euro area governments to ensure fiscal sustainability. Portugal and Spain have committed to additional fiscal consolidation measures in 2010 and 2011, which will be presented on May 18. Governments have also committed to reform the Stability and Growth Pact to ensure fiscal discipline. It was also made clear that any country drawing down on any of the above facilities will have to subject itself to strict IMF conditions and monitoring.
These measures are critical in importance not only because of the size of response, but also the speed and cohesiveness of the policy action. Investor negativism towards euro assets over the past few months has been based on more than just the deteriorating fiscal. For, in reality, the euro area’s deficits and debt ratios are no worse than many other developed economies. The aversion to euro assets was based more on the EU institutional weakness, exposed while handling this crisis. The core problem of Europe not having a strong, centralised and empowered political leadership which can take quick, decisive action was shown up. The initial reluctance on the part of Germany to support Greece, the need to constantly revise the rescue package and the need for parliamentary approval in each country further highlighted the fractured decision-making model.
The sovereign credit crisis has brought Europe to a critical fork in the road as to its own existence. It can choose either closer political and fiscal integration or eventual disintegration. This crisis is similar to the ERM currency crisis during the early 1990’s which eventually pushed the main body of European countries towards a monetary union.
While the real efficacy of the announced policy package is still to be tested, it clearly shows that the EU leadership is not prepared to give up on the single currency, and, in fact, seems to be prepared to move further down the road to much greater cooperation on fiscal and budgetary issues. This crisis may go down in history as the turning point wherein Europe accepted the need to move towards a loose fiscal union with far greater coordination and monitoring of each other’s budgetary matters. As to the outlook for markets from here, there are two clear schools of thought.
One group is of the view that this package does nothing to address the fundamental issues of sovereign solvency. All we have done is given Greece, Portugal and Spain some time to get their fiscal house in order (without even addressing the issues in Italy and Ireland). This group is not optimistic about the ability of these countries to actually implement fiscal adjustments of the magnitude of 10 per cent of GDP and that too in a few years, and without being able to devalue the currency. The bears don’t think there is enough political will or willingness to endure hardship in the above-mentioned countries, and a serious moral hazard problem. This group also questions the entire burden of adjustment having to fall on the local populace of these countries (through the fiscal consolidation). A more fair adjustment process would involve creditors also taking a haircut (be they banks on their bonds or other countries on their fiscal transfers). The bears fear the burden of adjustment on the local populace will be too high, growth will collapse, leading to a negative spiral of contracting GDP and rising debt ratios, and some type of debt restructuring will be inevitable and still lies ahead.
The counter point to this is an interesting study done by BCA which points out that in the past 30 years, there have been seven instances of successful fiscal adjustment in Europe where we have seen a fiscal correction of more than 10 per cent of GDP. In each of these fiscal adjustments (except for Greece), GDP growth actually accelerated as the relevant country gained competitiveness and sustained productivity improvements. Key success factors which enabled these fiscal adjustments were a focus on expenditure cuts rather than tax hikes and a societal consensus supporting the necessity for the fiscal retrenchment. One may need to track the progress of Greece, Portugal and Spain on both these counts, to better handicap their chances of successfully completing the fiscal adjustments needed. The BCA study shows that it can be and has been done before.
The bulls point to the fact that global growth continues to surprise on the upside, with the latest US employment numbers surprising positively and purchasing managers indices (PMIs) improving across all regions. The current earnings season also continues to surprise positively, with the majority of companies continuing to beat analyst estimates. With strong earnings and low rates, markets screen cheap. Liquidity conditions will also continue to be supportive, as the latest crisis will only further push out any attempts at normalisation of monetary policy on the part of both the Fed and ECB. Markets thus continue to be in the sweet spot of very easy liquidity, super low rates but improving growth and earnings. For this camp, any corrections are a buying opportunity, as they continue to believe in the inevitability of markets rising till such time as the central banks remain on hold. Risk assets will get a bid, and capital will keep moving towards those asset classes and regions where growth is strong and benefiting from very easy macro policy settings.
It looks like being a very tough call, but I would tend to slightly tilt towards the bulls, and thus would remain invested, but have portfolio protection to safeguard against another potential shock. The markets should do fine if the relevant countries can deliver credible fiscal adjustment plans (based on spending cuts, not huge tax hikes) and we see greater buy-in from the local populace in understanding the need for austerity. In the absence of local buy-in, sharing the adjustment pain more broadly through debt restructuring comes back on the table, with potentially very serious consequences for the EU banking system and global liquidity. The only clear trade seems to be a further depreciation of the euro.
Net net, stay invested but remain paranoid...
The author is the fund manager and chief executive officer of Amansa Capital
