By John Beck, London-based SVP and co- director of Franklin Templeton’s International Bond Group
The whims of investor sentiment often hold sway over the markets, even if fundamentals might seem to dictate otherwise. A herd mentality can take over and certain asset classes or regions fall out of favour, whether rightly or wrongly so.
In the first half of this year, the investing herd was stampeding out of Europe, with its crushing debt crisis and spectre of a euro breakup. Today it appears sentiment is shifting direction—toward the euro’s survival—so will the herd make a U-turn? Investors have grown impatient waiting for the eurozone economies to recover, but patience is a virtue. It is impossible to go around the time required for the recovery process, but we are already seeing improvement in three key areas: the banking system, sovereign debt, and politics. We are beginning to see things put in place that we feel will at least begin to stabilise the situation, to get it resolved over a period of time that is achievable. In December of last year we had one step toward resolving the problems in the banking system—the three-year Long- Term Refinancing Operations (LTRO). More recently we’ve had some of the sovereign problems partly resolved with the ECB’s announcement of Outright Monetary Transactions (OMT).
It requires contingencies for countries that apply for the programme, so that means there is political agreement from the stronger countries to provide financing for the countries that are struggling at current terms to raise money. The third element was the political commitment. Dutch elections resulted in a pro-European outcome, and it’s been voted through in the German parliament. So we have a combination of improvement in the banking sector, in the sovereign sector and in the political sector. We do finally have an opportunity to begin to resolve things, so one could take a more optimistic view. The euro was conceived of as a single zone, but the debt crisis has proven the risk clearly is not equal among the member countries. In our opinion, some areas remain a bit sickly, but others are on the path to recovery. For some countries, we would still be very cautious. We think there are significant reservations over Greece, and probably over Portugal, and a question mark whether the OMT is perhaps beginning to resolve some of the problems in Spain. But for other countries where the debt-to- GDP ratio has been more stable, where the fiscal position has been less in deficit, for example, in Ireland or in Italy, there are all grounds for optimism. We think some of the peripheral economies now do offer some value. Banks have got funding for three years, but what banks are likely to do in those three years is lend less money.
That’s not going to be good for European growth. Governments now can get money through the OMT, and again that’s good for governments, but what will governments do? We think they are likely to spend less money over the next three years to bring the fiscal position in order, and again that’s likely going to be a drag on growth. The private sector was perhaps a little spooked by some of the political uncertainties and not terribly willing to spend money either. So we think growth in Europe is going to look pretty weak for some time. So if we don’t expect anyone to ramp up spending anytime soon, what does have the power to restore investor confidence? A period of calm might be a good starting point. In the last two to three years we have stumbled from one crisis to the next crisis and hoped for resolution that was never really ultimate and forthcoming. So we hope for a quiet period where we don’t have to look forward to an election, or vote, or disaster, or the necessity of a midnight finance ministers’ meeting. We hope we can actually go back to some perhaps slightly more normal degree of relative spreads between sovereigns that reflects their credit fundamentals rather than the fundamentals of panic and liquidity.
Comments