... And now what? (Eurozone crisis)

30-11-2009

Davis Burns

... And now what? (Eurozone crisis)

With rumours circulating about the demise of the euro following Greece’s economic implosion, David Burns reveals how market expertise can result in an alter native view.

In much the same way as comedians are expected to be funny all the time and to have an endless repertoire of jokes, those of us who work in the investment management business have a similar problem. We are expected, at any given moment, to be able to comment on what is happening in the world’s various economies.

Not so long ago, a colleague from London introduced me to a complete but very charming stranger, whose second question, having ascertained what I did for a living, was: “What do you think is going to happen in the markets?” The short and honest answer would have been, of course, that no one really has a clue. However, I was clearly expected not only to know exactly what was going on around the globe, but also to come up with the magic formula that would increase this particular individual’s savings at a rate that would be off the (Richter) scale.

Unfortunately, it is necessary, in the investment management business, to have a view, and one only hopes that it is forgotten if it turns out to be wrong and remembered if time proves it to be right.

Living and working in Bermuda, and spending much of my time meeting with and talking to existing and prospective clients of Schroders, I develop my views and opinions in part from other people’s comments and in part from doing some quiet thinking and a little research. There is no magic formula, no crystal ball; one simply has to do one’s homework, which in this day and age is not very difficult. The Internet gives us all the ability to access the latest news, events and expert opinions upon which we can form views and suggest what might be the appropriate investment decisions.

When trying to understand what is happening or what is going to happen, Bermuda is probably a good place to be, as one can look in a number of different directions. West towards the US market and Latin America, east towards Europe, and over the top of both towards the emerging markets of the Middle East and Asia. As a European, and for obvious reasons, I have recently been focusing on the turmoil in Europe and what some interpret as the beginning of the end for the euro.

In a rather spectacular and somewhat acrimonious fashion, European Union (EU) leaders announced the creation of a €750 billion stability package in an attempt to stop the precipitous fall in market confidence. This came on top of the €110 billion bailout for Greece, which was approved by both eurozone leaders and the International Monetary Fund. At the same time, the European Central Bank (ECB) announced that it would be purchasing government bonds through secondary markets, as well as providing additional liquidity through its longer-term refinancing operations.

All this is aimed at restoring our confidence in the struggling economies of southern Europe, and is an attempt to shore up the belief that the euro project is alive and well. Furthermore, and probably most importantly, the hope is that new life will be breathed into the European economies as a whole. So should we invest in the old continent?

In a sense, the actions announced recently ticked all the boxes and made an explicit statement to the markets that European governments were prepared to go to extraordinary lengths to defend the single-currency union. However, the structural problems withinthe weaker eurozone members remain, and serious repair work is now needed to restore credibility to Europe’s fiscal framework. One should expect tougher new rules on fiscal management to follow, with stricter implementation of the excessive deficit procedure. There is still the thorny issue of the conditions to be attached to the support.

"It is almost ironic that emerging market fixed income should be considered a risk diversifier, but given the current state of the markets and the world's economies, it is not altogether surprising."

But we still have Greece to worry about. There is a significant probability that Greece (as well as Portugal and Spain) will not be able to implement all of the required fiscal-tightening measures. Union opposition is strong and the threat of civil unrest is a serious concern. It is likely, however, that the eurozone members will probably soften the conditions of support loans rather than leave them to fend for themselves. It is worth remembering, particularly when listening to some of the gloomier European commentators, that the €860 billion of aid announced so far is large enough to bail out Greece, Portugal and Spain over three years, twice over. I am still not convinced, though, that my hard-earned savings should be put to work in the equity markets of Europe. The fixed-income market over there nevertheless is looking attractive, with rumours of rate hikes and inflation beginning to creep back into the various economies that make up the European Union.

Looking westwards and beyond, I would venture to comment that the recovery, as weak as it appears to be, will continue to fund support in corporate spending, particularly in the US and in the economies of the emerging world. Rates may rise later this year, but will stay low over the cycle as the authorities pursue a cautious exit strategy and accommodate fiscal tightening. Some would argue that deflation poses more of a risk than inflation, except in emerging markets, but I am not sure that I agree. Looking beyond the current year, I have concerns over the possibility of the Chinese economy overheating, and I have to think that unless budget deficits are reduced, there is a risk that the public sector will crowd out a revival in private sector activity.

So, as I watch the ups and downs of the equity markets, the volatility in certain hitherto stable fixed-income instruments and currencies, the perceived risk in a number of historically riskless assets and the minimalistic returns on treasury bonds, my interest and comfort level with emerging markets debt increases. I have been an investor, in a private capacity, in this asset class for a number of years and have never been disappointed with the returns, nor have I ever been concerned with the associated risks and resulting volatility. There are a number of emerging market debt products in the market, but very few are able to offer investors the opportunity to diversify their risk while offering consistent returns with singlefigure volatility. Even fewer are able to offer a long-term track record and a stable fund management and product specialist team.

It is almost ironic that emerging market fixed income should be considered a risk diversifier, but given the current state of the markets and the world’s economies, it is not altogether surprising. Generalisation is always dangerous, but it could be said that emerging economies are in better shape than their emerged counterparts, with lower debt levels, controlled spending, significant reserves and stable governments.

So right now, when I am introduced to charming strangers and I am asked the ‘now what?’ question, I am happy to reply: “EMD.”

Davis Burns is the country head of Schroders Bermuda. He can be contacted at david.burns@bm.schroders.com

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