Euro zone: Bargain or basket case?
Over the past several weeks investors have had to fasten their seat belts as markets gyrated wildly back and forth responding to almost every economic news bit or comment from a government official. As of this writing, the summer's downward spiral had been briefly punctuated by a few slivers of modestly better US economic data last week together with supportive comments from US Fed chairman Ben Bernanke which added a modicum of price support amid the ongoing global economic struggles before markets tumbled back down again. This week economists finally came to the conclusion that balancing fiscal budgets around the world will result in lower growth.
Morgan Stanley cut its forecast for global growth this year to 3.9 percent, down to 4.2 percent and other firms including Citigroup and Goldman Sachs have followed suit. Equity markets fallen so far this year with returns of -8.6 percent on the Morgan Stanley World Stock Index and -8.15 percent on the S&P 500 while the price of gold reaches a new high almost every day.
Hit even harder than other developed countries' markets, European equities have been punished more as nervous investors react to the region's litany of troubling news; it seems that problems in Europe are never easily fixed. The Stoxx 600 index of European equities is down 15.3 percent, almost twice as much as the US benchmark. In addition to a large menu of beat up stocks, many investment quality Euro area corporate bonds have also been knocked down in price to levels where they are now offering extraordinarily high interest rates compared to identically rated issues in other markets. With such promisingly high relative value being offered to a world starved for yield and return, investors may be asking: Is now the time to buy?
Spotlight on Euro zone
Now that the US budget agreement has been finalised and the Standard & Poor's rating agency has paid penitence for its past credit transgressions by notching down America's AAA rating, the spotlight has swung over to the euro zone where the drama continues.
Italy was latest of the troubled PIIGS countries (PIIGS being Portugal, Ireland, Italy, Greece and Spain) to cause a ruckus after its soaring sovereign debt yields forced the country to sign up for a 45.5 billion euro austerity package of spending cuts and tax increases over the next two years designed to balance its budget by 2013.
While there has been political agreement on the need to cut Italy's debt, there has also been growing concern about the slow pace of Italy's recovery whose economy grew just 0.3 percent in the second quarter of this year. The government's most recent forecasts for 2011 in April predicted a 1.1 percent growth rate, while the Bloomberg consensus estimate has fallen to 0.8 percent growth for the year making it one of the lowest in the region. And so it goes balancing budgets means lower growth everywhere.
With their egregious spending policies, overly generous entitlement programmes and sloppy tax collection techniques, the PIIGS are easy targets; yet the Northern European countries, heretofore the stalwart members holding the Union on course, are also showing signs of weakness. In fact with Italy's plan now in the works attention has turned towards weaker growth occurring in France and Germany, the two most important 'core' Euro zone members.
Germany last Tuesday announced slowing GDP growth of just 0.1 percent versus the 0.5 percent consensus estimate. The disappointingly low number follows France's below-expectation numbers in the prior week and prompted the two core European leaders, Angela Merkel and Nicolas Sarkozy to meet and discuss policy.
At last week's summit meeting in Paris the pair backed plans for all 17 members of monetary union to write balanced budget clauses into their constitutions by next year. It also sought better governance of the single currency through the creation of a euro zone president.
The problem with the European Union has been in its inherently complex structure, the fundamental differences among its member countries and the lack of a governing body which possesses the authority to execute decisions. A prime example of policy weakness was demonstrated by recent bank 'stress tests' which did little to restore confidence in the markets. The euro zone stress tests are now widely viewed as inadequate measures of Europe's financial system. Capitalised at just three percent of assets, the euro zone's largest banks seem to be unable to contain the damage done during the 2008 credit crisis and desperately need to be recapitalised back to levels sufficient for absorbing the pending losses.
Playing the Euro Crisis
Euro zone's central problem of too much debt and the need to repay its creditors while sustaining growth is really no different than the same concerns facing the other major world economies including US and Japan. However the complicated structure of the fundamentally fractured Union makes resolution more challenging. On the plus side for investors, the jagged market action and ongoing heated controversy may also be offering attractive investment opportunities for the savvy (and patient) investor.
Probably the easiest way to play the unfolding euro crisis is to invest in securities of outside of the euro markets using euro-related broad market sell offs as buying opportunities. For example, the broad index of US bank stock index has sold off over 20 percent so far this quarter, largely in reaction to the euro zone headline news; and yet the total exposure of the US banking system to troubled euro credits is relatively small. At LOM we have been actively purchasing shares in high yielding, defensive US stocks, including electric utility companies trading down as much as 10 percent in sympathy with the broader averages and yet having no exposure to Europe. The newly launched LOM Stable Income Fund has been a buyer of quality electric utility companies paying dividends of around of around five percent to shareholders versus ten-year US Treasury Notes paying just over two percent. Similarly, high grade financial bonds backed by stable US banking franchises such as JP Morgan look like a good bet. Bonds which are tied to LIBOR (London Interbank Offering Rate) are especially intriguing as the benchmark rate ticks up in response to the crisis.
For investors with a stronger stomach, direct euro area investment is another option. On the credit side, highly rated and internationally diversified companies such as Spain-based Banco Santander are offering yields of up to four percent on bonds maturing in two years, rated AA by both S&P and Moody's rating agencies.
On the stock side, global multi-national companies which happen to be based in the euro zone but are doing business all over the world have become more interesting as their prices tumble farther than their peers. Attractive dividend yields combined with potential longer term price upside can be had on Novartis AG, Royal Dutch Shell plc and Total SA.
Bryan Dooley is portfolio manager at LOM Asset Management Ltd. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. The information contained herein, has been compiled from sources believed to be reliable, but no representation or warrant, express or implied , is made by Lines Overseas Management Limited or any of its affiliates or representatives, as to its accuracy, completeness or correctness. Investment in LOM funds is not insured or guaranteed by any government agency. Past performance is not indicative of future performance, and any investments in LOM's funds are subject to risks, which may result in a loss to your principal investment. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.