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Don’t Count the Euro Out Yet

Despite the challenges, concerns that the end of the euro is near are overblown, fund managers say.

Mara Dobrescu, 02/01/2012

While markets have reacted with increased volatility to the escalating debt crisis in Europe, some fund managers are beginning to see light at the end of the tunnel.

Europe is embroiled in a full-scale economic, banking, and political crisis, and fund managers, both in Europe and the rest of the world, say they have felt the consequences. During the past year, markets have been reacting with increasing concern to the European Union’s struggle to stave off defaults and restore stability to its financial system, making it often difficult for investors to separate legitimate macroeconomic concerns from short-term market nervousness.

Europe’s Headwinds

The debt/GDP ratios of European countries have been steadily growing, and recent developments have introduced new levels of complexity to the problems facing Europe:

Slow Growth
For the past few decades, the eurozone countries have been growing at a much slower pace than the rest of the world, including the United States—making the prospect of “growing out of debt” a difficult challenge.

Increasing Public Deficits
Demographic trends are adding to the debt burden, as aging European populations imply spiraling health-care and retirement expenditures.

Political Paralysis
The EU’s cumbersome governance system, which requires consensus among all member states, makes it difficult to react quickly to growing market concerns. In addition to this, profound disagreements between economically “strong” and “weak” countries are stretching the limits of solidarity within the EU.

ECB Mandate
The European Central Bank’s focus on preventing inflation means that the eurozone cannot simply inject vast amounts of liquidity in order to devaluate its debt through inflation.

Banks’ Exposure to Public Debt
Accepting the insolvency of peripheral states by rescheduling their debt is not a realistic option because “core” European banks still hold significant amounts of government debt and would thus incur crippling losses.

What Fund Managers Are Saying

While much has been said about the possible breakup of the euro, and even the European Union itself, many of the fund managers we speak to have a more nuanced view of the situation.

First, most agree that concerns about the end of the euro are overblown—there is enormous pressure to keep the monetary union afloat. Second, they acknowledge that current fiscal reforms are part of the solution and that European countries will likely go through a period of deleveraging by reducing their spending and increasing taxation—although not all agree on the actual consequences to expect from a prolonged period of fiscal restraint. Finally, fund managers agree for the most part that increased ECB interventionism is a positive signal, although it might not necessarily prove sufficient to ease credit and monetary conditions.

To gather views from fund managers across the world, we spoke to Morningstar analysts based in North America, Europe, and Australia who regularly speak to investment managers about their strategies and views on the global economy. Here are some of the views that fund managers have shared with us and their current positioning with regard to the European debt crisis.

Robert Rodriguez, managing partner and chief executive officer, First Pacific Advisors (United States)
Rodriguez says that the central bank’s moves are only temporary Band-Aids, which do not attack the core issue of the unfolding crisis, namely uncontrolled fiscal spending. He blames economic fundamentals in the region, such as lack of competitiveness, for these negative trends. Rodriguez, therefore, highly doubts that the necessary and very longterm fiscal austerity measures can be carried off successfully and thus believes that the current financial/fiscal maneuvering will only address short-term challenges.

In his opinion, in much the same way that liquidity and swap lines were thrown at the U.S. economy during the last financial crisis, fundamental structural reforms, both fiscally and financially, have not been done. Initially, liquidity-easing measures only had a short-term positive impact in the United States, but the final cost of these actions, including nontraditional monetary policies, has not yet been totaled. He, therefore, expects that we will continue to be in an interim environment where uncertainty prevails.

Rose Ouahba, fixed-income chief investment officer, Carmignac Gestion (France)
Ouahba says that austerity programs (such as raising VAT) are likely to depress economic growth, precisely the wrong thing to do because slower growth will make deleveraging much more difficult in the long run. There is, therefore, a chance that the eurozone will miss its debt-reduction targets in spite of the current fiscal restraints. She says that governments should instead concentrate on measures favorable to growth, such as selling government-owned assets (privatizations) or reforming labor markets to help increase productivity. In addition, she says that Germany should use its current surplus to initiate a stimulus package meant to encourage internal demand.

The reason why the current debt crisis in Europe is so complicated, Ouahba says, is the fact that the rest of the world is also growing at a slower pace than ever before, making it even more difficult for Europe to export its high-value-added goods. Yet, if both the United States and emerging markets eventually manage to avoid recession, and if the euro weakens, the eurozone should be able to regain some of its competitiveness.

Ouahba also sees the ECB’s willingness to buy large amounts of public debt on the secondary market as a first step toward quantitative easing, although it would be even better if the ECB could intervene directly on the primary market. This would not require any major structural change to its mandate but would give markets a clear signal that the ECB is finally measuring up to the gravity of the situation.

Finally, Ouahba says that she is convinced that concerns over the fate of the euro are overblown. The Germans are very attached to the euro, and peripheral countries such as Greece and Portugal simply cannot afford to leave the union.

Johnny Debuysscher, fixed-income chief investment officer, Petercam (Belgium)
Debuysscher is cautiously optimistic about the situation and says that there is some hope to see a Europe more united than in the past, as an ambitious consensus has emerged around the common goal of reducing deficits.

While EU officials still need to formalize the mechanisms needed to enforce fiscal restraint and fine-tune some of its key measures, the main achievement is that all member states have grown to accept the need to adopt a unitary fiscal structure. Europe, therefore, might emerge again as one of the strongest entities in the world, at least politically.

Debuysscher says that we might be witnessing the start of Europe and the United States taking divergent economic paths. The United States could be on a higher growth path— comforted by recent positive employment figures and some inflation stemming from an aggressive quantitative-easing policy coming from the Fed. Europe, on the other hand, might follow a longer-term “Japanese scenario,” with low growth and low inflation.

Finally, Debuysscher believes that the outlook for the European banking system, the collateral victim of the debt crisis, should actually improve over the medium term. He says that European banks reduced their exposure to government bonds by two thirds over the course of 2011, gradually deleveraging and cleaning up their balance sheets. He says that year-end figures published by banks will be a positive surprise, which should help market sentiment and alleviate current nervousness.

Hamish Douglass, CEO, Magellan Financial Group (Australia)
Douglass’ analysis is that Germany is actually in full control of the European situation. He says that while markets are reacting negatively to the uncertainty (an extremely frustrating situation for investors who would love a more definitive solution to end the bond crisis), the Germans aren’t fazed. They want to keep the pressure on Greece, Italy, Spain, and even France and force through measures that are going to put Europe on a more stable footing for the long term. According to Douglass, Germany believes it has time on its side, and by allowing bond yields to go up, it is adding pressure for change to happen politically and economically, which is fundamentally in its own interests.

Douglass says that he has been very impressed with German chancellor Angela Merkel’s leadership during the crisis and that we might be witnessing the rise of Germany as a potential new superpower that ultimately won’t let the EU collapse. He says that Germany is in fact running the largest global trade surplus (larger than China’s, relative to GDP). The Germans are tied to a currency that fundamentally undervalues their competitive advantage in terms of exporting, and they want to maintain that advantage, just as China wants to maintain its advantage.

Andreas Busch, senior macroeconomist, Bantleon (Germany)
Busch believes that politicians alone cannot solve the debt crisis.

“Sooner or later, the European Central Bank has to come to the rescue if the monetary union is to be saved,” he says. “Given these facts, it is more than questionable whether the ECB can keep on hiding behind the excuse that it is not allowed to finance government debt. This argument is not very credible in any case, as it has not prevented the ECB from buying more than EUR 200 billion of peripheral countries’ debt so far.

“It will also be crucial for the ECB to continue buying sovereign debt—not in order to fund government budgets, but to shore up the economy. The exceptionally high interest burden that we are seeing in peripheral countries could intensify recessionary trends, trends that the central bank can only counteract over the short term.”

Michael Hatcher, director of research, Trimark Funds, Invesco (Canada)
Hatcher says that the key issue surrounding the current sovereign debt crisis is public confidence.

“The current political structure of Europe makes it extremely difficult to build a consensus around a workable solution, thus hampering public confidence further,” he says. “As the core members of the eurozone have benefited significantly from the euro, it is in their best interest to find a solution in the first half of 2012.

“However, there could be a significant impact on the more peripheral European economies both within the euro and those looking to join— and this impact is currently too difficult to call. Until a workable solution is tabled, the short term will remain volatile due to swings in confidence. Once a viable solution is found, confidence should slowly start to improve and the market will be able to refocus on the underlying economics of each business.”

Fund Analyst, Morningstar France

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