Barry Norris (pictured), Partner, Argonaut Capital Partners and Manager of the Ignis Argonaut European Alpha Fund, on how the Eurozone is defying the doom-mongers…
When S&P downgraded France, Spain and Italy earlier this year it was seen by many observers to be confirmation that the Euro-zone was insolvent and the single currency at risk of imminent collapse. Instead, European equity markets have had their strongest start to the year since 1998; Italian and Spanish government bond yields have fallen 200bps from their highs in November to 5.5% and 5.0% respectively and high yield credit spreads have fallen now to 5.5% (having been as high as 8.7% last October). A second credit crunch – which seemed odds on a few months ago – has been averted. Markets have stuck two fingers up to the ratings agency automatons and have left the professional doom-mongers foaming at the mouth.
We had feared that the Euro was a foreign currency for all who borrowed in her. The European central bank seemed too aloof to stand behind its banks if their solvency was questioned, in the same way as the Federal Reserve and the Bank of England have done effectively in the US and UK. The recent change of leadership at the ECB and its announcement that it was willing to lend to its banks for three year duration at 1% without stigma and was willing to accept a much wider range of collateral was a much needed development. The first of these auctions took place in December where 523 banks had raised EUR489bn of liquidity. Consequently Euro-zone banks can now fund their assets cheaply at the ECB rather than have market forces extract a higher rate of funding or even decide not to lend to the bank at all. Under the new arrangement, no Euro-zone bank will now run out of money.
“If the ECB has effectively back-stopped the banks, this means no Euro-Zone Sovereign will be forced to rescue them. It was only when Ireland had to rescue its banks that the Irish sovereign had its own solvency questioned. Similarly, Spain’s solvency is sound if it does not have to take Spanish bank liabilities onto its balance sheet. Sovereign risk has therefore been significantly diminished (but not removed). In this way the ECB has broken the negative feedback loop between Euro-zone sovereigns and their banks. The actions of the ECB should buy necessary time for much needed German style supply–side reform in the rest of the Euro-zone and the development of credible institutions for a unified fiscal policy. Moreover, as no Euro-zone bank will have to hastily shed its assets for lack of funding, this has given a boost to credit markets that will encourage higher economic activity. Ultimately, only nominal economic growth will cure a deflationary debt cycle.
European companies in the real economy are telling us that the last few months of 2011 were tough but not as bad as they feared. Inventories have been run down and the start of the New Year has seen a pick up in order activity. European leading economic indicators have started to recover, pointing to the Euro-zone economy as a whole coming out of a mild recession. We now think that expectations of European economic growth have troughed and we will see upgrades to 2012 estimates from here.
Together with the depreciation of European currencies against the dollar and robust global growth, this means that far from worrying about corporate profits collapsing this year, we may actually see upgrades to earnings. Given bearish sentiment and lowly valuations, it is therefore understandable that the equity market is reacting positively.
Indeed it is not beyond reason that European equities could be the best performing global equity market over the coming months, as the recovery of risk appetite – seen at the end of last year in the US - finally arrives in Europe.