Europe: Fragile markets, agile investing
BlackRock's Charles Prideaux offers his thoughts on investment opportunities amid Europe's turmoil.
As Europe seemingly lurches from one crisis to another, the case for avoiding investing in the continent seems to strengthen every day. Indeed, many investors, fed with a constant diet of negative headlines about Europe, are opting for caution and seeking to allocate their money elsewhere. But while this approach may provide such investors with a sense of security, it might also cause them to miss out on some compelling opportunities while overpaying for risk assets in other regions.
Continuing sovereign and systemic risks are driving volatility higher in Europe. At the same time, regulatory and structural changes in capital markets are forcing financial institutions to deleverage - in other words, to exit businesses, sell assets and transfer risks. This process has only just begun and will continue for some time. Developments such as these are regularly causing the price of European assets to deviate from fair value, particularly in fixed income markets, where there are opportunities to purchase credit at attractive prices while hedging systemic risk.
Investors who move quickly to purchase assets and portfolios being sold by financial institutions may discover rich new sources of income and yield. And this is not a niche market we're talking about: our estimates are that €1.5trn-2.5trn of impaired or other assets from European financial institutions will become available over the next 18-24 months.
For example, some European financial institutions may hold assets on their balance sheets they cannot afford to sell - for example, US non-agency residential mortgage-backed securities (RMBS) - but that present unattractive capital requirements. Those financial institutions may want to transfer those risks to a third party and gain capital relief.
Opportunities may also arise to purchase mortgage servicing rights (MSRs), which banks are looking to sell because upcoming Basel III capital requirements will make them much less attractive to hold. An MSR is a right to a stream of cash flows from a diversified pool of mortgage loans for performing mortgage servicing functions (such as providing reporting or collecting fees), or delegating the functions to a third-party sub-servicer.
Further down the liquidity spectrum (with holding periods between two and three years), competition is increasingly muted, as fewer capital providers are equipped with the structuring expertise and tolerance for illiquidity necessary to participate in this segment of the market. There are numerous instances in which a premium may be available to specialist investment managers that are able to commit capital and navigate the complexity of off-the-run and/or out-of-favour situations.
But opportunities in European credit are not limited to the availability of bank assets at cheap prices. Volatile market conditions, fuelled by unpredictable and inadequate policymaking, are forging ideal conditions for certain macro trading strategies - long/short relative value, for example. Spread volatility in the most liquid segments of the European fixed income markets is creating opportunities to generate asymmetric trades and profits within a market-neutral portfolio. This could be achieved via long positions in idiosyncratic risks in high-yield corporates and financials in core European countries, combined with short positions in systemic and cyclical risks in sovereigns, peripheral financials and corporates.
Another area with potential is high-yield debt. The current high volume and breadth in primary new issuance of European high-yield bonds implies that this market will continue to grow as European banks progress down their deleveraging paths. Although yields are not as elevated as they were in late 2011, ongoing risk aversion in European markets due to systemic and sovereign solvency concerns continues to support substantially higher yields than those on offer in the US high-yield market.
Of course, the risks associated with investing in Europe will remain for the foreseeable future and should not be underestimated. Any investment in Europe - like all other investments - must be made in alignment with the investors' goals, risk tolerance and time horizon. But providing these conditions are met, the opportunities currently available in Europe will, for many, prove too powerful to ignore.
Charles Prideaux is head of institutional business for the EMEA region at BlackRock