Markets telling us 'euro-zone is safe' – Schroders
EUROPE - While some peripheral economies are heading for default or restructuring of their debt, UK-based asset manager Schroders thinks this risk is already priced into markets and that markets are signalling that contagion via Spain into Belgium and Italy is unlikely.
It sees a value opportunity in European equities relative to emerging markets and the US as a result.
At a press briefing at its London headquarters, Schroders European economist Azad Zangana said the European Financial Stability Facility (EFSF) was too small. The total amount of debt that needs to be refinanced by Italy, Spain, Belgium, Greece, Portugal and Ireland between now and 2018 is €2.9trn, he pointed out - and that does not include any new funding, let alone bank bailouts.
"The road we are on is heading to default or restructuring for Greece and possibly Portugal," he said.
But he added that that is priced into credit markets.
"If the crisis spreads to Spain, then it is an easy next step for it to spread to Belgium and Italy, which both have high public dept-to-GDP ratios," he warned, but while a "tail risk for asset allocation purposes", that is not the company's "core view".
Zangana noted that while spreads on peripheral bonds are rising, it is "encouraging" to see de-coupling from Italian and Spanish bonds.
His colleague Rory Bateman, head of European equities, observed that Spain's household, government and bank debt was "no worse" than the picture across the euro-zone or the US.
Its government debt to GDP ratio, at 56%, is actually much lower than that of Italy, France and even Germany.
While Spain's banks leave it more vulnerable to a global downturn should that happen, they are not seen as a great risk in themselves.
Bateman said: "Portugal is a problem, and I won't deny that. But the markets are telling us something here: equities in Europe have been performing well, the bond markets are de-coupling Spain and Italy from the rest of the periphery. The markets don't expect a cataclysmic breakdown of the euro area."
Germany and France, representing 47% of the EFSF, "hold the purse strings", he added.
"The survival of the euro is a political decision - and there's no way they are going to allow the periphery to break it up.
"Germany can't afford to leave, as any new deutschemark would soar and cripple its exporters. And its banks' exposure to these problems means any hint of a breakup would be 'catastrophic' for them."
European equities are cheap relative to both emerging markets and the US because they are pricing in the risks associated with the peripheral euro-zone countries, he observed.
But those countries only contribute 12% of Europe's GDP and 7% of Europe's equity market capitalisation.
"Worrying about peripheral Europe is overshadowing what is a great opportunity in some core European companies right now," Bateman said. "We still expect continued momentum for Europe as a whole, with GDP growth beating forecasts. The fiscal issues in the periphery are not sufficient to detract from our positive outlook for European equities overall."
Nonetheless, his portfolio is overweight core and Northern Europe and underweight peripheral European companies with high domestic demand exposure - reflecting the fact continuing divergence between core and peripheral economic performance still poses less extreme risks.
Year-on-year retail sales growth in Spain remains negative and has been so for the past three years. Italy is also weak on this metric.
While overall euro-zone GDP continues to grow, and final demand is taking over from the inventory cycle as a driver of that growth, this divergence is putting the ECB in "a difficult position", said Zangana.
"Up until last month, I'd have said the ECB would struggle to raise rates, but now we have had a clear signal it will do so in April." Schroders expects 50 basis points by year-end and 150bps by the end of 2012.
Zangana conceded there was a risk of rising bund yields causing problems for the peripherals - indeed, that is part of the problem Portugal has been experiencing recently.
"That's why the ECB has been so concerned to have the details of the Stability Mechanism resolved, so that it can begin safely to raise rates," he said. "It will be interesting to see if the ECB does carry out its plan for rate rises, given the progress on that from last week."