The euro-zone: We're not out of the woods just yet
What will Mario Draghi's plan means for investors? According to Aon Hewitt's Tapan Datta, we can expect plenty more uncertainty in the euro-zone.
Germany's support for the European Stability Mechanism (ESM) is vital for Mario Draghi's plans for greater intervention by the European Central Bank (ECB), and the country's consent essentially marked the start of the latest effort to rescue the euro from its current crisis. While the ECB heralds this as a valuable step on the route to recovery, many investors may well see this as a sign to expect ongoing uncertainty.
In short, the aim of the so-called 'Draghi plan' is to allay the concerns of creditors that they will be exposed to heightened convertability risk by lending to debtor nations in Europe. The risk is that the debtor exits the euro-zone and repays in a currency other than the euro. The ECB is seeking to achieve this by offering to purchase government bonds where the market has priced in convertability risk to unaffordable levels in yield terms. Simply put, for nations that apply to the ESM, the ECB will act as a lender of last resort.
So what does this mean for investors? Ultimately, the fundamental economic problems are still with us. Government borrowing costs at the front end of the yield curve have, indeed, fallen substantially since the initial Draghi 'we will do what it takes' announcement in July, with helpful (albeit much smaller) declines even at longer maturities in the past few days.
However, debt-refinancing costs still remain unaffordable for economies that are shrinking, alongside sharp declines in tax receipts. More pressing, financial conditions in the banking systems of Italy and Spain are worsening. Spain, in particular, is encountering significant deposit flight and acute bank deleveraging. With austerity programmes also dragging on growth, there is no obvious indication economic growth is likely to come back in a hurry. It was always clear that economic conditions would be critical to the question of whether euro break-up fears would retreat on a lasting basis, and it is still the case that the current toxic mix of fiscal austerity and tightening financial conditions remains a rather large obstacle for the success of the ECB plan.
A key concern here is that the ECB has, in effect, raised the stakes in the battle to save the euro. While this was inevitable at some stage, it means the markets will be unforgiving if the commitment to intervene and 'do what it takes' stance taken by Draghi falls short of what is needed. At this time, the promise to intervene is reducing the need to actually purchase peripheral bonds, but at some time, the ECB's commitment will be tested.
Previous attempts by the ECB such as the Long-Term Refinancing Operations (LTRO) at the turn of the year did lower the temperature of the crisis, but not for long. Against this backdrop and given the more sweeping nature of the ECB's commitments this time, the stakes are clearly higher now. A failure now, and break-up risks do widen appreciably.
In August, it seemed that a 'muddle through' scenario would be the most likely for the coming year in relation to the euro-zone crisis. Here, there would be no break-up, though markets would still be impacted by non-trivial risks of an eventual break-up. Even after recent events, this remains unchanged. Importantly, equity and bond markets are responding to the likelihood of a break-up or saving of the single currency in different ways.
True to bond markets' generally more pessimistic cast of mind, current ultra-low bond yields in the major 'safe haven' markets of the UK, US and Germany appear to see a break-up as a much higher probability than equity markets, which have notched up reasonable gains of late. A break-up would be bad news for equities, but leave bond markets largely unmoved. However, the success of the ESM and resolution of the euro-zone crisis would correspondingly be bad news for bonds - German bonds should have more to lose, since victory means bigger bills here, but we would expect Gilt yields to rise in the UK, too.
And what about the more highly anticipated situation where euro-zone leaders continue to muddle through? In this instance, equities will remain in a weak trading range on the back of euro-zone worries and the increased challenge of keeping corporate profits growing. Gilts may not attract much support in this scenario, partly because of how expensive they have become, though any rises in yields will probably be held back by continued worries over Europe.
Pension funds would have a great deal to celebrate in a scenario of a successful defusing of the euro-zone crisis. The crisis has been one of the key drivers of low Gilt yields, which have dramatically inflated the value of their liabilities. It may be oddly comforting that, from a liability perspective, a break-up may not be any more damaging than what we have seen in recent years, even though equity market falls would undoubtedly worsen their financing predicament further.
For now, however, comfort is thin on the ground. If, as market sentiment suggests, the euro-zone crisis continues to endure, we may see Gilt yields slightly higher, but equities and other growth-focused assets are likely to struggle to sustain gains. In the near term, to gauge the likely success of the latest plan to save the euro, investors should look to Spain and Italy to observe the political difficulties both countries have in meeting the conditions that are attached to the ESM.
Tapan Datta is senior asset allocation specialist at Aon Hewitt