As Europe sorts out debt crisis, where can investors seek pockets of strength?

January 10, 2012

In what has surpassed even soccer as a continental pastime, investors are sitting on the sidelines of the European sovereign-debt crisis, watching politicians, central bankers and government economists battle over euro bonds, bailouts and other macroeconomic “bazookas.”

But as doomsday scenarios, talk of austerity measures and a flurry of policy outcomes are bandied about, investors on both sides of the pond are wondering: Where in the world do I put my money?

The answer for some is to look to the periphery of Europe — to economies that don’t use the euro or to public companies in the European Union that have a strong global presence and an unfairly discounted stock price. “The primary investment theme for Europe in 2012 will be to identify quality asset categories that have been sold off in the second half of 2011” because of the overall sentiment toward the E.U. economy, said Tsvetan Kintisheff, a Berlin-based research analyst who recently co-founded Alpha Leonis Advisors, a firm that focuses on Poland.

So what happened? “The crisis in the eurozone is a crisis emanating from a fundamentally flawed economic architecture — 17 countries pooled their monetary sovereignty but not much of their fiscal sovereignty,’’ economists at Nomura Global Economics wrote in December. “If there had been a fiscally ‘United States of the euro area,’ there would never have been a crisis in the first place.’’

The euro replaced the French franc, the German mark, the Italian lira and other currencies on Jan. 1, 2002. The idea for a common currency surfaced after World War II as a way to get once-warring nations to cooperate. By creating a monetary — but not fiscal — pact, the countries thought they would forge economic cooperation and preserve national independence.

Now, E.U. economic titans Germany and France are discovering that such a structure magnifies risk in individual member countries such as Greece, Italy and Spain “and then amplifies and transmits [that risk] to other countries in the eurozone,’’ the Nomura economists wrote.

Greece, for example, continued to roil the rest of the E.U. as the southern European country’s public debt rose to 160 percent of gross domestic product in 2010, putting it at the forefront of the world’s most indebted economies. The E.U. and its member states created two loan packages totaling roughly $280 billion in the past year and forced creditors to accept a 50 percent debt haircut, aimed at helping Greece reduce its debt-to-GDP ratio to 120 percent by 2020.

The economists at Nomura argue the long-term solution must involve easing the monetary union or strengthening the fiscal union. “The former means some degree of breakup of the euro,” they wrote. “It would go against the recent historic tide of increasing European integration, and it could wreak havoc in global financial markets.”

German Chancellor Angela Merkel and other euro-zone leaders appear fixed on the latter solution: increasing economic unity within Europe and central bankers’ control over member countries’ finances, particularly countries that appear to have mismanaged their economies. But getting there means countless meetings and political tangles between presidents, finance chiefs and central bankers. Already, the people of Italy, Greece and Spain have seen national leaders deposed and new technocrat governments installed that are implementing changes along the lines that E.U. and euro-zone leaders want.

In December, the European Central Bank offered $640 billion in three-year loans to European banks at a 1 percent interest rate. Many of the 500 banks with access to the mechanism will use it to buy European sovereign debt yielding interest of 6 to 7 percent, alleviating some liquidity concerns in Europe.

Separately, heads of state in Europe — 26 of the 27 members of the E.U., including all 17 countries that use the euro — issued a plan Dec. 9 that increases fiscal stability with a compact that enforces rules such as holding annual budget deficits to no more than 3 percent of GDP. The agreement moves the E.U. one step closer to a fiscal union. But “ratification of that step will be difficult — implementation even more so,” wrote Dirk van Dijk, chief equity strategist for Zacks.com.

Risks going forward

Many Wall Street economists are wary of European equities because the European Central Bank, unlike the U.S. Federal Reserve or Bank of England, does not have the authority to act as a lender of last resort. Further credit-rating downgrades of European sovereign debt and regional banks are in the works.

“Investors should be cautious toward European banking stocks,” said Altin Tirana, vice president of wealth management at Morgan Stanley Smith Barney. “Even if European policymakers manage to craft a debt plan that quells investor concerns, the data suggest that a European recession might have already begun.”

Some say the common currency could still break up in the first half of 2012. Several strategists put the risk of the euro breaking up at roughly 30 percent. But many experts say that would create a huge recession in Europe, giving rise to losses on par with the 2008 collapse of Lehman Brothers and rippling across the Atlantic to the United States and markets beyond.

Economists also worry, however, that keeping the euro and imposing fiscal policy changes could hurt short-term growth in weak economies such as Greece and Italy, increasing the chance of defaults.

Some of those states might also revolt. Already, Italy, Greece and others have seen riots in the streets. “The loss of democracy is not going to sit well with the people of Club Med,’’ van Dijk said, alluding to Spain, Italy and Greece, which are known for a relaxed lifestyle with generous public sector wages and retirement plans. Such countries, if they remain part of the euro, will undergo internal devaluations with higher unemployment, lower salaries and reduced standards of living.

Impact on markets

Assets under management at the more than 3,000 European hedge funds fell to $380 billion by November after crossing the $400 billion mark earlier in 2011, according to the Eurekahedge European Hedge Fund Index. “By mid-year, the sovereign debt situation came to the fore once again with investors becoming increasingly risk averse and preferring to hold on to their cash,” its analysts wrote.

Tirana said: “This past year has been a disappointing one for investors in European equities, with the ongoing sovereign-debt crisis acting as a considerable drag. Investors should remain cautious toward European markets.”

Strategists at Zacks estimate that a moderate euro-zone recession will create a GDP decline for up to three quarters and could create a drag on U.S. growth, as well as stocks. They say U.S. equities could fall 7 percent in the first quarter if the crisis reaches its darkest hour. But Zacks also predicts that clarity from Europe could result in a broad recovery, with stock indexes rising roughly 13 percent in the last three quarters of 2012 and 27 percent more in 2013.

Nomura Global Economics predicts a recessionary environment in Europe in 2012 even though it expects policymakers to keep the euro intact. If a breakup of the euro takes place, however, Nomura expects euro-area GDP to drop 6 percent, the United States to tip back into recession and Asia to feel a drag.

“The situation in Europe remains our key concern,” wrote Bob Doll, chief equity strategist for Fundamental Equities, and Peter Fisher, global head of fixed income at New York-based investment firm BlackRock, which has $3.34 trillion in assets under management. But they and other strategists say markets have overly discounted the downside economic risks, pricing them into some corporate stocks and creating the potential for a rebound.

Ken Taubes, chief U.S. investment officer for Pioneer Investment Management, said he is optimistic that the euro zone will stay together. “The downside of a breakup of the euro is too awful to consider,” he said.

Taubes said the European Central Bank is providing more liquidity than many people realize, which will move the crisis from a boiling, front-burner issuer “to a slow simmer on the back burner.”

Although investors should avoid risky European assets, Tirana said, “it might be unwise in the long term to completely avoid an entire asset class. Europe is home to a number of so-called global gorillas that investors should probably consider in this unsettled environment.” Such blue-chip companies as German automakers Daimler, BMW and Volkswagen or Swiss-based global food giant Nestle — like their U.S. counterparts such as McDonald’s, Coca-Cola and Apple — have strong brands with lots of exposure to fast-growing emerging markets.

Taubes said, “For a lot of these companies, life and business will go on, and I think they have been unfairly bruised.” His firm ranks European assets as underweight, but he has started looking for securities in the region worth buying.

Bullish on Poland

Financial advisers agree that emerging markets such as India, China, Brazil and even Poland remain a strong bet in the uncertain economy. Consulting firm McKinsey predicts that global financial assets will rise to $371 trillion by 2020, with 30 percent of that in emerging economies, up from 21 percent today.

Kintisheff said Poland’s stock market decline in the past six months was caused by “capital outflows as foreign investors moved to consolidate and cover their exposures in the face of uncertainty.” He thinks such fears were overdone.

“Poland has exhibited impressive resilience to the economic crisis ever since it first began in 2008,” he said. “Poland’s economy did not experience a single quarter of GDP contraction, which is unique among the Eastern Europe group of economies. The strong trend continues.”

Kintisheff points to Poland’s GDP expanding by a better-than-expected 4.2 percent in the third quarter of 2011, compared with a broader E.U. GDP growth rate of 0.2 percent. That’s driven, he said, by strong internal demand and a longer-term trend of growing affluence in the country’s young and rising middle class.

His firm does not yet have exposure to Poland or any exchange-traded funds. But he mentions two blue-chip, U.S.-traded Polish ETFs — the Market Vectors Poland ETF and the iShares MSCI Poland Investable Market Index Fund. He thinks Poland will lead any reversal in money flows in Europe during 2012 as investors “look beyond the economic head winds in the E.U. as a whole, and bottom-fish for opportunities in the next upturn.”

Glader is a financial journalist based in Berlin and edits WiredAcademic.

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