The debt crisis that has been bubbling up in Europe for over the last 18 months appears to now be reaching a boiling point.
On July 21st the Euro Group pledged to pass legislation to make their rescue fund, the European Financial Stability Facility (EFSF), more flexible, but we are now two months down the road and it is still to be ratified by all 17 national European governments. As we have previously stated, the original enhancements to the EFSF are inadequate to cope with the sizeable debt burdens of the periphery of Europe. As world leaders headed into last weekend's G20/IMF/World Bank meetings, Eurozone politicians were under increasing pressure to find a "Plan B" to get ahead of the curve in resolving the crisis. Initial indications are that the gravity of the situation is finally being accepted by Europe and that additional measures will be discussed. The possible "Plan B" that is being worked on appears to involve some combination of:
1) Interest rate cuts (remember the ECB have been hiking rates this year so unlike the Fed /MPC they have some room to ease).
2) Increasing liquidity through more six month Long-Term Refinancing Operation (LTRO) and possibly re-introducing 12 month LTROs.
3) Increasing the ECB Securities Markets Program by increasing the size of sovereign debt purchases or re-starting the covered bond purchase program.
4) Leveraging up the EFSF to increase its fire power.
5) Allowing a larger Greek haircut (50%), but recapitalising the European Banking system to prevent contagion.
However, what exactly will be done, and whether it will work is very difficult to predict and although we have seen a better tone to markets at the start of this week, we remain cautious as the implementation risk and possibility of disappointment remain high.
Outside of the Eurozone, the Federal Reserve instigated "Operation Twist" as expected which involved reinvesting its short dated US Treasuries into longer dated ones. This is intended to bring down bond yields across the curve. This is different to QE1 and QE2 which were designed to inject capital into the economy and raise inflation expectations and risk asset prices. It remains to be seen what the impact of this latest development will be, as risk appetite indicators are at panic levels and financial conditions indices continue to show tight conditions. We will monitor the situation closely to see if additional monetary easing will be required.
Finally, emerging markets which had been seen as a form of safe haven up until a couple of weeks ago, have now seen some significant underperformance of their currencies and increases in local bond yields, as crowded trades are being unwound. Our leading indicators in the emerging economies continue to point to a slowing in growth and the central banks are now appearing dovish. This view would have been considered as "losing credibility" only a couple of months ago, but highlighting the extent sentiment has changed, this is now considered to be "being pro-active".
Through this period of volatility, portfolio remain low in risk utilisation with slight overweights to areas where we see value, High Yield and Investment Grade corporates, while maintaining a long duration bias.
Iain Stealey, Portfolio Manager, Global Multi-Sector Income Strategy, at J.P. Morgan Asset Management.
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