We do not believe that the recent weakness in Spanish bonds is the start of a new phase of the eurozone debt crisis nor likely to lead to a new leg down in equities and other risk assets.
A few weeks ago Italian Prime Minister Mario Monti said that the eurozone crisis was ‘almost over’. Shortly afterwards Spanish government bonds and to a lesser extent Italian government bonds sold off sharply. However, while Monti’s comments were overly optimistic with the debt crisis likely to last years, we think that the problems are largely contained within the affected countries and will not be an impediment to further equity gains.
In 2010 and 2011 weakness in peripheral bonds led to weakness in equities and a slowdown in the global economy. We think the impact is likely to be much less significant this time around, even if Spanish and other peripheral bonds weaken further. There are three main differences between the situation this year and last:
Ø The long term refinancing operation (LTRO) has greatly reduced the link between banking sector weakness and sovereign weakness. Banks (especially those in peripheral economies) are now likely to be fully funded until 2014/2015. The LTRO also shows the ECB’s commitment to ensure financial stability and support the eurozone.
Ø The European Financial Stability Facility (EFSF) has been expanded and along with the soon to be European Stability Mechanism (ESM) could provide substantially greater and more flexible support for sovereigns.
Ø The peripheral economies have taken steps to reform their economies and reduce their deficits: Italy, for example, plans to balance its budget by 2013. While these steps are incomplete and are perhaps less than is optimal, they are nevertheless a significant improvement on what was in place in 2010 & 2011.
The imbalances within the eurozone took years to create. Likewise, the rebalancing will also take years to complete and is made harder by the inability of the affected countries to devalue their currencies. The economic pain, along with the political and social problems this causes, is likely to continue for some time.
Germany and the rest of the eurozone could bring the crisis to a close now (through agreeing to the joint issuance of Eurobonds for example). However, Germany (rightly in our view) sees it as critical that new governance structures are in place before such measures are considered to ensure that the affected countries continue to reform. Without these reforms, Germany could find itself funding other parts of the eurozone for years to come without any effective exit route. These necessary changes will take years to implement.
In summary, the economic, political and social challenges facing some eurozone countries are likely to continue for years. They will remain a focal point for economists, politicians and historians. However, we think that unless you are directly investing in these countries, the significance of these problems is much more muted. With corporate profits continuing to rise, valuations favourable, interest rates low and investors generally underweight equities, we think the outlook for equities remains favourable.
Rupert Watson, Skandia Investment Group
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