While the recent European Union summit wasn’t the hoped for ‘mother of all summits’ but it did provide a clearer framework for a solution, according to the BlackRock Investment Institute’s commentary titled what’s next for the Eurozone.
“The high drama and furious pace of developments in the European debt crisis have not let up. However, there’s a lot that can go wrong in the future and many questions remain,” it added.
“Sometimes the stuff that gets the least notice turns out to be the most important. The ECB’s extraordinary actions to secure funding access for European banks are a case in point.
“Crucially, they reduce the risk of a bank liquidity crisis that would spread around the world. Secondly, they enable national governments to push their banks harder to buy their government debt. We believe that breaking the buyers’ strike is a key to getting yield spikes under control.
“In the near term, the crisis is mostly about the ability to roll over debt, not about the ability to pay. Countries such as Italy will suffer higher rates, which they can afford. That will be tough. But it’s not nearly as bad as suffering a loss of market access, which nobody can afford.
“Don’t get us wrong: Rolling over the mountain of debt that comes due early next year is a huge challenge. Eurozone governments need to refinance a staggering euro 519 billion in the first half alone and European banks have a similar amount of debt coming due in that same period.
“European banks need to raise an additional 115 billion euros to close capital shortfalls, according to the European Banking Authority. That likely means more shedding of risk assets, raising the odds for some markets to lock up again and prolonging a European recession.
“The agreed-upon rules to enforce fiscal discipline still need parliamentary fiats and in some cases approval by referendum. That means more market volatility ahead. There should be plenty of opportunity – and a real need – to learn about the inner workings of parliamentary and election procedures in previously off-the-radar countries such as Finland.
“Expect political considerations to trump economics. The high drama that had the UK back out of the summit accord had its roots in domestic politics. For all the soul searching, we see little impact for UK asset prices in the short term beyond a slightly weaker currency helping exporters.
“Politics matter more than ever, especially with elections coming up in key European countries such as France, Finland and Greece next year. A finance degree alone is not good enough to anticipate risk and exploit opportunities in this climate.
“Ratings agencies are also focused on politics, and have held out the prospect of mass downgrades of eurozone debt. The downgrades are likely to come sooner rather than later, but we believe bond markets have largely factored them in for countries such as France, Italy and Spain. The yield spreads between their sovereign debt and benchmark German bunds have widened significantly this year.
“Traditional ratings are important, but their influence will likely to decrease over time as investors look beyond the ratings agencies’ ‘ABCs’ to focus on the economic, fiscal and political prospects of the issuers.
The BlackRock Sovereign Risk Index, for example, already ranks nine issuers ahead of Germany, including South Korea and Chile.
“A big worry is the prospect of a European recession, especially a deep and long one. It’s very clear that European companies have started to defer capital spending and stopped hiring. We now believe that we’re in for a full-fledged recession, including one in France and Germany that could cut GDP by 1% to 2%.
“Short-term austerity measures could worsen the recession, defeating their very purpose of closing budget gaps. Subsequent declines in tax revenues and more spending on unemployment benefits would enlarge government deficits.
“Don’t be fooled: The Merkozy plan to reduce deficits will not work unless economic growth returns. That means European companies need to improve productivity faster than the rest of the world to gain export share. That’s a multi-year task. Much of Europe has deep-seated productivity problems that need urgent fixing.
“Future interest rate cuts by the ECB and other monetary easing – which we think are likely because inflation should abate – are unlikely to offset the effects of the downturn. The silver lining is that the euro would likely weaken, boosting exports.
“What does this mean for European equities? There’s no question they are cheap: Eurozone companies trade at 8.7 times 2012 earnings while pan-European stocks (including UK equities) trade at 9.3 times expected earnings. That’s at the bottom end of our 35-year range.
“The problem is that euro stocks are cheap for a reason. Analysts have ratcheted down 2012 profit forecasts for European companies, but are still too optimistic. Consensus estimates have European companies increasing profits about 10% next year, whereas we think a decline of 5% is more likely. We expect to see a slew of profit warnings in the upcoming fourth-quarter reporting season.
“While euro stocks look to be great buys by historical standards, we’re cautious. We focus on companies with strong balance sheets. We believe in “self-help stories,” companies that can withstand a recession or worse. We prefer recession-proof sectors such as healthcare and food & beverage. And we like companies that derive a large proportion of sales and earnings from emerging markets.
“There are fantastic values to be found for long-term investors … but expect choppy times ahead for now,” it added.