After a year of political indecision in both Europe and the United States, the 2012 is shaping up as a year for decision-making, according to Dexia Management report.
It all started in 2010, when a country whose GDP amounted to less than 3% of European GDP triggered a major systemic government-debt crisis that even called into question the existence of the European political project. With one crisis following hot on the heels of another (Greece … Ireland … Portugal) in 2010, two other major dominoes – Italy and Spain – toppled in 2011. The several European summits were aimed at curbing market speculation by trying, on the one hand, to reduce the deficits and, on the other, to impose a certain degree of financial solidarity. Even if these last-chance-saloon summits managed to prevent bankruptcy becoming more widespread in Europe, their stick-and-carrot strategy ended up generating a whole series of vague and dangerous concepts, voluntary Private Sector Involvement (PSI) is a prime example. Implemented as a means of sustaining Greek debt while penalising private investors, PSI was to be applied to all countries in receipt of supranational aid. The idea of a more widespread application of PSI was eventually consigned to the dustbin due to the dangerous jurisprudence issues that such a measure might have engendered. The seniority of the European Stability Mechanism (ESM) is another telling example of misguided European ways. Popular in March 2011 as a means of protecting virtuous countries, the ESM, which merely accelerated the contagion by weakening the debt of the countries being drip-fed, financing, was eventually discarded for good.
What grounds, therefore, do we have for hoping for a resolution of the European crisis in 2012 when confronted with such political turnarounds? Funnily enough, the uncertainties of last year could be the start of the solution. In the first place, because some of the toxic ideas rose in 2011 have been left for dead (reassuring … as long as they do not resuscitate). Next, because of the significant progress made in 2011, in particular in relation to the subtle, unorthodox reaction from the European Central Bank. As per usual, the ECB pulled off a surprise by purchasing more than 200 billion Euros’ worth of sovereign debt and, in so doing, staving off disaster. As there is good reason to believe that it will, if necessary, keep doing so, and do not be surprised to see its balance sheet exceed the 500 billion mark in 2012. Weak growth in 2012 will make it more difficult for States to reduce their debt. This will, nonetheless, be far from “Mission: impossible” if the Europeans manage to reassert their credibility. If the central bank proves itself in one way or another a lender of last resort and if the European States make some headway in the institutional solidarity process, investors will undoubtedly revert to the debt of countries with a healthy solvency margin.
In the United States, 2012 is also election year – one in which the budget will be a highly influential factor. Even though the FED will undoubtedly do it’s utmost to support the economy and lower long rates, any decision to remain on the path of fiscal profligacy, deferring fiscal support mechanisms, will adversely affect treasury bonds, which, traditionally, are very expensive in a recovering economic environment.
“As we go into 2012, the fixed-income investor is caught in two minds: European binary choice … or the US alternative,” Nicolas Forest, head of interest-rate strategy at Dexia Asset Management, said.
The choices made will have to be based on a highly selective approach, even in the case of AAA-rated countries. While awaiting some straight answers to these questions, investors could do worse than keep an eye on the emerging countries. Even though ongoing global imbalances are accelerating further, the good health of the developing nations is a constant window of opportunity.
In spite of the turbulence within the EMU, the euro, in 2011, ended up depreciating relatively little in comparison with its partners (-1.5% only, in terms of the real trade-weighted exchange rate); regardless, the decline will almost certainly continue throughout 2012. The collapse of the euro will remain on people’s minds, even if we are sure that European governments be will do their utmost to avoid such a fate, which would be to no one’s benefit.
We find the well sought safe-haven currencies (the Japanese yen, the Swiss franc) already pretty expensive, given the appreciation tendency already noted in 2011 and the authorities’ wish to end the trend. As a consequence, the American dollar is the currency that gets our vote. It has better appreciation possibilities than the euro, thanks to better US-growth outlook, interest-rate differentials that should evolve in its favour, a currently cheap valuation and, in particular, a euro which will probably suffer owing to (a) investor mistrust of European growth, (b) the sustainability of the debt and (c) internal EMU imbalances. Against this background, we believe that the euro/dollar level will drop to 1.20 in the course of 2012 and that the dollar is a worthwhile diversification investment for this year.
In 2011, the acceleration of the sovereign crisis and the revision of growth outlook proved detrimental to credit. This was the second-worst performance in the past ten years: 4.7% down on German sovereign debt. The risk premium widened by 161 basis points, rising to 382 bps, the result of an almost perfect correlation with the sovereign debts for, on the one hand, companies in weakened countries and, on the other, the European financial sector, which is still in the eye of the storm.
When it last stress-tested the European banking sector (October 2011), the EBA demanded that equity capital in the strict sense of the word be urgently raised to 9% between now and June 2012 – a positive factor for holders of senior secured debt. Capital increases for banks should, as a matter of priority, make use of private resources (internal capital generation, buy-back of subordinate debt, equity issues, …) before reaching out to the States.
Stricter regulations and economic outlooks are leading to a deleveraging of the banking system. For three months now, the European banks have been seriously tightening their credit standards, as the threat of a credit crunch and its macroeconomic consequences are worrying the authorities. The ECB’s exceptional liquidity measures should help cushion this phenomenon and oxygenate the sector, which is facing major refinancing levels in 2012 (around €250 billion in Q1). But, we do not think that much of the funds borrowed from the ECB will be put to the purchase of sovereign loans, still considered risky assets by bankers.
Fiscal austerity will usher Europe into a minor recession in 2012, one that has been largely anticipated in Non-financials’ spreads (246 bps), which also include illiquidity premiums. In the course of the next twelve months, we foresee a slight deterioration in the sector’s debt ratio, to 2.37, which is, nonetheless, below the 2.82 suggested by the current spread level, and will have no unforeseen consequences for the quality of the credit, given that fiscal prudence will remain a prime feature in 2012.
“There will be sunshine after the rain and, even if financial market volatility continues until a viable solution is found to the sovereign crisis, current spread levels provide an attractive valuation”, Koen Van de Maele, head of fixed income management at Dexia Asset Management, said.
The breakeven of the 12-month senior banking spread at 120 hints at an outperformance of credit in the year to come. In addition, once risk aversion has eased technical factors such as negative debt supply and cash available to investors will support the asset class.
After a prudent start , we will be ready and willing, in the upcoming months to seize any opportunities that come our way by constructing a more specific exposure to credit. “We are opting for issues of senior bank debt (because of their attractive valuation), covered issues (because of their defensive nature), debt of peripheral non-financial companies (Telefonica, Iberdrola, Enel, … because of their geographical and/or operational diversity) and BBB-rated non-financials (Pemex, Veolia, Vale, … because of their credit quality). We are, nonetheless, underweighting highly cyclical issuers and subordinated financial debt”, were Koen Van de Maele’s closing words