Eurozone Crisis Report Card

Ryan DresselRyan Dressel, Investment Analyst, Brinker Capital

In January 2013 Amy Magnotta wrote in detail about how the actions of the European Central Bank (ECB) finally gave the markets confidence that policy makers could get their sovereign debt problems under control.[1] The purpose of this blog is to measure the progress of the ECB’s actions, as well as other critical steps taken to resolve the Eurozone crisis.

Maintaining the Euro: A+
The markets put a lot of faith in the comments made by the head of the ECB Mario Draghi in July, 2012. Draghi stated that he would “Pledge to do whatever it takes to preserve the euro.” These words have proven to be monumental in preserving the euro as a currency. Following his announcement, the ECB still had to put together a plan that would be approved by the ECB’s governing council (comprised of banking representatives from each of the 18 EU countries)[2]. The politics of the approval essentially boiled down to whether or not each council member supported the euro as a currency. Draghi’s plan ultimately passed when Germany’s Chancellor, Angela Merkel, endorsed it in September 2012.[3] The stabilization of the euro boosted lending and borrowing for European banks, and allowed governments to introduce necessary economic reforms outlined in the plan.

Since the plan was approved, the euro’s value versus the U.S. Dollar has continued to rise; reaching levels last seen in 2011. There is still some debate as to whether or not the currency will last over the long term, but for now its stability has helped avoid the worst possible outcome (financial collapse). There are several key elections coming up over the next month, which could renew the threat of breaking up the currency if anti-EU officials are elected.

Government Deficit Levels: B
The average Eurozone government deficit came in at 3.0% in 2013, which was down from 3.7% in 2012. Budgets will need to remain tight for years to come.

Corporate Earnings: B
The MSCI Europe All Cap Index has returned 27.46% in 2013 and 5.01% so far in 2014 (as of last week). The Euro area also recorded first quarter 2014 GDP growth at +0.2% (-1.2% in Q1 2013).[4] This indicates that companies in Europe have established some positive earnings growth since the peak of the crisis. On a global scale, Europe looks like an attractive market for growth.

Dressel_EuroZone_ReportCard_5.30.14

Unemployment: C
Unemployment in the Eurozone has stabilized, but has not improved significantly enough to overcome its structural problems. The best improvements have come out of Spain, Ireland and Portugal due to a variety of reasons. In Ireland, emigration has helped reduce jobless claims while a majority of economic sectors increased employment growth. In Spain, the increased competitiveness in the manufacturing sector has been a large contributor. Portugal has seen a broad reduction in unemployment stemming from the strict labor reforms mandated by the ECB in exchange for bailout packages. These reforms are increasing worker hours, cutting overtime payments, reducing holidays, and giving companies the ability to replace poorly performing employees.[5]

Dressel_EuroZone_ReportCard_5.30.14_1[6]

There are also some important fundamental factors detracting from the overall labor market recovery. The large divide between temporary workers and permanent workers in many Eurozone countries has made labor markets especially difficult to reform. This is likely due to a mismatch of skills between employers and workers. High employment taxes and conservative decision-making by local governments and corporations have also created challenges for the recovery.

Additional Reading: Euro Area Labor Markets

Debt Levels: D
Total accumulated public debt in the Eurozone has actually gotten worse since the ECB’s plan was introduced. In 2013 it was 92.6% of gross domestic product, up from 90.7% in 2012. The stated European Union limit is 60%, which reflects the extremely high amount of government borrowing required to stabilize their economies.

Overall Recovery Progress: B-
On a positive note, governments are finally able to participate in bond markets without the fear of bankruptcy looming. Banks are lending again. Unemployment appears to have peaked and political officials recognize the importance of improving economic progress.

Unlike the 2008 U.S. recovery however, progress is noticeably slower. The social unrest, slow decision making, low confidence levels, and now geopolitical risks in Ukraine have hampered the recovery. When you consider the financial state of Europe less than two years ago, you have to give the ECB, and Europe in general, some credit. Things are slowly heading in the right direction.

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

[1] January 4, 2013. “Is Europe on the Mend?” http://blog.brinkercapital.com/2013/01/04/is-europe-on-the-mend/
[2]
European Central Bank. http://www.ecb.europa.eu/ecb/orga/decisions/govc/html/index.en.html
[3] September 6, 2012. “Technical features of Outright Monetary Transactions. European Central Bank.” http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html
[4] Eurostat
[5] August 6, 2012. “Portugal Enforces Labour Reforms but More Demanded.” http://www.wsws.org/en/articles/2012/08/port-a06.html
[6] Eurostat (provided by Google Public Data)

Trouble in the Mediterranean

Joe PreisserJoe Preisser, Investment Strategist, Brinker Capital

Blue-chip stocks listed in the United States stumbled on their quest to reclaim the historic heights they recently attained, as a renewal of concerns from the European continent served to unsettle investors. Proverbial wisdom contends that markets will climb a, “wall of worry”, and this statement has rung particularly true this year as the Dow Jones Industrial Average has marched steadily higher amid a torrent of potential pitfalls. Up until this week, market participants have largely disregarded the political gridlock ensnaring Washington, D.C. and the possibility of a resurgence of the European sovereign debt crisis, instead clamoring for risk assets, and in so doing, have driven stocks into record territory. The current rally has, however, paused for the moment with the increased possibility that Cyprus may become the first member of the Eurozone to exit the currency union, once again casting the shadow of doubt across the Mediterranean Sea and onto the sustainability of this collection of countries.

A decision rendered by leaders of the European Union last weekend—to attempt to impose a tax on bank deposits within the nation of Cyprus in exchange for the release of rescue funds the country desperately needs—sent tremors through global financial markets. Although the Cypriot population stands at slightly more than one million citizens, making it one of the smallest countries in the Eurozone, the repercussions of this decision were felt across continents. Policy makers representing the nations of their monetary union hastily gathered to decide what conditions would need to be met in order to disperse the necessary financial aid to Cyprus, totaling ten billion euros, and in so doing, made a significant policy error. According to The New York Times on March 19, “Under the terms of Cyprus’ bailout, the government must raise 5.8 billion euros by levying a one-time tax of 9.9 percent on depositors with balances of more than 100,000 euros. Those with balances below that threshold would pay 6.75 percent, an asset tax that would still hit pensioners and the lowest -income earners hard.” Although the intentions of the European leaders making this decision were to target large foreign depositors, who have historically used the country’s banks as a tax haven, the proposed inclusion of those on the lower end of the spectrum has created widespread uncertainty.

EurosThe imposition of a tax on deposits that would include those of 100,000 euros and less, which had been guaranteed by insurance provided by the European Union, has created concerns over the stability of the banking system in Cyprus and by extension, that of the Eurozone in its entirety. By negating the very guarantee that had been put in place to strengthen this vital portion of the Eurozone’s financial system, policy makers have increased the risk that large scale withdrawals will be taken across Cyprus, which is exactly the type of situation they had hoped to avoid. The New York Times quoted Andreas Andreou, a 26-year-old employee of a Cypriot trading company, who gave voice to the feelings of the populace when he said, “How can I trust any bank in the Eurozone after this decision? I’m lifting all my deposits as soon as the banks open. I’d rather put the money in my mattress.” In order to forestall such an event, and protect against the possibility of contagion to the other heavily indebted members of the currency union, the country’s banks have been shuttered and are scheduled to remain so until Tuesday.

Uncertainty continues to swirl in the warm Mediterranean air as the Cypriot Parliament on Wednesday rejected the original terms of the bailout, casting the nation’s leaders into direct conflict with those of the European Union. With the deadline for
the country to propose a viable plan to raise the requisite 5.8 billion euros,
set by the Continent’s Central Bank for Monday, fast approaching, the stakes of
this game of brinksmanship have been raised, as the possibility of the country
leaving the euro zone has been broached. Eric Dor, a French economist who is the head of research at the Iéseg School of Management in Lille, France offered his opinion on the rationale of Europe’s leaders in The New York Times on Thursday, “They are saying we can take the risk of pushing Cyprus out of the Eurozone, and that Europe can take the losses without going broke.” Although the raising of the possibility of Cyprus being expelled from the monetary union, is most likely a negotiating tactic designed to goad Cypriot leaders into adopting the reforms the E.U. has deemed necessary, with the more likely outcome of a compromise being reached, the current impasse serves as a reminder of the difficulties facing the Continent as it continues its unprecedented experiment in democracy.

A Tale of Two Currencies

Joe PreisserJoe Preisser, Brinker Capital

As the global marketplace continues to recover from the worst financial crisis since the Great Depression, two of the world’s major currencies, the yen and the euro, have embarked on remarkably different paths of late in a reflection of the efforts of the Central Bank’s, which guard the levers of these economies, to achieve growth and stability. The responses of the nations ‘ respective policy makers has led directly to a steep decline in the value of the Japanese Yen, while the European continent has seen its common medium of exchange rise to heights unreached since 2011. Although the nature of the challenges facing what are two of the largest economies in the world differ significantly, the efficacy of the monetary policies employed to combat them will have a profound effect on markets across the globe.

In Japan, newly elected Prime Minister, Shinzo Abe, has grabbed headlines after only a few weeks in office, through his advocacy of aggressive measures designed to foster growth within a nation that has been mired in stagnation. Dubbed “Abenomics”, the plan is a multifaceted approach to economic stimulus whose centerpiece is a desire to devalue the nation’s currency, in an effort to support its exporters by rendering the goods and services they provide less expensive on the world stage. According to the Wall Street Journal, on February 6th, “Analysts at Goldman Sachs Inc. estimate that for every 10 yen the currency weakens against the dollar, profits of exporters would rise by 7% to 10%.” Mr. Abe has professed his aim to achieve this through a controversial limiting of a measure of the Bank of Japan’s (BOJ) autonomy in an effort to effectively force the reflation of the economy through a program of unlimited monetary easing and large scale stimulus. In addition, the Prime Minister has pledged to fill the recently vacated position at the helm of the BOJ with an appointee who shares his commitment to revitalizing the country’s economy through all available means (The Economist, Jan 26th). The efforts undertaken thus far, combined with Mr. Abe’s emphatically-stated focus on combatting the deflation that has plagued Japan for more than a decade, have resulted in a sharp fall in the value of the yen, and a steep rise in equity prices listed on the nation’s exchange, which should be sustained as long as this endeavor proves successful. “The Nikkei has surged 32% since mid-November…The yen has declined 14% against the dollar over the same period…The gains in Tokyo have made Japan the world’s best-performing major stock market over the past three months ”(The Wall Street Journal, February 6th).2.8.13_Preisser_Currencies

On the Continent, the nearly four-year-old struggle to maintain its union in the face of a perilous debt crisis that threatened the world economy, has led to an unprecedented effort by the European Central Bank (ECB) to support the common currency. The fear of a possible dissolution of this unique collection of countries led directly to the widespread selling of the euro, as well as large scale liquidations of bonds issued by its sovereign members. As the cost of repaying the debt of a host of the European Union’s members rose to unsustainable levels the President of the ECB, Mario Draghi elected to act pledging to do, “whatever it takes to preserve the euro”(Bloomberg News July 26,2012). This statement manifested itself in a series of massive sovereign debt purchases by The Central Bank in September of 2012 which was dubbed, “Outright Monetary Transactions.” Mr. Draghi’s effort brought stability back to the euro-zone, and as a result led to an appreciation of its currency. As investors have become more confident that the worst of the crisis has been averted, the euro has risen further, and is now back to levels untested in two years. The sequence of events on the Continent stands in stark contrast to those in Japan, as Europe’s exporters have seen the cost of their products increase, thus making it more difficult for them to compete in the global marketplace. The threat that this state of affairs poses to the recovery of the region’s economy is such that it was directly and repeatedly addressed by Mr. Draghi this week during a press conference in which he suggested that the Central Bank may take steps to counter the effects of the currency’s rise. The ECB President was quoted by Bloomberg News as saying on Feb 7th, “The exchange rate is not a policy target, but it is important for growth and price stability…We want to see if the appreciation is sustained, and if it alters our assessment of the risks to price stability.”

The historic measures undertaken by both the European Central Bank, and the Bank of Japan in the interest of maintaining stability and fostering growth have thus far been largely successful, however it will be the ongoing maintenance of the consequences of this success that will ultimately determine the fate of these economies.

Is Europe on the Mend?

Magnotta@AmyLMagnotta, CFA, Brinker Capital

We have spent so much time focusing on the U.S. fiscal cliff that the concerns regarding Europe seemed to have been pushed to the sideline. On the positive side there has been progress in Europe. Mario Draghi, head of the European Central Bank, can take some credit for the progress. The Financial Times even named him their Person of the Year.

The €1 trillion Long-Term Refinancing Operation (LTRO) put in place in late 2011 helped fund the banking system. In July, Draghi pledged to “do whatever it takes to preserve the euro.” His words were followed up by the ECB’s open-ended sovereign bond buying program called Outright Money Transactions (OMTs) designed to keep yields on Eurozone sovereign bonds in check. The next step could be establishing the ECB as the direct supervisor of the region’s banks.

Source: FactSet

Source: FactSet

These actions have brought down borrowing costs for problem countries such as Italy and Spain, helping to change the trajectory of the crisis and prevent an economic collapse. Yields on 10-Year Italian and Spanish bonds have fallen over 200 basis points to 4.4% and 5.2%, respectively. The Euro has also strengthened versus the U.S. dollar since July, from a low of 1.21 $/€ to 1.32 $/€ today.

Source: FactSet

Source: FactSet

I wonder how long this lull in volatility in the region can continue in the face of a weak growth in the region. Seven Eurozone countries fell into recession in 2012 — Greece, Portugal, Italy, Spain, Cyprus, Slovenia and Finland. The Greek economy experienced its 17th consecutive quarter of contraction, while Portugal completed its second year of recession. There remains a stark difference in the economic performance of Germany and the rest of the Eurozone. Unemployment rates are at very high levels and continue to increase. Youth unemployment is above 50% in both Greece and Spain, a recipe for social unrest.

The ECB’s actions have bought time for the Eurozone economies to get their sovereign debt problems under control. However, continued austerity measures implemented in an attempt to repair the debt crisis have only served to further weaken growth in the region and exacerbate the situation by pushing debt to GDP ratios even higher. While some confidence has been restored to the markets, policymakers should attempt to implement more pro-growth measures to pull the region out of recession.

12.28.12_Magnotta_Europe_ChartCombo

Europe’s equity markets have rebounded nicely in 2012, leading global equity markets on a relative basis since the second quarter; the rally helped by the ECB’s actions. I remain concerned that the ECB’s measures, while improving confidence, do not address the underlying problems of weak to negative economic growth combined with deleveraging. Weak growth in the region should weigh on corporate earnings and keep a ceiling on equity valuations. The deleveraging process takes years to work through. Because the situation remains fragile, we are likely still prone to event risk and periods of increased volatility in the region.

Source: FactSet

Source: FactSet