After a meeting in Brussels on Wednesday, the heads of all 27 EU states have called for the creation of medium-term bank guarantees to avoid another credit crisis. The leaders agreed to a 50% writedown for private bondholder on their Greek debt and called for more coordination among European institutions. Speaking after the summit, French President Nicolas Sarkozy said the region’s rescue fund would be leveraged ‘four of five times’.
Despite the vagueness of such a plan, investors around the globe have cheered the leaders’ actions, with markets in Asia rallying Thursday morning and European indices picking up the baton and running on average 2%-4% higher at the time of writing.
The reaction is bound to be a knee-jerk one. After months of inactivity Europe’s leaders are finally showing an increased level of coordination and a resolution to address the region’s debt problems rather than continue to kick the can down the road. It appears that Merkel, Sarkozy et al have finally decided to notice that the can is now so severely distorted that, as one Morningstar.co.uk reader recently pointed out, “soon it will be difficult to accurately kick it anywhere”.
Clearly whether Thursday’s rally is sustainable remains to be seen. Given that Wednesday’s summit and resultant decisions are merely the start of a long and arduous process, it appears that the FTSE’s performance is no less fragile than it was 24 hours ago and, similarly, Italy’s 120% debt-to-GDP ratio, for example, is no easier to manage than it was 24 hours ago.
“Europe is destined for a multi-year workout,” commented Dominic Rossi, Global CIO of Equities at Fidelity Worldwide Investment, adding that during this time “economic growth will be very restrained and equities will remain cheap.”
Rossi welcomed the recapitalising of Europe’s banks as a step in the right direction and noted that, though the impact on growth in the short term will be a negative as the deleveraging process continues, a better capitalised banking system “has got to be good in the long term.” But he also pointed to the lack of detail surrounding proposals to leverage the EFSF ‘four or five’ times. “Unless the fund has a sound equity base I think it is a heroic piece of financial alchemy,” Rossi said.
Gary Jenkins, head of fixed income at Evolution Securities, also has questions that remain to be answered regarding the EFSF leverage, such as whether it will work in giving private investors confidence to invest in struggling sovereign markets. “The true success of the agreement will be seen in Italian bond yields six months down the line rather than from the sugar-rush reaction we might see today,” he commented.
Fidelity’s Rossi added that the Greek write-down sets a watermark for other European countries and asked how Italy looks on this basis. “The eye of the storm will now move to Rome and its fragile government,” he said, “I don't think yields on Italian debt will fall on the back of this agreement for long.”
The real test of whether this EFSF leverage works will become apparent once the ECB stops supporting the market via purchases of Italian bonds and it is left to investors to pick up the slack, pointed out Jenkins at Evolution.
The consensus appears to be that while progress has clearly been made this is merely the start. A lack of detail leaves many questions unanswered but, as described by GAIN Capital research director Kathleen Brooks, we now “have the broad brush strokes in place to provide a financial back stop, which has been so sorely missed from the currency bloc in recent years.”
Markets famously—or, rather, infamously—hate uncertainty, and the apparent decisive action, no matter how vague, is today being celebrated in trading, but performance is likely to continue to track each political and economic event, reminding us that for the long-term investor ear plugs can be a welcome intervention against the day-to-day market noise.
