Continuing to Underweight Eurozone

Continuing to Underweight the Eurozone September 12, 2011, Bill Witherell, Chief Global Economist and Portfolio Manager

Global markets have endured yet another week of being buffeted by developments in Europe, with no resolution of the debt crisis in sight. With slowing global economic activity and depressed consumer confidence in the developed-market economies as a backdrop, any bad news from Europe has a sharp negative effect on global markets, while positive developments tend to be discounted. This certainly was the case last week, which ended with the euro at a seven-month low.  The iShares EFA ETF that tracks the benchmark MSCI EAFE Index for Advanced Markets ex North America declined 7.9% in the week and is down 16.3% year-to-date.  The iShares SPY ETF that tracks the S&P 500 lost 4.2% last week and is down 7.8% year-to-date. German markets were hit particularly hard, with the iShares Germany ETF, EWG, losing 12.7% last week alone and down 25.6% year-to-date. Recall that in the first half, the German equity market, along with those of France and Spain, outperformed most other advanced markets.

There were several important positive developments coming out of Germany last week. First, German industrial production for July was much stronger than expected. (Industrial production in France also registered a positive surprise.) Offsetting this good news, new orders for Germany declined in July. Also, Germany’s constitutional court issued a positive ruling on the legality of the Greek bailout and the European Financial Stability Facility, but also granted the Bundestag a role in approving further euro rescue moves. This ruling, while not unexpected, did remove one uncertainty about current euro rescue efforts.

Negative developments in Europe overwhelmed markets as the week came to a close. The resignation of Germany’s Jürgen Stark from the Executive Board of the European Central Bank (ECB) shocked markets and Germany’s political system on Friday. Stark was the remaining conservative German Bundesbank veteran in the ECB’s governing council and the ECB’s top economist. He is among the very best central bankers, and his counsel will surely be missed.  Last February the Bundesbank President, Axel Weber, resigned after a dispute about ECB policy, which also appears to be the motivation behind Stark’s departure. Both are concerned that the ECB has moved beyond its monetary policy mandate into fiscal policy, supporting government budgets and thereby undermining the central bank’s independence. The German government moved quickly with an attempt to shore up market confidence by nominating, as a replacement to Stark, Jörg Asmussen, currently number two in the German Finance Ministry. They clearly have chosen a highly qualified replacement. Nevertheless, there are concerns within Germany and in financial markets that Stark’s departure represents the end of the close relationship between the ECB and the strict monetary policy principles that have characterized the German Bundesbank. A weakening of German political support for the ECB would hamper future efforts to address the Eurozone debt crisis.

The other negative development was a standoff between the Greek government and its major international lenders (the “troika” of the International Monetary Fund, the European Union, and the European Central Bank [ECB]), which threatened to result in a Greek default. Fears of such an outcome roiled markets at week-end. The Greeks did move over the weekend, announcing a new two-year property tax that should raise $2.7 billion this year.  This will close a foreseen budget gap that had to be closed in order for the international lenders to continue to disperse bailout payments.  This development probably means that the next payment tranche will be approved when the “troika” meets in Athens this week.  Meanwhile we have the German Economics Minister stating that “all possibilities should be on the table to stabilize the euro” and that “this includes an orderly default of Greece if the instruments are available.” 

Our greatest concern remains the health of the Eurozone’s banking system.  A recent study of bank coverage ratios by Ned Davis Research indicated that “most European banks failed to have adequate provisioning against known bad loans.” Note the term “known.” Exposure to the sovereign credits of the troubled Eurozone members would be an additional concern. Meanwhile European banks are facing a serious funding problem. The Financial Times reports that “The cost for European banks to swap euros into US dollars has jumped fivefold since June.”  The impact has been greatest for French banks that rely heavily on the interbank markets for funding.  Also, Moody’s in June placed major French banks “on review” for possible downgrading, and a decision is due by Thursday.  It is interesting that the Ned Davis Research study cited above found that French (and Austrian) banks were among the best with respect to reserve coverage of known bad loans.  In Germany, the Finance Ministry is understood to be reviewing how it would recapitalize the German banking system should there be a Greek default.

In short, the Eurozone debt drama continues to unfold. The prospect is for more global market volatility arising out of Europe. We see no reason to change our underweight positions for the Eurozone in our international and global portfolios.

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