Europe. |

12th September 2012

Ian Copelin, Investment Director, my wealth comments “Global equity markets rallied strongly last week after the President of the European Central Bank (ECB), Mario Draghi, said policy makers had agreed to a potentially unlimited bond purchase program, known as the Outright Monetary Transaction (OMT). The aim of the OMT is to reduce the borrowing costs of those indebted Eurozone countries, such as Spain and Italy, that are struggling to access to debt markets due to Euro-era record interest rates caused by default worries.

The ECB plans to target government bonds in the secondary market which have maturities within the next 1-3 years, which should put sufficient downward pressure on bond yields to help countries issue new debt at an affordable level to finance their deficits.

We reduced client exposure to Europe last week, having benefitted from an overweight position in Europe since 4 June 2012, when Mario Draghi pledged to preserve the Euro at all costs. Over this period the Stoxx 600 Index has gain around 16% and had an eleven week back-to-back gain (the longest winning streak since 2006).

While it was a brave step that the ECB took last week and markets were suitably impressed (yields on government bonds across Europe fell and equity markets rallied), we have to be mindful of the caveats, the unknowns and obvious traces of compromises that have gnawed at the currency union during the past 3 years, which include:

The ECB’s OMT is ‘fully sterilising’ the purchases. ‘Sterilising’ (or offsetting the purchases with sales of other ECB assets, means that the overall impact on the money supply will be neutral as the money in circulation is unchanged). This could make this bond purchase program no more effective than the ECB’s failed bond-purchase program of 2010/11, which also was offset by asset sales. Sterilisation helps the ECB distinguish its OMT plan from the QE (quantitative easing) programs of the Bank of England and the Federal Reserve in the US, which are explicitly aimed at supporting the money supply and is clearly bowing to pressure from Germany, which is anti the ECB expanding its balance sheet as they believe it could be inflationary;
The ECB announcement left a number of important blanks that need to be filled in, such as: the timing and size of the OMT; and whether the conditions would be palatable for countries such as Spain and Italy. However, we do know that ECB will only buy bonds issued by those nations that officially request aid and this aid will be tied to strict conditions from Europe’s government-led rescue facilities – the European Financial Stability Facility (EFSF) – which means more austerity in those nations. So far, Spain & Italy have avoided/resisted seeking aid, and with local elections in Spain on 21 October, it is obvious that the Spanish Prime Minster, Mariano Rajoy, will try playing for time (which could result in market uncertainty);
Although the ECB’s 22-1 vote in favour of the OMT appeared overwhelming, the dissenter was the head of Germany’s Bundesbank, Jens Weidmann. In addition, Germany has yet to ratify the €500 billion ESM treaty. The European Stability Mechanism (ESM) was designed to replace the EFSF which was set-up as a temporary vehicle to help debtor nations in 2010. In addition, later this week the German supreme court is due to rule on the constitutionality of the ESM. If Germany doesn’t participate, the ESM won’t be created and other bailout measures could be thrown into doubt.
The new Greek coalition government has so far failed to agree further spending cuts. A large proportion of the spending cuts proposed by the Greek government have not been accepted by the troika, which is pressing for public sector redundancies. The Eurozone ministers are expected to make a decision on the disbursement of Greece’s next loan tranche by 8 October 2012.

While we hope we are wrong and that the Eurozone issues are finally being addressed and resolved, we feel that European bourses have got slightly ahead of events and it is safer for our clients to hold less in Europe in the short-term.”