Number three on our list of ten surprises for the coming decade (published in June) was:
The Eurozone survives and thrives amid new integration strategies spawned by the age of fiscal responsibility. But this is not before its weaker members survive near-death experiences. Debts of Greece, Portugal, Ireland and Spain are restructured in the first half of the decade, causing the banking system to recapitalize with help from the European Central Bank. By facing the debt crises head on, the Europeans adapt and change well ahead of the U.S.
We still believe this is the likely outcome. However, the process of getting there is turning out to be painfully slow. This should surprise no one who has ever tried to get a committee to decide anything, much less a committee of 17 governments!
Germany, who holds the title of most fiscally responsible in the Eurozone, is holding tight on the bailout reins, forcing two things to happen: (1) the weaker states to put in place meaningful fiscal reforms and (2) setting the stage for changes to the structure of the Eurozone that call for much tighter, centralized fiscal controls and strong penalties for non-compliance.
Even though the markets may be impatient, Angela Merkel’s strategy is working. Indeed, look no further than the fact that the heads of the governments of three weaker states – Greece, Spain and Italy – have all lost their jobs to fiscal conservatives who are supporters of the Eurozone policy trajectory.
Next up, expect focus on the structural changes at the summit this weekend.
These are all positive developments but there remains very difficult work ahead. Most importantly, the banking system will need to come clean about the valuations of banks’ sovereign debt holdings. (As will the rest of the bondholders in a forced restructuring for the worst credits and a significant write down on the others.) It is already abundantly clear that they will need recapitalization. TARP you say? Not so fast.
In the fall of 2008, the US was able to put TARP in place (about $800 billion) without any concern on the part of the markets about the creditworthiness of the US Treasury. In the Eurozone, no one’s credit is above reproach -- the recent downgrade by Standard & Poor’s just reinforced what markets already knew. Germany is the best but it doesn’t have nor does it want to offer the resources to bail out the entire European banking system. That means a delicate dance will need to take place around how to structure the debt that will ultimately recapitalize the banks. This will not be quick or easy.
After the fiscal reforms and tight centralized controls are put in place, then we will see how this recapitalization plays out. We think that some sort of Eurobond will be necessary but, with Germany in the lead once again, we expect the scope to be strictly limited to the “emergency” lending needed to recapitalize the banks. All members of the Eurozone will be expected to share in the burden but how the weakest members, already swimming in debt, do so will be a difficult puzzle to solve.
This process will grind on methodically over the coming year but it will move forward. The alternative – a breakout of the Eurozone and failure of the common currency – is not in anyone’s interest. Failure likely puts the entire region into depression – with no country emerging as a winner. While the grinding continues, Europe will likely be in recession (negative GDP growth) and those who export to Europe will see a significant slowdown.
From an investment perspective, we expect continued headline risk as good news is mixed with setbacks and delays. And, with a third of the world’s economy in recession, it will be very difficult for the other two thirds to grow strongly. Therefore, we will focus our efforts on finding investments that maximize exposure to growing markets and minimize exposure to Europe. Looking a year or two out, we could easily find ourselves swapping the US for Europe in this equation – as Europe deals with its problems now and we wait until after the 2012 elections before even beginning a discussion.