Credit openings emerge amid European muddle

From Asset Allocation / Fixed Income 29 June 2012

By Elliot Smither

The consequences of an unmanaged Greek exit from the euro would be so severe that central banks should continue to support the currency, creating attractive opportunities for credit strategies, according to fixed income specialists ECM

Ongoing problems in the eurozone – which see governments struggling to balance austerity measures with promoting growth, while the banking sector adjusts to changing regulation – could throw up some interesting opportunities for credit strategies.

“The problems in Europe are coming in ebbs and flows,” says Satish Pulle, lead portfolio manager for financials at European Credit Management Limited. The London-based firm specialises in European fixed income, and currently manages approximately $9.5bn (E7.5bn) of assets.

“One day it is Greece, the next Spain, Italy or Ireland. But we think that if you stand back from the day to day issues, one of the major factors that we find quite positive about what is happening in Europe, is that the ECB (European Central Bank) has many bullets left.”

While the ECB has been providing substantial support, it has not been on the same magnitude as the other central banks such as the Federal Reserve in the US and the Bank of England, explains Mr Pulle.

“While we worry a lot about the troubles in Europe and compare it with the relatively easy ride that the US seems to be having, part of that is because the Fed has already fired a lot of their bullets.”

The kind of integration that exists in Europe is much more important than the kind that doesn’t, says Mr Pulle. “Whether we like it or not we don’t have fiscal union, but we do have central bank union. The Dutch, Luxembourg and German central banks have together lent close to €700bn to the euro system, and most of the other central banks have borrowed that money. So we have central bank union, and this is more important than fiscal union.”

The close-run Greek election, which saw a vistory for the pro-austerity parties, failed to calm fears over the eurozone’s future, but Mr Pulle believes that some kind of “muddle-through” is still the likeliest outcome.

“The losses to the other European countries from an unmanaged exit of Greece from the euro would be so substantial that we feel some kind of muddle-through agreement will be reached. One example from Nomura (see chart) puts the losses to Germany at €70.3bn after a 75 per cent haircut on Greek debt, which on the one hand is disconcerting, but on the other will drive the next level of fiscal support.”

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Mr Pulle believes that if a lot of the reforms that are being suggested were adopted there could be a boost to growth in almost all European countries. He points to the low rankings of Spain and Italy in ease of doing business reports.

“The bang for the buck in terms of reform is very, very high in Italy and Spain, but they were never going to do it until they were in a crisis like this. But once they start doing these kinds of reforms then we think that the impact could be substantial. Everyone is applauding Germany for having a very good economy, but Germany went through a long period of reconstruction under Gerhard Schröder, who paid the price for doing all of that, while Merkel is reaping the benefit.”

If ECM was really bullish about financials they would aim to allocate about $2bn to the sector, but this figure currently sits at around half that sum. Yet Robert Montague, senior investment analyst for financials, at ECM, does see some positive signals.

“We expect extensive sector restructuring over the next five years as banks try to deal with the sins of the past and increased regulation,” he explains.

“Having said that, banks’ financial fundamentals are improving, they are delevaraging and desrisking their balance sheets, they have improved liquidity immeasurably over the last few years and have been raising equity and cutting costs. All of these factors are positive from our perspective.”

Yields will remain attractive for credit investors, predicts Mr Montague, with continued sovereign concerns ensuring they remain high, while spreads should also remain alluring.

“It will take time to work all of these issues out, and we are going to be in a risk on/risk off market, and it will not be pleasant,” warns Mr Pulle. “But then of course it hasn’t been pleasant in Japan for a long time, and that didn’t mean that any of the big banks went bust, nor did it mean that assets weren’t being invested in government bonds or credit.”