EU debt promise could trigger risk reappraisal

By Natsuko Waki – Analysis

LONDON (BestGrowthStock) – The implicit guarantee from the European Union to prevent a default of Greece and other debt-laden members may do more harm than good for the euro and may even start hurting the bloc’s benchmark bonds.

However, peripheral euro zone debt is set to outperform as higher yields attract investors, while the scope for prolonged easy monetary policy and a weaker euro could boost the bloc’s stocks.

A bailout — or even the existing promises from the European Union to help — is likely to delay painful and lengthy structural reforms, such as slashing fiscal deficits and public sector wages.

This will let tensions build up again and the cost of dealing with the debt would only snowball in the future.

“(There is an) assumption no euro zone country will be allowed to default. Because of that, they don’t restructure and this is not sustainable. These are the problems that will challenge EMU again,” Stephen Jen, head of currencies and macroeconomics at hedge fund BlueGold.

“There is a legacy cost of the problems which we are starting to discover now and the future cost of structural reform. This will affect the underlying performance of euro assets and euro itself. The desire to hedge FX risk is higher and yields will converge toward the middle (of all 16 euro zone credits) rather than down toward Germany.”

Jen estimates that the cost of the bailout could reach 100 billion euros in a worst case scenario where all of the peripheral countries encountered sovereign debt pressures, and that Germany and France would foot up to 76 percent of the bill.

The costly rescue package could reverse safety-seeking flows into German debt away from peripheral euro sovereigns, a move which could adjust German yields higher going forward.

The GDP-weighted average of 10-year yields from all euro zone bonds stand at just below 4 percent, according to Julius Baer, compared with Germany’s 3.2 percent.

WEAK LINK OPPORTUNITY

An EU pledge to help Greece will all but remove the risk of a Greek default. This would make Greek debt — whose 10-year yield is the bloc’s highest at around 6.4 percent — look more attractive for its risk/reward profile.

Christopher Probyn, chief economist at State Street Global Advisors, said Greek bonds at current spread levels were a good buy for non-euro investors if currency exposure were hedged.

Billionaire financier George Soros told Reuters last month that Greek debt might be worth buying as Greece could not afford to fall out of the euro zone.

The euro exchange rate has been under pressure from the debt woes and some say a further fall may prompt institutional investors and central bank reserve managers to change their existing long-term view, adding to selling pressure.

Of the $4.4 trillion of the world’s hard currency reserves where the International Monetary Fund has detailed breakdowns, the euro commands a share of almost 28 percent.

“They don’t need to change their attitude for the euro, they just need to be less positive, to make a change,” Jen said, who expects the euro could trade below $1.30 — lows reached this time last year during the crisis surrounding Eastern Europe.

Jen estimates European banks’ exposure to Greece and other peripheral countries measured in percentage of GDP to be around four times as serious as the Eastern European crisis and about 50 times more serious than Dubai.

EQUITIES AND INTEREST RATES

European equities could actually benefit from increased fiscal strains on core euro zone economies from a possible bailout as this will encourage the European Central Bank to leave interest rates and a weaker euro would make exports cheaper.

Some 45 percent of the respondents polled by the BofA Merrill Lynch this month expect the ECB to do nothing until 2011, up from December’s 17 percent.

Investors have also de-rated peripheral European countries, weighing on valuation — another factor which might lure bargain hunters.

According to Nomura, peripheral stock markets trade at a 10 percent discount to the euro zone on a price-to-earnings basis, having consistently traded in line with the region’s average since the euro’s birth.

It also says many large cap companies in the peripheral area with sizeable non-domestic business benefit from a weaker euro. Firms that account for two thirds of the market capitalization in the area derive more than half of their revenues overseas.

“The depreciation of the euro has a feedback mechanism to help equities through its positive impact on earnings for the European corporate sector,” it said in a note to clients.

“There is a mispricing of sovereign risk with a too bearish outcome factored in for peripheral European countries.”

Stock Market News

(Editing by Toby Chopra)

EU debt promise could trigger risk reappraisal