Losing faith in the euro zone?

By Jeremy Gaunt, European Investment Correspondent

LONDON (BestGrowthStock) – Whatever ultimately happens in the Greek debt crisis, investors are having to come to grips with an unstable euro zone they had not bargained for.

A knife-edge British election, a European Central Bank meeting and monthly U.S. jobs data would all be expected to dominate markets in more normal times. But it is the fate of Europe’s peripheral economies that still eclipses all else.

Markets are in what AXA Investment Managers calls “panic mode,” resulting in the European bond market being drained of liquidity and with some investors forced to sell because of sovereign debt downgrades.

And longer-term, the landscape has been changed by the crisis.

Germany’s reluctance to take on its traditional role as European Union paymaster and its willingness to let the International Monetary Fund get involved has, at the very least, thrown some doubt at the once-solid political foundation of monetary union.

The struggle of Greece and others such as Portugal, Spain and Ireland to manage mountains of debt has lit up a core weakness of multiple countries sharing a currency — the inability to devalue yourself out of trouble.

It has left millions of people in Europe facing not the wealth that they expected from adopting the euro, but a period of potentially breathtaking austerity they are ill-prepared for.

Little wonder, then, that investors have been voting with their feet against holding euro zone paper.

Reuters asset allocation polls show holdings of euro zone debt at 38.4 percent of bond portfolios at the end of April, compared with more than 42 percent in January.

Although the Reuters polls found little change in holdings of euro zone equities, fund tracker EPFR Global says non-UK European equity funds have had 12 straight weeks of net outflows for year-to-date redemptions of more than $8 billion.

The euro itself has fallen nearly 7 percent against the dollar this year as the crisis has built.

“People are avoiding Europe and its currency,” said Michael Arone, who develops investment vehicles for clients with nearly $2 trillion under management at State Street Global Advisors.

Over the short-term, this could well continue even with an EU/IMF aid package that could come as soon as this weekend.

SHAKEN FAITH

There is also a longer-term issue of whether investors will ever look again at the euro zone in the same light.

Johan Jooste, fixed income and currency portfolio strategist at Merrill Lynch Wealth Management, says a number of his private clients have been questioning the sustainability of monetary union as a result of the crisis.

Other analysts have joked that troubled debt such as Greece’s would be a good buy as long as you do not intend to hold on to it until maturity.

“I wouldn’t go so far as to say we concur, but the view on the street is that this has been a pretty bad example of how to manage a single currency zone,” Jooste said.

“This is the (euro zone’s) first real stress test and the system has been exposed in many ways.”

That exposure, at the very least, could cause a permanent re-rating of euro zone debt, driving investors to demand more risk return from peripheral euro zone economies and building demand for the core, notably Germany.

As for equities, while an unstable euro zone might not have an immediate, direct impact on European companies’ earnings, it can prompt investors to look around for alternatives.

“Our preference for the U.S. among the world’s developed markets is in some respects enhanced, on a relative basis, by the events in Greece and elsewhere,,” said David Joy, chief market strategist at RiverSource Investments.

STEPPING BACK

All this has put most other issues in the background, even if they are hugely important.

The ECB will almost certainly leave interest rates unchanged at its meeting on Thursday. But it should also give some indication of the state of the euro zone economy, incorporating the Greek problem.

Britain’s general election, also on Thursday, could see pressure on sterling if it produces no clear winner, currently the prediction, potentially leaving a government without the clout to enact tough fiscal measures required to curb the UK’s own ballooning deficit.

The U.S. non-farm payrolls report on Friday — generally the markets’ No.1 economic indicator — will also be seen as a gauge of how far the U.S. economic recovery has filtered down.

All three come as investors have been giving various signals that the more than year-long equity rally is ready to pause or correct.

MSCI’s all-country world index (.MIWD00000PUS: ) hit a more than one-year high in mid-April but has not come close to testing that level since.

State Street, meanwhile, reported that its monthly index of institutional investor confidence fell back to levels last seen in March 2009 when the stocks market slump was hitting bottom.

Reuters asset polls had a similar finding, with allocations to stocks among 48 leading investment houses falling to their lowest level of the year.

But it will be Greece, Portugal and the others that seem set to get the lion’s share of attention.

Stock Market Report

(Additional reporting by Claire Milhench and Jennifer Ablan, editing by Mike Peacock)

Losing faith in the euro zone?