The European sovereign debt crisis has reached a crucial point due to European policymakers’ inability so far to effectively respond to, manage and contain the crisis, which has now led to heightened funding concerns for European banks and sovereigns as well as the likelihood of more sovereign downgrades. The deteriorating outlook in Europe warrants caution given that policymakers are behind the curve, global growth is slowing and investor confidence is waning.
All this suggests a more significant policy response is needed, particularly if the global economy weakens. Unfortunately, investors may have to wait for European leaders to agree on a coordinated response and decisive action plan, which at this point appears contingent on accepting greater fiscal union and structural reforms within the European Union (EU) as well as agreeing to stricter rules which require enhanced fiscal and budgetary discipline among member states.
In this uncertain environment, volatility will likely remain high, liquidity poor, risk premiums wide and the global economy fragile as financial and credit conditions tighten. The combination of these factors, should they intensify, could “tip” the globe into recession. Fortunately, many central banks around the world have the ability to ease monetary policy and they also appear more willing to coordinate and provide liquidity to support the global economy and financial stability given that the European sovereign debt crisis has escalated and is increasingly likely to affect the rest of the world.
With global growth slowing and risk and uncertainty increasing, easier monetary policy, including the potential for a significant expansion of balance sheets from a wider group of central banks, is increasingly likely across both developed and developing economies. While the world anxiously watches for the European Central Bank (ECB) to act, a bolder and more coordinated “all in” global moment may be on the horizon.
No coordinated game plan
As a result of large philosophical differences and poor policy coordination, European leaders and policymakers to date have no effective game plan for the sovereign debt crisis: They simply can’t agree on what is the right path ahead for Europe. On this front, Europe is like the U.S. in that ideological differences, similar to those between Republicans and Democrats, are deeply dividing the EU, leading to political paralysis and gridlock. Europe lacks a coordinated, integrated and centralized decision-making process, which has prevented a broad and authoritative “bazooka” policy response.
Germany and several EU members, including France, remain at odds over whether the ECB should go “all in” aggressively by acting as lender of last resort through large-scale purchases of government debt in peripheral countries. European leaders are also divided on the use of the European Financial Stability Facility (EFSF), Eurobonds and the timing and scale of austerity measures required of peripheral countries as a condition of support. While a path forward could materialize in the weeks ahead, the ECB and Germany remain in the camp that the EU must move towards greater fiscal union and discipline, and their full support appears conditional upon firm commitments by member states. Without an agreement and more forceful and coordinated action from European policymakers and the ECB, the risk of a disorderly outcome, including the potential for countries to walk away from the euro or the EU, has materially increased.
Inability to ‘crowd in’ private sector
Europe has so far been unable to “crowd in” investment or encourage the private sector toward greater activity because European policymakers lack a credible backstop plan. As evidence, non-EU countries, including emerging market countries with large reserves, see how the ECB has yet to fully commit its balance sheet, and therefore they remain reluctant to step up to the plate and provide the support Europe desperately needs.
With healthy balance sheets still on the sidelines, Europe’s crisis has now intensified as European banks, which need more capital under Basel III regulations and are generally highly exposed to deteriorating sovereign government debt, are now likely to de-leverage.
Deposit outflows from the weaker banks in Europe have also accelerated, and banks’ funding conditions have worsened as credit conditions tighten in light of sinking confidence. These factors in combination have led to an adverse feedback loop of mutual reinforcement: Shrinking bank balance sheets tighten credit in Europe and threaten the global economy through the potential for weaker equity prices, declining confidence (figure 1), more rating agency downgrades and still tighter financial (figure 2) and credit conditions.
Increased risk of hard landing
Without a more forceful and coordinated policy response, Europe now faces an increasing risk of a hard landing given high debt levels, poor growth prospects and a lack of competitiveness. A severe recession in Europe could lead to a sharp slowdown in global economic growth in both developed and emerging markets. Europe’s financial crisis is bad timing for the U.S., which already faces a private sector which continues to de-lever and increasing fiscal headwinds (figure 3) over the cyclical horizon with the potential for payroll tax cuts and employment benefits to expire. Similar to Europe, the U.S. increasingly lacks both the willingness and ability to use fiscal policy to offset slower growth due to heightened concerns over rising government debt levels.
On the corporate side, while most large multinational corporations have strong balance sheets, significant cash positions and healthy profit margins, senior executives remain risk-averse given the deteriorating outlook in both Europe and Washington and rising geopolitical tensions in Iran. Companies’ lack of animal spirits could constrain hiring and spending in many industries and lead to managers using cash for more shareholder-friendly actions as opposed to investment. Finally, emerging market growth is slowing due to tighter credit conditions, softer real estate construction and infrastructure investment and weaker export demand. At the same time, leading indicators such as global manufacturing purchasing managers’ indices (PMI) (figure 4) have softened.
Offsetting positives
On the positive side, U.S. consumers’ headwinds are slowly fading as housing price declines decelerate and the labor market (figure 5) gradually improves. Large U.S. companies are generally healthy due to strong balance sheets, cash flow and profits (figure 6), business investment is recovering in several industries (e.g., oil and gas, agriculture, mining, transportation and technology) and pent-up demand exists for durable goods such as autos (figure 7) due to an aging fleet and the need for smaller, more fuel-efficient cars. In addition, U.S. inventories are low, retail sales are holding up and bank lending is expanding.
Consumer, business and investor confidence remains very negative and expectations are low. As a result, if the outlook for Europe and Washington turns less negative and sentiment improves, cash is available to come in off the sidelines to invest. In addition, emerging markets public and private sector balance sheets remain under-leveraged and central banks in both developed and developing economies could become more accommodative through either rate cuts or an increased willingness to expand balance sheets (figure 8).
Investment strategy
Investors should consider waiting for European and global policymakers to reach an “all in” moment before adding to risk assets. A slower global economic growth outlook combined with European policymakers’ inability to get ahead of Europe’s sovereign debt crisis likely warrants an investment strategy that focuses on high-quality investments.
With global economic growth set to slow, consider favoring non-cyclicals and defensive sectors over cyclicals. Investments in the emerging markets and the U.S. (and Canada and Australia) may be favored over Europe given more attractive fundamentals. Portfolios should remain conservatively positioned, focus on senior securities in the capital structure, emphasize secured paper and hold higher cash balances than normal in an effort to capitalize on opportunities which could materialize given today’s uncertain and volatile environment.
In developed markets, investors may want to focus on the strongest balance sheets and seniority in the capital structure. In emerging markets, opportunities may materialize in select corporate debt and equities that stand to benefit from easier monetary policy (figure 9) as well as supportive emerging market consumer demand. Finally, investors should consider adding long-term secular positions where growth is healthy and debt levels are manageable in market pullbacks.
Waiting for ‘all in’
Given a deteriorating outlook in Europe and the current absence of a more forceful action plan, the global economy is set to become increasingly vulnerable. As a result, a more aggressive global monetary policy response is needed to help restore confidence and support both financial markets and the global economy.
Central banks around the world have the ability to take action and they now have the willingness as well due to the significant downside risks to the outlook in Europe and the likely negative spill-over impact on the global economy. While European leaders’ moves to deepen fiscal union should lead to more ECB support, central banks in developed and developing economies should loosen monetary policy through rate cuts and more aggressive forward policy guidance as well as consider more significant liquidity support for markets, including bolstering economic growth through the expansion of balance sheets.
A global and coordinated “all in” moment by the ECB as well as other central banks around the globe, should it occur, would lend confidence to markets and risk takers, providing the necessary and timely support the global economy now desperately needs to avoid a sharp global slowdown.
Easier monetary policy as well as the potential for more balance sheet support from a larger consortium of global central banks is needed over our cyclical horizon. If these actions are coordinated and timely, investors and risk takers would likely move off the sidelines and respond to a decisive “all in” moment by supporting risk assets and in turn the global economy.
Mark Kiesel
Managing Director
7 December 2011