14 September 2011: SH: Message to the ECB: Act now to avoid a crisis of confidence

Sep 14, 2011

Minute Read

Justin Bisseker, European banks analyst, presents his thoughts on exactly what the
ECB needs to do, immediately, to avoid a further deterioration in the eurozone…

Justin Bisseker
European Banks Analyst

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Recent weeks have seen severe drops in European bank share prices, with the sector acting as a conduit for investor concerns around the safety of eurozone sovereign debt, and the potential for a double-dip in the US and European economies. The moves we have seen have been extreme, to say the least. Quarterto- date we have seen European bank share prices are down 30% and the broader European equity market down 22%1. This in a quarter which saw the European Banking Authority stress test results, the euro area summit of 21 July (which enhanced the European Financial Stability Facility (EFSF) and sought to improve the sustainability of Greek public finances), and the commencement on 8 August of the ECB buying of Italian and Spanish sovereign debt – all of which were intended by policymakers to reassure markets.

So, what happens now?
The consensus seems to be that things will get worse before they get better, so why buy European banks now? Better to wait for policymakers to be pushed into a corner where they have no alternative but to put in place a sustainable solution (i.e. some form of fiscal union for the eurozone) which, at last, puts sovereign concerns to rest. However, things may well not be that straightforward. There are a number of things policymakers can do which will have a positive impact on European bank share prices, given that almost all investors are positioned for a negative outcome.

None may be the ‘silver bullet’, but they can provide ‘air cover’ until a more sustainable solution to current concerns is found – be that some form of fiscal union or just old-fashioned nominal GDP growth. Indeed, it makes sense to ask yourself whether you will make more money over the next 10 years buying European banks today (on 0.8x tangible book and 4-5x recovered earnings), European equities on a circa 40% PE discount to the US or Asia-Pacific (based on Graham & Dodd 10-year average earnings), or UK, US or German 10-year government debt with a yield of around 2%.

The euro project was a one-way trip with no return ticket available. Importantly though, the euro crisis is resolvable, and in the near term a number of actions can be taken to provide credible ‘air cover’ until a sustainable solution is put in place.”

Two fundamental issues

While it is impossible to second guess the sentiment of markets in the near term and the actions of policymakers over the medium term, two fundamentals are important.
First, the euro cannot break up – at least not in the sense of all 17 countries which have adopted the euro moving back to national currencies. The euro project was a one-way trip; there is no return ticket available because the financial system has become too interconnected.

Two fundamental issues

*The ECB should act to rein in Italian and Spanish sovereign credit spreads to prevent liquidity problems morphing into solvency problems. The ECB has been buying these bonds in recent weeks but probably simply in expectation that acquired bonds can be passed to the EFSF once the extension in its mandate has been approved by eurozone governments (thus limiting the overall amount that can be purchased to around €250 billion). Replacing this with some form of quantitative easing which places a ceiling on euro country sovereign spreads over bunds, with these spreads determined by the level of government indebtedness and primary balance trends, would ease current market tensions, materially, while also acting as a powerful incentive to the periphery to maintain fiscal discipline.

These proposals are not designed to be a long-term resolution to the crisis but to provide some vital breathing space for the European authorities, during which time policies for the long term can be put in place. These policies will have to reflect the fact that greater fiscal and political integration are inevitable if the euro is to survive.

Important Information:

The views and opinions contained herein are those of Azad Zangana, European economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.

Source: ETFWorld – Schroders

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