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Tags: Hurdles | Euro | Fragile | Recovery

Risks May Doom Euro’s Fragile Recovery

Tuesday, 03 August 2010 10:37 AM EDT

A rebound in eurozone assets, including fringe government bonds, shows investors are starting to look past Europe's sovereign debt crisis but long-term fiscal hurdles pose risks for assets of the most debt-laden nations.

Fund managers are being selective about what they buy and some have opted to steer clear of peripheral eurozone debt, even at the expense of missing the recent rally, until austerity measures to rein in record fiscal deficits start to bear fruit.

They also want to see whether governments resist the political and public fallout from unpopular deficit-cutting measures before they start raising their holdings of peripheral eurozone assets across the board.

"It's all about whether the austerity packages can be implemented and sustained. We're waiting to see what is the economic impact and stemming from that what is the political impact," said Russell Silberston, head of global interest rates at Investec Asset Management.

Eurozone countries from Germany downwards have pledged to enact dramatic fiscal cuts but it is the bloc's southern flank — notably in Greece, Portugal and Spain — where the most dramatic surgery is required and there that the risk electorates may not accept the pain is largest.

Ireland, which also faced dramatic debts, made an earlier start on tackling them but faces additional burdens having bailed out two of its biggest lenders.

Bank stress test results in July, which showed only seven out of 91 European banks failed, were the latest in a series of confidence-boosting exercises going back to May when a $1 trillion emergency package, including a bond purchase program by the European Central Bank, was created to stabilize the euro.

Such steps have boosted the euro, compressed the premium investors demand to hold peripheral eurozone debt rather than German government bonds, reduced sovereign credit tensions, and helped European stocks rise and outperform U.S. stocks.

The measures have also helped to defuse the tension that had begun to surround each government debt auction in any of the peripheral eurozone countries, and yields even fell at Spanish and Portuguese auctions last month.

That said, recent price moves have yet to reverse the bulk of decline seen in the past seven months.

This means the current rally could very well represent a correction from very bearish positions and at a time when markets are thinned by the Northern Hemisphere summer holidays.

"From the flows, and investor surveys it would appear that it is the covering of underweights, a lot of it from real money rather than any initiation of fresh long positions in the periphery," said Jack Kelly, Investment Director, Global Fixed Income, Standard Life Investments.

"A stopping out of "risk off" type trades from the hedge fund community has likely exacerbated the moves in fairly illiquid markets," he said.

The real test for euro assets will come when real money investors return in force next month, and when governments update their budget deficit forecasts.

"If the peripheral countries show good progress in deficit reduction, and the key political players continue to exhibit unity, then there is no reason why peripheral bonds cannot hold onto recent gains," said Martin Harvey, a fund manager at Threadneedle.

Having lived through the European debt crisis, investors will drill into the merits of eurozone member countries, rather than just buying or shunning their assets indiscriminately.

"We have added to positions in Italian bonds in the past few weeks, but remain cautious regarding the more risky names, such as Ireland and Portugal," said Threadneedle's Harvey.

Spanish bonds, which led the outperformance versus German Bunds, were starting to look extended on fundamental grounds, said Citi analyst Steven Mansell: "We would advise focusing on the stronger, non-core markets, notably Italy, for better relative performance potential."

For the euro, further long-term gains against the dollar are likely although driven more by deteriorating U.S. fundamentals. Near term, the single currency could struggle after a stellar rebound to around $1.32, from below $1.20 in early June.

"Next three months or so it could pull back toward $1.25," said Jan Lambregts, global head of financial markets research at Rabobank. "But on a 12-month horizon, we know that people are going to get a lot more worried about the debt situation in the U.S. ... that could see euro dollar trade up toward $1.35-$1.40."

© 2024 Thomson/Reuters. All rights reserved.

A rebound in eurozone assets, including fringe government bonds, shows investors are starting to look past Europe's sovereign debt crisis but long-term fiscal hurdles pose risks for assets of the most debt-laden nations. Fund managers are being selective about what they...
Tuesday, 03 August 2010 10:37 AM
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