Second half: more of the same?

By Noel O'Halloran, CIO, Tuesday, 3rd July 2012 | 0 comments

As we enter a new quarter, I want to share with readers my expectations for the next few quarters, and in particular my expectations for developments in the eurozone fiscal crisis. In short, I believe that the euro will survive, and that although we are living through a period of historical change in the eurozone, a large “risk premium” is priced into markets already, and as markets begin to price in 2013 earnings, a more positive tone will emerge.

Let’s begin though with a short recap of the first half of the year. As we expected, markets were volatile and dominated by the familiar themes of the last 12 months. The MSCI World equity index rose by 8.7% in euro terms (6.8% in local currency) for the first six months, and the eurozone bond index rose 5.2%. The dominant theme driving volatility during the first half of the year was the eurozone debt crisis. Equity markets had a good first quarter helped by the announcement of the ECB’s LTRO financing operation for eurozone banks, but many of the gains were eroded during the second quarter following the move by Spanish banks to seek emergency funding. Yet another EU crisis summit on the last day of the quarter produced some positive announcements to deal with the crisis, and led to a solid rally in asset markets.


Turning to the second half of the year, my expectation remains that 2012 will be a positive year for global markets. Although there has been some recent slowing of Chinese macro data and more mixed economic data from the US, I continue to forecast that neither economy will experience a hard landing and that there is in fact scope for both economies to re-accelerate through the second half of the year. There is more below on the subject but our central scenario remains that a “disaster scenario” for the eurozone will be avoided. I also note that in the absence of any material inflationary concerns, authorities continue to have scope to ease monetary policy, providing ample liquidity if and as required which, in my view, limits any downside. At the company level earnings and dividend growth have remained solid and are expected to remain so.

Over the coming months markets will begin to price in 2013 earnings and I expect a more positive environment as the various risks and challenges we have discussed diminish after some volatile summer months. While risks abound, I continue to remind myself there is a large “risk premium” priced into risk assets such as equities and a major “safe haven” status afforded to perceived risk-free assets such as core eurozone sovereign bonds as the chart below clearly illustrates:


Our current Eurozone roadmap:

Needless to say, the future of the eurozone is a key issue for all investors, and particularly those based in the eurozone and most especially for those trustees of defined benefit schemes faced with scheme funding decisions. We think that there are three main “end-game” scenarios from here, each of which we explain below.

  1. Continued “Muddle-through”

We see this scenario as, marginally, the most likely, with a 50% probability. In this scenario, the eurozone moves from mini-crisis to mini-crisis, with EU leaders doing – just – enough at the time of each mini-crisis to avert a full-blown meltdown, but not enough to sort out the crisis once and for all. In essence, while market conditions and sentiment would be bad from time to time, they would not get quite bad enough for the German and/or ECB authorities to agree to give up their resistance to extreme measures. Bailout funds (the ESM and EFSF) would probably have to be expanded to make sure that Spain can be bailed out if necessary, and a strong “firewall” would have to be put in place to make sure that the eurozone could cope with a Greek exit.

Basically this scenario is “more of the same”, for the next couple of years. In market terms, it would probably lead to continued volatility and underperformance of eurozone assets. ‘Safe haven’ assets would remain underpinned despite valuation concerns.

  1. Major Crisis/Major Response

In this scenario (which we rate as a 45% probability), the eurozone would experience a crisis in the next few months which would be significantly more serious than any of the various crises we have seen to date. A badly handled Greek exit from the eurozone could be the cause, or a problem in Italy which leads to it being unable to finance itself in the bond market (note that Italy is such a large economy that existing bailout funds would not be large enough to rescue it). Or it could be some other, currently unforeseen, eventuality. Whatever the cause, the result, in this scenario, would be an inability of all the peripheral countries to fund themselves in the bond market, large-scale bank runs in weaker economies, and a growing fear that a breakup of the eurozone is imminent within days or even hours.

In those circumstances, we believe it is highly likely that faced with the imminent collapse of the eurozone which would almost certainly lead to a global economic recession or indeed depression, the ECB and Germany would abandon their perceived key principles and agree to do “whatever it takes” to save the euro. This would probably involve the ECB printing money on a grand scale (something it has refused to do so far). It might also involve a “joint” government bank guarantee for all bank deposits, so that the German taxpayer would effectively guarantee bank deposits in countries such as Ireland and Portugal. It might also involve financial aid from other large economies, perhaps even China, in a bid to avert a global economic collapse. Indeed the range of measures that could be taken in such circumstances is large, as clearly caution would be thrown to the wind in a bid to make very sure that a collapse of the eurozone was averted.

While this scenario is not welcome, as it involves huge risks and much disruption, it would in the end be quite positive for most risk assets, as it would “solve” the eurozone problems in a way that the “muddle-through” scenario would not. In this scenario, ‘safe haven’ assets such as core eurozone bonds will be the big losers.

  1. “Meltdown”

In this scenario, which we rate as only a 5% probability, policy makers get it wrong, holding to their principles at all costs, and thus allow the eurozone to break up entirely. All European economies – including the “stronger” ones such as Germany – would be extremely weak, mainly due to the likely collapse – again! – of the international banking system. The rest of the world would also be severely affected, and a global recession would be highly likely and a global depression quite possible. It is precisely because the consequences of this scenario are so bleak, and so obvious to policymakers, that we believe it is very unlikely to be allowed to happen. From a German perspective, for example, while the costs of rescuing other eurozone countries might be very large, the costs of NOT rescuing them could be far, far higher.

Bringing all this together, Europe is going through a period of historical change, and such massive change is rarely achieved without disruption and difficulty. We do have a strong view that the euro will survive this period of disruption, but obviously it will be key to monitor these issues in the months ahead. We will keep you updated on our views as events unfold.



Bearing in mind our views as outlined above, for your portfolios we maintain a preference for emerging markets and US markets, as European markets will continue to struggle. Our stock selection continues to emphasise companies with strong fundamentals, i.e. balance sheet, cash flow and management. We continue to favour companies with strong and growing dividend streams as in this low return environment dividends will be a strong component of total return.



Noel O'Halloran, Chief Investment Officer

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