Wednesday, February 22, 2017

The Opening For Investors In Europe's Political Turmoil

By Komal Sri-Kumar
The Bloomberg View
February 22, 2017

After a period of relative calm, volatility and investor fear have returned to Europe. Investors took in stride the Brexit vote last June, along with the decision by Italian voters in December to reject Prime Minister Matteo Renzi’s referendum, which led to his resignation. But three national elections this year -- in the Netherlands next month, in France in April and May, and in Germany in September -- have fed uncertainty in currency, bond and equity markets. Italy may also move up the national elections set for early 2018, contributing to political risk on the continent.

Investor fear is centered on the possibility that an anti-Europe party could form the next government in one or more of these countries, leading to measures that could eventually take that country out of the euro zone. With the euro no longer the nation’s currency, assets would be redenominated in the new currency. Market concerns are focused on France and Italy, where debt has surged since the global financial crisis to 97 percent and 132 percent of gross domestic product, respectively.

The risk of a debt default or redenomination has created wider bond spreads in France and Italy with respect to Germany. With the anti-Europe candidate Marine Le Pen rising in the polls before the first round of the French presidential elections on April 23, the spread of the French 10-year sovereign over the German 10-year bund rose to 79 basis points at the close of European markets on Feb. 21, up from 48 basis points at the end of 2016.

Over the same period, the Italian spread increased from 155 basis points to 195 basis points over fears that the nationalistic Five Star Movement could form the next government. The spread surged this week after Renzi’s resignation from the ruling party on Sunday. If mainstream candidates continue to lose support in coming weeks, expect the French and Italian spreads to rocket upward from current levels.





How can investors in Europe incorporate political risk? One pointer comes from the way bond markets performed after risk of Greece’s exit from the single-currency area first surfaced in late-2009. Growing fears of “Grexit” caused the yield on 10-year Greek sovereign debt to go from 6 percent at beginning of March 2010 to 12.5 percent just two months later.

After a bailout arranged by the International Monetary Fund, the European Central Bank and the European Union, the yield dropped to 7.2 percent by mid-May. Investors who banked on Europe’s penchant for last-minute solutions benefited handsomely by buying Greek paper at its worst moment, and exiting when the bailout was announced. Even though Greece is a relatively small country, the euro zone could not afford setting the precedent of an exit in what is supposed to be a marriage without divorce.

Another example of bond investors dealing with euro zone financial crises is the surge in Italian sovereign yields in 2011 because of fear that the government might not comply with EU restrictions on its fiscal deficit under then-Prime Minister Silvio Berlusconi. The yield on the 10-year sovereign paper topped out at more than 7 percent in November 2011, about 500 basis points over the German bund. However, after a pledge in July 2012 by Mario Draghi, the president of the ECB, to “do whatever it takes” to save the euro, the situation stabilized. Italian debt ended the year yielding less than 4.5 percent. Again, if you bet on European officials muddling through at the final minute, you won.

The past is not always a perfect guide to the future, of course. Investors are currently faced with not one, but four, countries with rising anti-Europe forces. And France and Germany are significantly larger countries than Italy or Greece. What if Le Pen wins the presidency in May, and sets the stage for the country to exit the euro zone after a referendum?

In that case, French assets could be redenominated in “New French Francs,” which would promptly depreciate against the euro and the dollar. But remember that France runs a deficit in the current account of the balance of payments, and needs to encourage capital inflows to finance the shortfalls. The new government might have to implement policies that are investor-friendly to have foreigners provide the necessary capital.

While redenominated French debt may never regain its par value in euro- or dollar-terms to make holders whole, investors with a medium-term horizon should find ample opportunities in “distress” investments. Real estate, new currency-denominated debt at high yields, and well-managed export-oriented French companies taking advantage of the depreciated currency, would all be candidates for attractive returns under a new currency regime.

The bottom line is that 2017 looks like a year of huge investment opportunities in Europe. Another one-off problem similar to those of Greece and Italy in the past may make the bond markets attractive. An “Italexit” or “Frexit” would require investors to wait longer, but they should find returns in a variety of asset classes.


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