The late Sir John Templeton once said: “People focus too little on the opportunities that problems present.” There is certainly no shortage of problems in the eurozone right now, but Brent Smith, Managing Director, CIO and Portfolio Manager, Franklin Templeton Multi-Asset Strategies, and Matthias Hoppe, Vice President, Portfolio Manager, Franklin Templeton Multi-Asset Strategies, are focusing on the potential opportunities.
Their thoughts in brief:
- It is a positive development that in light of the European debt crisis, policymakers in many countries, including Greece, have been forced to directly confront shortcomings in their economies, adopt vital structural reforms and rethink the setup of the monetary union, with some of those issues having gone unaddressed for years.
- We think the beginning of a real dialogue among eurozone member states should bode well for the future. In our view, there are no fundamental reasons for disintegration.
- Despite the markets’ focus on Europe’s worst-case scenario, we believe panic-induced selling can present attractive buying opportunities, as it has in the past.
- While we concentrate on quality assets and try to avoid the hot spots of the crisis, certain equity assets, although riskier than traditional bonds, appear very attractive to us, even in the countries that are most affected by the European debt crisis. Conversely, government bonds from some presumed safe haven countries are currently expensive, in our view.
“In recent weeks, global stock markets significantly and broadly fell, triggered by the renewed threat of a Greek exit from the eurozone, the vulnerable state of Spain’s banking system and economy, and signs of weakened economic activity in most eurozone countries, as well as in the U.S., China and India. Following last month’s inconclusive elections in Greece and a severe deposit flight from the country’s flagging banks, financial markets started to price in the risk of a breakup of the currency union. With the markets decidedly fraught with risks, we believe the most pressing question for Europe is how to build a powerful firewall to stop contagion. While current proposals such as a centralized bank deposit guarantee by the European Union are being considered, trying to forecast the outcome of the current crisis enveloping Greece, Spain and the overall eurozone is very difficult—if not impossible—given that it is likely to be decided by political forces.
If we look back at history for some perspective, fiat currency monetary unions (with independent fiscal policies) such as the eurozone are not commonplace. Successful monetary unions that hold together remarkably well, with the U.S. as the best example, do so in large part because they are typically backed by integration on fiscal and political levels. Additionally, the economic and political consequences of a breakup would be extraordinarily severe.
Perhaps it is fitting to turn to Argentina, which unpegged its peso from the U.S. dollar in 2001, for clues regarding the possible aftermath of a monetary union collapse. Much like Greece today, Argentina was under tremendous economic pressure in the late ‘90s and struggled with a deep recession and substantial account deficit. The tools of monetary policy and the advantages of a free-floating currency regime were absent due to the peso’s peg with the U.S. dollar. As soon as the currency peg was called into question, market confidence evaporated and bank runs and capital flight followed.
The Argentinian government had to give up the peg at the end of 2001, which led to the peso substantially devaluating and inflation skyrocketing, and in 2002 Argentina defaulted on part of its international debt. Despite being effectively shut out of the international financial markets as a result, Argentina’s economic conditions eventually recovered. From 2003 to 2008, the Argentine economy made great strides despite a general lack of progress in structural reforms.”
“It is a positive development that, in light of the European debt crisis, policymakers in many countries, including Greece, have been forced to directly confront shortcomings in their economies, adopt vital structural reforms and rethink the setup of the monetary union, with some of those issues having gone unaddressed for years. Although a true fiscal and political union such as in the U.S. probably remains far off, we think the beginning of a real dialogue among eurozone member states should bode well for the future. We think efforts by the Spanish and Italian governments to implement reforms should not be dismissed despite heavy criticisms of how Spain handled its banking crisis.
The political will to survive is being tested, but major institutions like the European Central Bank are showing a willingness to adopt large-scale measures such as the Long-Term Refinancing Operation (LTRO). We believe such institutions could intervene again should pressures rise, making any kind of domino effect from a Greek exit less likely or severe. Also, the economic fundamentals of the overall eurozone have compared favorably to other major developed countries such as the U.S. and Japan, with the bloc’s public debt and budget deficit significantly lower and its current account position relatively better. In our view, there are no fundamental reasons for disintegration.
Despite the markets’ focus on Europe’s worst-case scenario, we believe panic-induced selling can present potential attractive buying opportunities, as it did this past September. While we concentrate on quality assets and try to avoid the hot spots of the crisis, certain equities that might be perceived as risky by some appear very attractive to us, even in the countries that are most affected. During the 2008/2009 global financial crisis, 12-month forward price/earnings ratios dropped sharply across many markets. In Spain and Italy, earnings per share were revised down from peak to trough by 23% and 47%, respectively.1
Based on the lower earnings estimates, the 12-month forward price/earnings ratios at 2008 troughs were 11.7 for Spain and 9.6 for Italy.2 As of May 31, 2012, the Spanish equity market was trading at a 12-month forward price/earnings ratio of 8.1 times estimates and the Italian equity market at 7.2 times estimates.2 For reference, the U.S. equity market was trading at 11.9 times estimates as of June 5, 2012.2
Conversely, government bonds from some presumed safe haven countries are currently expensive in our view. Taking into account expected inflation for 2012, 10-year bonds yielded -0.74% in the U.S. and -0.90% in Germany as of May 31, 2012. We believe this rush to perceived “safety” assets is ill-timed. These government bonds represented good investment opportunities five years ago, but they are currently overvalued, overbought and over-owned in our view. The valuation gap between these sovereign bonds and equities has seldom been this large.
Should the situations in Greece and Spain worsen, we believe we are likely to see additional policy easing from Europe, which we believe would be a boost to assets (such as stocks) that investors view as more “risky.” In addition, more stimulative measures from the emerging markets could also serve as a signal of potential opportunity and could trigger investors to move out of “safe-havens.” Given the extremely negative sentiment in recent weeks, we think the time to add more [of these types of assets like stocks] back to our strategies could be around the corner.
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What are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business, and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year.
1. Source: IBES Aggregates; Spain: 30 June 2008 (peak) to June 30, 2009 (trough); Italy: February 29, 2008 (peak) to August 31 2009 (trough).
2. Sources: MSCI; Standard & Poor’s®. All MSCI data is provided “as is.” In no event shall MSCI, its affiliates or any MSCI data provider have any liability of any kind in connection with the MSCI data. Copying or redistributing the MSCI data is strictly prohibited. Standard & Poor’s®, S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC. One cannot invest directly in an index.