The last few months have been a welcome respite from the maelstrom that began at the end of last summer. In fact, the only surprise to investors from mid-December to early March is that the Greek crisis has not sunk the European banking system and with it a huge chunk of capital.
Whilst I am sure recent gains are a big relief to beleaguered equity investors, it would be a serious mistake to assume that Greece’s problems have been solved. They have not.
Greece is about to embark on a “voluntary” debt default of Herculean proportions, its economy has shrunk by nearly 1/5th and unemployment, particularly amongst the young, is rife (51% of Greeks below the age of 25 cannot find jobs). Even with a default equivalent to over half of the face value of government bonds, the forecast for Greek government debt, as a percentage of GDP, is still over 120% in 2020. And that assumes the country can generate positive economic growth, which is unlikely in the short-term as the European Union demands further belt-tightening.
So why the market optimism and short-term recovery? The answer is that something quite remarkable has happened at the ECB (European Central Bank). It has, for the first time ever, acted pre-emptively to head-off a major problem.
In December 2011 and February 2012 the ECB made available unlimited credit, to European banks, and agreed to accept lower grade collateral. Europe’s banks borrowed over €1 trillion under this arrangement, which is called an LTRO (long-term repo operation). It simply means that the collateral posted to the ECB will be re-purchased from the banks at the amount they have borrowed, plus a bit of interest (just 1% per annum).
Credit for this action goes to the ECB’s new president, Mario Draghi. Mr Draghi has proved a breath of fresh air to an ϋber-conservative institution that is overly obsessed by inflation. Under the previous incumbent, Jean-Claude Trichet (Mr Trichet handed over to Mr Draghi on 1st November 2011), the ECB increased interest rates at the beginning of 2011 despite ample evidence that Europe was struggling. This was typical behaviour from a central bank run by career academics and bureaucrats with little experience of the private banking sector, but the new president is from different stock. Born in Rome, Draghi attended the local Sapienza University, but then earned a PhD in economics from MIT (the Massachusetts Institute of Technology) under the guidance of Nobel Prize winning economists Franco Modigliani and Robert Solow. He was a professor at the University of Florence from 1981 until 1991 before becoming a fellow at the Institute of Politics at Harvard University, and then joining Goldman Sachs, where he became vice chairman and managing director of Goldman Sachs International and a member of the firm’s overall management committee. As a Roman Italian that completed his education in the US before rising to a senior position in the world’s cleverest bank, Mr Draghi understands the global banking system very well.
Unfortunately, the ECB’s recent actions have only bought time. The provision of short-term liquidity to the European banking sector will help, but the Euro Area must soon decide whether it will genuinely support its troubled members as they fail to meet their fiscal targets and need more cash. If, behind the scenes, Mr Draghi has used his experience, intellect and Italian charm to coerce politicians into a credible plan that will solve Europe’s debt problems, then expect a further abatement of volatility and a strong upward movement in equity values. But if he proves anything other than a truly “super Mario”, and the initiative is again left to the out-of-touch European politicians, then expect volatility to return.
I know I sound like a broken record, but our position has not really changed. The fundamentals make equities attractive for the longer-term, particularly when compared to the potential returns available from cash and bonds, but the price of this potential is short-term volatility. It is for this reason that we have been maintaining protective positions, particularly within our Cautious and Balanced Strategies, and will continue to do so over at least the next few months.
Warning - The views expressed in this summary are reached from our own research. COURTIERS cannot accept responsibility for any decisions taken as a result of reading this document and investors are recommended to take independent professional advice before effecting transactions. The price of stocks, shares and funds, and the income from them, may fall as well as rise. Past performance is not necessarily a guide to future returns.