· Germany and other strong sovereign balance sheet nations in Europe have to make a choice: continue to provide financial assistance to countries with more debt and assist in helping to restructure the debt of some European peripheral countries, or potentially move forward with a smaller, stronger group of countries - or at the extreme walk away from the Euro and the European Union all together.
· Without bold and coordinated action from European policymakers and the ECB, we can expect financial markets to remain on edge; causing volatility to remain elevated until equity capital is injected into weaker European banks and permanent term financing is provided to those solvent European peripheral sovereign countries.
· We believe investors should wait to see whether policymakers can be effective in formulating a coordinated and credible solution for Europe before taking on more risk. In the near term, we favor focus on maintaining higher-than-normal cash balances, investments in areas with strong fundamentals and balance sheets and staying defensive in non-cyclical sectors as well as in investments senior in the capital structure.
”‹The question on everyone’s mind these days is whether policymakers can contain the European sovereign debt crisis. Europe has roughly the same amount of government debt as a percentage of GDP as the United States. However, the magnitude of Europe’s total debt is not the issue in our opinion, it is the distribution. Germany has a lower, sustainable debt level whereas some peripheral European countries do not, particularly at current interest rates. As part of Europe’s entire Economic and Monetary Union (EMU), participating countries don’t have the benefit of an independent currency and monetary policy. This means countries with higher debt lack the ability to devalue their currencies in an attempt to improve exports. Monetary policy is also set for the EMU by the European Central Bank (ECB), which limits options for peripheral countries needing more accommodative policies. For many peripheral European countries these factors are major headwinds to growth which means to stay competitive these countries must move forward with structural reform. Yet, significant fiscal austerity and reform may prove so challenging that a few of the most leveraged European peripheral countries, like Greece, may have to restructure and leave the Euro in order to restore competitiveness and debt sustainability. Ultimately, Germany and Europe’s other strong sovereign balance sheet nations will have to make a choice: continue to provide financial assistance to countries with more debt and assist in helping restructure the debt of some European peripheral countries in order to keep the EMU intact, or potentially move forward with a smaller, stronger group of countries – or at the extreme even walk away from the Euro and the European Union.
The importance of the European sovereign debt crisis should not be underestimated. Simply put, Europe remains a main driver of “animal spirits” and volatility (see Figure 1) in financial markets and can significantly shape the outlook for the global economy. The risks associated with the sovereign debt crisis are significant. What was initially perceived as a liquidity crisis is increasingly becoming a solvency crisis for a growing list of European countries. Timing is critical as financial markets appear to be moving faster than policymakers’ ability to come up with a credible solution. ”¨As interest rates increase on higher-debt European countries in the south, debt sustainability will be increasingly tested. The fact that financial markets are effectively marking-to-market European government bonds and interest rates in real time means the European financial crisis is spreading quickly into their banking system since many banks have large exposure to European sovereign debt. While central banks have provided liquidity support so banks can get short-term funding, a fiscal and growth solution is needed to restore confidence in vulnerable European sovereign balance sheets as well as in numerous European banks (see Figure 2), which increasingly appear under-capitalized and exposed to deteriorating sovereign credits.
Link to the complete report: http://www.pimco.com/EN/Insights/Pages/AllEyesOnEurope.aspx
· Without bold and coordinated action from European policymakers and the ECB, we can expect financial markets to remain on edge; causing volatility to remain elevated until equity capital is injected into weaker European banks and permanent term financing is provided to those solvent European peripheral sovereign countries.
· We believe investors should wait to see whether policymakers can be effective in formulating a coordinated and credible solution for Europe before taking on more risk. In the near term, we favor focus on maintaining higher-than-normal cash balances, investments in areas with strong fundamentals and balance sheets and staying defensive in non-cyclical sectors as well as in investments senior in the capital structure.
”‹The question on everyone’s mind these days is whether policymakers can contain the European sovereign debt crisis. Europe has roughly the same amount of government debt as a percentage of GDP as the United States. However, the magnitude of Europe’s total debt is not the issue in our opinion, it is the distribution. Germany has a lower, sustainable debt level whereas some peripheral European countries do not, particularly at current interest rates. As part of Europe’s entire Economic and Monetary Union (EMU), participating countries don’t have the benefit of an independent currency and monetary policy. This means countries with higher debt lack the ability to devalue their currencies in an attempt to improve exports. Monetary policy is also set for the EMU by the European Central Bank (ECB), which limits options for peripheral countries needing more accommodative policies. For many peripheral European countries these factors are major headwinds to growth which means to stay competitive these countries must move forward with structural reform. Yet, significant fiscal austerity and reform may prove so challenging that a few of the most leveraged European peripheral countries, like Greece, may have to restructure and leave the Euro in order to restore competitiveness and debt sustainability. Ultimately, Germany and Europe’s other strong sovereign balance sheet nations will have to make a choice: continue to provide financial assistance to countries with more debt and assist in helping restructure the debt of some European peripheral countries in order to keep the EMU intact, or potentially move forward with a smaller, stronger group of countries – or at the extreme even walk away from the Euro and the European Union.
The importance of the European sovereign debt crisis should not be underestimated. Simply put, Europe remains a main driver of “animal spirits” and volatility (see Figure 1) in financial markets and can significantly shape the outlook for the global economy. The risks associated with the sovereign debt crisis are significant. What was initially perceived as a liquidity crisis is increasingly becoming a solvency crisis for a growing list of European countries. Timing is critical as financial markets appear to be moving faster than policymakers’ ability to come up with a credible solution. ”¨As interest rates increase on higher-debt European countries in the south, debt sustainability will be increasingly tested. The fact that financial markets are effectively marking-to-market European government bonds and interest rates in real time means the European financial crisis is spreading quickly into their banking system since many banks have large exposure to European sovereign debt. While central banks have provided liquidity support so banks can get short-term funding, a fiscal and growth solution is needed to restore confidence in vulnerable European sovereign balance sheets as well as in numerous European banks (see Figure 2), which increasingly appear under-capitalized and exposed to deteriorating sovereign credits.
Link to the complete report: http://www.pimco.com/EN/Insights/Pages/AllEyesOnEurope.aspx
