The introduction of LTRO in Europe has had a significant effect on markets. Concerns about liquidity with regard to the banking sector have been substantially alleviated, with a second round of LTRO funding to follow in February. The LTRO has boosted confidence and allowed funding markets to reopen, leading to a significant amount of debt issuance by both banks and sovereigns in the first weeks of 2012. The LTRO has dramatically reduced the tail risk of bank failure and is thus a significant positive step. However, it does not resolve the many problems of the European system.

·       The ballooning of the ECB’s balance sheet is a reflection of how bad the situation is – the banking sector has become very dependent on the ECB and will stay this way for a long time.

·       Europe’s fundamental problem is a lack of growth and competitiveness – this provision of liquidity is likely to exacerbate the problem. If banks lend more to governments through bond purchases, they are likely to withdraw further from lending to the economy, undermining recovery. This is classic crowding-out.

·       Increased austerity measures will continue to provide a very significant headwind to growth and, until we see fundamental restructuring in Europe and the accompanying supply side reforms, the current environment of heightened volatility and continual flirting with recession are here to stay for a very long time.

·       Excessive government debt remains a significant and long-lasting issue that can only be resolved through growth, inflation or money printing.

 

There is a long way to go.

 

A checklist to end the crisis

 

Markets need to lower their expectations – the principal policy focus in the Eurozone continues to be on avoiding catastrophe – buying time and allowing austerity to work. Still, growth in the Eurozone is going to be undermined for a long time, with deleveraging measures making its problems worse. There are several key steps towards ensuring the successful resolution of the its problems:

 

·         A lender of last resort to troubled sovereigns - the ECB is acting as lender of last resort to the banking system, but not yet doing the same for sovereign nations. Such action may take the form of quantitative easing, or it may be through forcing the banking system to purchase government bonds. Some type of open-ended commitment to purchase government bonds is essential to solving the Eurozone crisis.

·         Disinflation – deflationary forces are a necessary prerequisite to rapid monetary expansion and/or quantitative easing. Fading price pressures, in the face of economic distress will open up a new array of policy measures for the region that appear less palatable at present.

·         Some degree of fiscal coordination across the Eurozone

·         Forced bank recapitalization - the scale of balance sheet reduction in the absence of equity raising and the removal of bank credit from the economy is too severe for the Eurozone economy to withstand. A retreat from this stance is necessary to preclude the recession from becoming a self-reinforcing downturn.

 

The impact of Eurozone outcomes on markets

 

There are still several potential conclusions to the Eurozone crisis, and each of them has different implications for markets and investment strategy. Equity and fixed income markets have already factored in a slow-growth environment, and are certainly including some risk premium around the further risk of a Eurozone meltdown. Thus, these scenarios may not take the markets completely by surprise.

 

Scenario 1 – the Eurozone survives intact. Equities should rally 10 percent-20 percent under this scenario, as fear abates and earnings push higher. Peripheral government bond yields should fall, but most developed-market yields will rise. Decelerating inflation, slow growth and anchored short rates should prevent a steep sell-off in gilts, limiting the rise in rates to no more than 50bp -100 bp over 2012. Gilts would be expected to produce returns of around -2% to -7%. High quality corporate bonds would post an expected return of roughly 0 percent.

 

Scenario 2 – some countries exit the Eurozone. If policymakers are able to control market contagion, this event may lead to short-term losses but market moves would be somewhat limited given the extent to which this risk is recognized. We believe that interest rates/bond yields and equities would remain range bound around current levels.

 

Scenario 3 – Full scale Eurozone break-up. This is a small probability (less than 10 percent), but would produce catastrophic outcomes. UK interest rates would fall but gilts would struggle to produce returns greater than five5 percent. Equities would fall very sharply but predicting the chain reaction of events that might ensue is difficult. Even with aggressive policy action, a global recession would be a near-certainty and risk premiums would rapidly escalate.

 

In summary, there can be no doubt that the current crisis represents a transformational event in economic history. Undue concentration on daily developments, however, can leave investors blind to the longer-term opportunities and threats. The legacy of this crisis will be felt for decades, irrespective of upcoming policy responses.

 

Which asset classes will investors turn to as they search for income without exposing themselves to excess risk?  High yield and emerging market bonds arguably offer greater transparency and a better risk/reward trade-off than government bonds, and both are therefore likely to continue to be well supported.  Shares in large-cap, high-yielding companies with strong balance sheets, robust cash flow generation and proven capital allocation strategies are also likely to be in demand as the January rally in equities has demonstrated.   It is a world of serious challenges, but one that will be rich in opportunity for flexible investors. Both in fixed income and in equity markets, stock-picking is the key.