Euroland not out of the woods yet

A year after Mr Draghi’s London speech, a nascent recovery is starting to heal the wounds of recession and fiscal austerity in Euroland, but it would be a mistake to assume that the euro crisis is over.

Major challenges remain for Euroland, including completion of institutional reform, in particular the banking union, engagement in proper economic rebalancing, the building of a macroeconomic framework that combines structural reform and demand-supporting measures, and the addressing of  Europe’s political and fiscal finality.

The upcoming German elections have raised expectations about policy change in Europe but we anticipate that the key issue is not the election and the election result per se but much more what happens afterwards.

We see two scenarios.

First, in the absence of market pressure, Europe may be unable to overcome and align different national economic and political incentives. Lack of progress would then leave Europe vulnerable to a return of market stress, most likely when growth weakens. That would not be a story for 2013 but could possibly rear its head in 2014. In theory, this could mark the return of “crisis-led reform” – but in practise, we cannot be certain that the single currency project could politically survive another period of intense market stress due to the economic and social “collateral damage” that would entail.

The second scenario is that in order to prevent the first scenario, Europe overcomes national incentives and finds a new model for policy coordination, with a central role for Germany, but we see only limited scope for more proactive leadership. Progress would therefore require co-operation of many actors going forward and we are writing separately on the key players, their incentives and constraints, and the resulting range of possible outcomes.

As to what can be achieved, we see the greatest scope for more economic rebalancing and a somewhat more growth-friendly macro framework. Institutional reform will be challenging, however, and we are concerned that the crucial banking union will arrive later and will fall far short of the pan-European framework that proper currency union warrants and may require. What’s more, getting to a shared and coherent vision of the future of Europe is inherently tricky and we should at least expect longer negotiations and less clear-cut solutions. Only time will tell if it will be enough to prevent the return of market stress in the long run.

In terms of market impact and implications, a push towards core rebalancing should put upward pressure on core yields and boost assets geared to stronger core demand. Peripheral spreads should benefit but are also subject to progress regarding banking union.

Senior unsecured debt is the most vulnerable part of national capital structures, due to its subordination, and the risks do not look to be fully priced in. In line with markets we expect stronger banks to privately recapitalise and a more forced bail-in of unsecured creditors in weaker banks, particularly in the periphery. We expect the interconnection between banks and sovereigns to be only partially broken.

For Greece, we expect that negotiations will be dragged out and there will be heightened mark-to-market volatility as political pressure mounts (especially in spring next year) – initially idiosyncratically, but then causing contagion to Portugal. We expect only the 2014 financial gap to be addressed immediately and gradual payment in sub-tranches to continue. Against this backcloth, Greek government bonds will likely continue to be the most levered exposure to the prospects for the euro.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla