The eurozone provides an extreme example of this, where the severity of the problem is compounded by the need to co-ordinate policy among seventeen member states. In this context, the announcement of bank recapitalisation, a leveraged EFSF and a 50% haircut on Greek debt by the European authorities should be encouraging. Have they finally heeded the warning from the markets?
Certainly these measures, on the face of it, could help to calm markets as we go into the year end. The good news is that the European authorities in general, and the German government in particular, have understood the need for action. With the prospect of further announcements over the next few days and weeks it will be hard for market participants to ‘short’ European political risk.
However, the devil will be in the detail: in order to leverage the EFSF at a reasonable cost France must retain its AAA rating; there is still a lack of clarity as to what the role of the ECB will be; and will a 50% haircut be enough to save Greece from bankruptcy? Finally, longer term issues remain relating to how the competitiveness of the peripheral economies can be restored in the absence of currency devaluation.
Overall, we have increased our exposure to equities and credit over October in the expectation of improved market performance into year end. In the short term, US economic data have improved and for the time being the European authorities have kicked the can a little further down the road.
However, we remain vigilant. Remember, debt has not been retired – only shifted - and at some point the options are to pay it back or to default. Both are painful events that will limit growth for an extended period. Moreover, the absence of a sound banking system which can extend credit will further depress potential growth. Against this backdrop we continue to focus on the trends we trust. Within equities, our emphasis is on higher quality exposures and, across other asset classes, we aim to focus on enhancing yield in a low interest rate environment.