For Europe, Bad to Worse

03.01.2012 08:01

WSJ: Bouts of panic. Moments of elation. Vertiginous plunges. Markets lurching on the scantiest fragment of news from a Parliamentary committee in a minor-league country.
That was investing in Europe in 2011. Be prepared in 2012 for at least more of the same.

The rocky road was thanks to weakening economic performance across the continent and, most of all, to the euro-zone debt crisis.

The economic story is almost certain to be worse. Europe saw modest growth in the first quarter of 2011, and then the slowdown began. Most economists now project recession in 2012.

As for the debt crisis, it is far from over. At the end of 2011, European leaders all but gave up their bid to build a giant bailout fund—they just don't have enough cash—and instead scrambled to assemble the underpinnings of a tighter fiscal union, in the hope of giving a reluctant European Central Bank confidence to step in and offer support for government-bond markets.

But Europe has only touched its toe on the fiscal-union path, the faraway end of which is common debt issuance for the 17-nation bloc. A lot could go wrong before it gets there.

The peril starts in January, when euro-zone governments plan to issue a wall of debt. "It's going to be hard to take it all down," says Nick Firoozye, senior European rates strategist at Nomura Holdings Inc. in London.

Then come the fraught negotiations over Greece's debt restructuring. Euro-zone leaders and big creditors agreed in October that bondholders would take a 50% haircut, but the mechanics of the complex restructuring aren't finished. Greece may try to push for a better deal. "It's in Greece's interest not to reach an agreement," Mr. Firoozye says.

But there is pressure to complete a deal before mid-March, when Greece is scheduled to repay a €14.4 billion ($18.7 billion) bond. Any hiccups could unnerve markets.

Across asset classes, investors should expect volatility and uncertainty. Here's a guide:

European government bonds have been the asset class most affected by the crisis so far. It has been "an environment punctuated by bit of optimism and bits of pessimism," says Nicholas Gartside, international chief investment officer for fixed income at J.P. Morgan Chase & Co.'s asset-management arm. "You've had both extremes, and our view is you are likely to see those extremes continue into the next year."
The extremes in 2011 were dizzying. Like U.S. Treasurys, German government bonds rallied strongly as a safe-haven bet. But Italian yields spiraled into junk-bond territory.

Performance of "peripheral" euro-zone bonds—a category that probably now includes Italy, the third-largest economy in the bloc—is likely to be hugely volatile. The yields are enticing, but the investment isn't for the faint of heart.

The giant risk is a sudden stop in financing to Italy. The ECB has tried to prevent that with a modest program of bond buying and big injections of liquidity into the banking system. But many analysts are skeptical that banks will take that cash and finance Italy. Regulators are pressuring them to reduce their exposure to the wobbly periphery, not increase it.

At the same time, Mr. Gartside says the outlook remains bright for Germany. There is little visible threat from bond investors' two chief villains—inflation and higher interest rates—and Germany should continue to be a haven.

The Euro
One of the head-scratchers of the debt crisis so far has been how well the euro has held up amid all the frantic fretting about the dissolution of the currency zone. The euro started 2011 at $1.34 and ended it at $1.30 (with rounding). Yes, there have been ups and downs in between, but the common currency never broke $1.50 and only barely sank below $1.30.
There are a few explanations. First, the fear of a schism in the euro zone is probably overblown. Second, currency rates are influenced by banal factors such as interest-rate differentials, crisis or no crisis. And even after a round of rate-cutting, the European Central Bank has a higher target rate than the Federal Reserve.

There are more-subtle factors. Stephen L. Jen, managing partner of London hedge fund SLJ Macro Partners and a currency watcher, says European banks and corporations have been repatriating overseas assets—helping to offset flight out of the euro zone. And much movement has been "south-to-north" migration, he says—investors pulling out of Greece, but piling into Germany and the Netherlands. That is neutral for the currency.

What to expect in 2012? A crucial dynamic will be the recession everyone expects is coming. If it is nasty, the ECB may cut rates and, some analysts believe, even hold its nose and adopt a quantitative-easing policy where it buys bonds to provide monetary stimulus to the economy. That would erode the interest-rate advantage the euro has over the dollar and implies a weaker euro.

Of course, the ECB isn't the only one with these concerns: If the U.S. Federal Reserve embarks on a third round of quantitative easing, or QE3, the pressures are potentially reversed.

And there is always the threat of policy stumbles by European leaders jolting the markets.

All in all, "trading euro-dollar will require a lot of care," Mr. Jen says.

European equity investors probably wish 2011 were just a bad dream. The U.K.'s FTSE 100 was off 5.6%, Germany's DAX fell 15% and France's CAC-40 lost 17%.

Can investors hope to wake up in 2012? Maybe.

Domestic economic performance will likely be bad, but the big companies in Europe's major indexes are world-wide players, and they can benefit from a brighter picture in Asia and even the U.S.

"The rest of the world is in a much better place," says Nick Nelson, UBS AG's European equities strategist. "It's a European recession, not a global recession."

A somewhat weaker euro, he expects, will also aid the region's exporters.

The downside? The debt crisis has been an albatross for equities. Mr. Nelson notes that the price-to-earningsmultiple investors have been willing to pay for European stocks correlates inversely with an index of European sovereign credit-default swaps—a measure of the risk of government debt default. In other words, when the debt crisis rears up, investors are less likely to take a gamble on stocks.

That was on full display in August, when Italy tumbled into the maw of the crisis. The Milan exchange was pummeled, but so too were bourses in Paris and Frankfurt and London. The DAX had three days in August on which it fell by more than 5%; before August, the last such single day was in March 2009.

Mr. Nelson predicts a small rise in European indexes in 2012—but it is an outlook dimmed by uncertainty. "Volatility," he says, "is massive."

Write to Charles Forelle