ANALYSIS – Big money tiptoes back to Europe

By Reuters Staff
July 14, 2010

By Mike Dolan

LONDON, July 14 (Reuters) – Whether the euro zone is at the middle or end of its existential sovereign debt crisis, investors are starting to take a fresh look at the region’s assets and wondering if this year’s market panic was overdone.

Few analysts would be brave, or rash, enough to sound an “all-clear” on the regional financing storm — one seeded by Greek government profligacy and dodgy statistics but which also exposed flaws in the single currency’s framework and spread rapidly to other highly-indebted euro governments.

The global reverberations through April and May saw equity volatility — the seismograph of financial shocks — soar to levels not seen since the depth of the 2008/2009 global recession, even as euro zone industrial production growth was roaring at an annualised rate in excess of 10 percent.

Spooked by a lack of visibility and heightened political risk, investors scrambled to reduce exposure to euro government debt, underlying equity markets and banking stocks and the euro currency itself. Conviction about the likely outcome was less important than the fact it was impossible to see a roadmap.

Yet after three months of infusing market prices with “tail risks” — or worst-case scenarios from cascading sovereign defaults to banking system collapses and euro breakup — money managers are again looking for opportunities to exploit the resulting price extremes in the event of more probable outcomes.

The question now is whether that euro asset phobia has run its course and whether EU policymakers — backed by the Group of 20 leading world economies — have managed to create a firebreak with their May 10 rescue package for euro bond markets.

Two months on, a progress report shows the authorities have at least reached first base — stabilising bond prices with selective buying by the European Central Bank and stopping the hysteria, contagion and self-feeding spirals that forced Greece to be locked out of capital markets altogether.

Debt market premia for the peripheral euro zone governments, with the exception of Spain, are all below pre-rescue levels. And despite a credit rating downgrade in the interim, Spain has continued to sell bonds around the world to brisk demand.

European equity markets have rebounded by six percent, while equity market volatility has almost halved. Even the euro  has managed to return within a whisker of pre-rescue levels against the U.S. dollar.

RESCUE REACHES FIRST BASE

So far, so good then. For euro governments, time has been bought to get parliamentary approvals for the rescue; establish a special financing vehicle to act as future fireman; rebuild confidence in European banks via stress tests and — crucially — pass austerity budgets to fill in widening fiscal holes.

For investors, the political fog starts to lift, visibility returns and they can resume what they do best — assess valuations, high-frequency economic and earnings data and relative pricing.

And in that regard, they find a premium on European blue-chip dividends over core government bond yields at its highest level since the Lehman Brothers’ bust in autumn 2008 and Thomson Reuters data shows these equity risk premia almost two percentage points above historical averages.

“Despite the fiscal austerity measures coming out of the region, we think that Europe is now an interesting place to invest,” Henry McVey, New York-based head of Asset Allocation at Morgan Stanley Investment Managers, told clients this month.

“Now may be the time to consider shifting regional preferences out of the United States and back towards Europe.”

Such views were almost startling in their rarity this year — certainly after six months in which fund tracker EPFR reported a net $12 billion exiting western Europe equity funds.

Not to get carried away, McVey goes on to explain that a big price spike may not be warranted; public cohesion around austerity plans was still a risk; and bullishness centred on rotating to core “value” stocks rather than “growth” stocks.

But he added: “We now believe that — compliments of the Greek debt debacle — European financials and energy companies have become more attractively priced.”

Fund managers polled by Bank of America Merrill Lynch this month also showed extreme pessimism easing and they reported that underweight positions in euro zone equity fell to almost a third of extreme June levels.

Likewise, euro currency bears have also retreated and data from the Commodity Futures Trading Commission shows speculative “short” euro contracts falling to a third of May peaks.

Even global demand for European government debt has re-emerged with Spain’s international bond issue. China’s currency reserve managers are reported to have taken almost 10 percent of this month’s 6 billion euro debt sale — soothing fears that central banks were cutting euro exposure.

The euro zone has not imploded in a puff of smoke and, despite its many travails ahead, the investment world cannot ignore the world’s second biggest economy for long. (Graphics by Scott Barber; editing by Stephen Nisbet)

((London newsroom +44 207 542 8488. Email:mike.dolan@reuters.com))

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