French manager Conviction turns positive on European peripheral debt

Paris-based Conviction Asset Management is seeking to capitalise on market fears by investing in Italian, Spanish and Irish bonds, even though its managers think risks posed by European sovereigns are higher than those facing its beleaguered banking sector.

Reform efforts underway within those economies should lower risk levels, making the debt an attractive asset class, said fund manager Alexandre Hezez. But Greece is seen as too risky by investors everywhere, he said.

The firm’s gamble is based on the belief of Hezez and firm President Philippe Delienne (pictured) that Europe’s political leaders and the ECB have no choice but to pursue radical action to stabilise its markets.

The ECB’s asset purchases of Spanish and Italian debt to maintain spreads under a level of 6% mean risk is high, but can be contained, they said. “Massive action is necessary”, they added.

The central bank’s promise to provide unlimited liquidity, and enlargement of the European Financial Stability Fund offers a “security blanket” for fearful investors, they said.

But recapitalisation of Europe’s banking sector is “impossible”, particularly for French banks, said the managers. The banks’ valuations weighed against their capitalisation requirements, and expected losses on their risk-weighted assets to core tier capital holdings shows an inability to meet those requirements, said Hezez. According to the firm, Europe’s banks have reached “the end of the lever”.

Ironically, that means they are positive on hybrid banking and insurance securities at tier one and lower tier two level, due to banks’ need to hold on to that capital. Conviction is neutral on banking and insurance stocks however, based on expected lower valuations.

Returns will not come from emerging debt or equity markets, said Hezez and Delienne, who are neutral on both asset classes. But emerging market currencies are expected to perform strongly, they said.

Market volatility is increasing equity risk premiums due to perceived risk, said Hezez and Delienne. They are selecting US corporate stocks, in the belief the economy will perform well into 2013 if consumption sustains. Rising consumption is in contrast to falling confidence however, as long-term US unemployment is a potential threat to future growth.

Europe faces low consumption, with tightening credit conditions from banks lowering conditions for growth, they said. Both the US and Europe will rely on exports for recovery, the managers said.

But surprise macroeconomic indicators show an improvement for the US, Europe, Japan, and emerging markets during October 2011, they said. According to Delienne, the situation is “less bad, but not good”.

France is particularly under attack by CDS markets, while interest rates on its debt are widening against German notes. Its debt trajectory is set to grow to 2014, according to Moody’s data supplied by the firm.

But market pressure on France and the rest of the eurozone is having the paradoxical impact of forcing policymakers to seek stronger action, they said. Strong European governance and five to 10 year Eurobonds should emerge as a response to crisis, they said.

A central role in saving the sovereign and banking system will ultimately fall in the hands of the ECB, which has some margin for manoeuvre, they said. That is in contrast to the Fed, whose strategy of buying long-term Treasuries and selling those on short term will have a limited impact, they said.

US politics is likely to hamper its debt recovery strategy, but the Eurozone is also at risk if consensus cannot be established, particularly with Germany, Dezez added.

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