In rough weather: adjust speed, check equipment and stay on course, says Carmignac’s Saint-Georges

Didier Saint-Georges, member of French manager Carmignac Gestion’s investment committee discusses investment strategy in light of ongoing policial, monetary and fiscal challenges across Europe.

As we wrote in our March newsletter (“It’s more than just economics”), confidence and liquidity have become decisive factors in the markets’ short-term performance.

The radicalisation of political alternatives in Greece, Spanish leaders’ futile denial of the need for a European rescue plan and electoral posturing by a French government seeking a parliamentary majority have made the markets’ highly dependent on political hazards.

Meanwhile, the concentration of flows towards safe-haven assets (Germany can now borrow for nothing over two years, while the dollar is at its highest against the euro since the summer of 2010), the fear of capital flight and calls for another liquidity injection by the ECB illustrate the importance of liquidity movements in how the crisis develops. This backdrop, which it would be unwise to underestimate as it allows for no easy or quick solution, continues to justify our global investment strategy: actively manage short-term risk exposure using various tools and remain focused on a few strong medium-term economic convictions, after closely checking their soundness.

The threat is worse than the reality (chess expression)

Sooner or later, it was inevitable that growing anger in the streets of Athens would be expressed at the ballot box (see our December 2011 newsletter, “No more taboos”).

Estimates of the financial impact of a possible Greek exit from the euro are many. However, you do not have to be a mathematician to realise that the amount of capital in the European banking system is still not enough to absorb a new wave of balance sheet losses. It is equally clear that a Greek exit would be extremely painful for the country, which would be cut off from outside funding at a time when its budget – even if all interest charges were cancelled – still shows a primary deficit. Hence why bargaining positions on all sides (“who will blink first?!”) are scaring the markets, but failing to hide the fact that a Greek departure from the eurozone would be in nobody’s interest at the present time.

It is also arguable that if such a scenario were to play out, the ECB would intervene massively alongside other central banks, giving the markets another breather. Things could definitely be worse.

The wind is picking up

Since the end of March, the interest rates demanded by international investors in order to lend to Italy and Spain have risen sharply. Spain in particular must now pay a rate similar to that infl icted on it before the ECB’s intervention last December. The recycling of liquidity provided by the ECB to banks in the purchase of government bonds therefore only provided temporary respite. On the contrary, it further strengthened the fatal link between countries’ economic situation and banking risk.

As it is, the Spanish economy is collapsing with unemployment reaching 25%. Meanwhile, Italy has already had two quarters of negative growth. Even for countries trying to implement brave fiscal adjustment plans, the lack of growth makes their success unlikely and their social acceptability harder with every passing day. The markets’ distrust of governments is therefore spreading to banks, which now fear an even faster run on deposits.

This is especially the case in Spain, where the banking sector -and Bankia in particular- remains significantly undercapitalised [as of writing this on 1 June].

This is a key issue as deposits held by Italian and Spanish banks (€3 trillion) are 17 times greater than the amount deposited in Greek banks.

These are considerable sums, which would make a serious capital flight uncontrollable. As such, it is essential to limit the perception of a short-term liquidity risk to the system.

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