As we think about the commentaries on the future of the euro that we’ve seen in recent weeks, we are reminded of the advice that the legendary Swiss avalanche expert Andre’ Roch would give to mountain climbers and skiers who sought his counsel: “Remember, the avalanche does not know you are an expert.”

Just as it is impossible to predict the exact course of an avalanche, it is impossible to predict the exact future of the euro. There are simply too many factors that will determine the outcome. Moreover, the relative importance of these factors continues to alter over time, making a complete picture impossible to grasp.

What can be done is to consider a range of outcomes and their likely impact on the financial markets. From this, we can identify several portfolio strategy themes that all investors should consider in the months ahead.

As of this writing, the most probable (and optimistic) scenario is that the European Central Bank (ECB) agrees to act as the lender of last resort and embark on a program of buying as many sovereign bonds as necessary to stop the rise of eurozone interest rates (see chart below). In return, eurozone members would agree to a so-called fiscal union, which would control the deficits individual countries could run. The resulting austerity measures would probably push Europe into a recession but the global financial markets would likely experience a relief rally.

Source: Bloomberg

A second scenario involves the weaker peripheral countries (e.g., Greece, Italy) abandoning the euro while the stronger countries (e.g., France, Germany) move toward fiscal union. The short-term effects of this decision would hit Europe’s banks hard. Depositors in the weak countries would attempt to get their money out before a conversion to a new, weaker currency. Creditor banks in the strong countries would face massive write-downs. So, while the euro would survive in some form, Europe would be left with a weakened banking system and the likelihood of a more severe recession. Consequently, for some period of time, the cure might be indistinguishable from the disease.

The third scenario is a complete breakup of the euro. We think this is the least likely scenario simply because even the most ideological policymaker must realize that the consequences of this scenario could rival the meltdown the global economy faced in 2008-2009. No office holder would want to be known as having played a part in such an outcome.

So given these scenarios – or variations we haven’t imagined – what are the implications to portfolio strategy? We believe there are several:

 

• Maintain adequate liquidity – Having access to ready cash to meet operating or living expenses is always important, but especially during periods of market duress. We recommend that cash equivalents be kept near the upper-end of investment policy strategic ranges. It is also important to make sure your money market holdings are not overly exposed to European debt.
• Returns on European assets will face headwinds – It is hard for us to imagine a resolution to the euro crisis that can also avoid a recession in Europe. In fact, based on the recent purchasing managers’ data, the eurozone may have already entered a recession (see chart below). While current stock and bond valuations seem to discount all but the most severe economic outlook, a meaningful recovery will take time to unfold.

 

Source: Bloomberg

 

• Alternative strategies should be additive to portfolio returns – Until fears of a euro breakup are behind us, market volatility will remain high, providing ample opportunities for alternative managers pursuing long/ short or directional strategies to add value. Also, the turmoil in the European credit markets is likely to provide distressed debt and special situation managers a large opportunity set.
• Traditional active managers may continue to struggle to outperform passive benchmarks – Correlations between securities and asset classes tend to rise during periods of market uncertainty. This makes it difficult for active managers to add value over passive benchmarks. This should be considered when evaluating portfolio returns in the months ahead.

 

Unfortunately for investors, most of the important events that affect the financial markets cannot be predicted with any precision. Consequently, the only way investors can preserve and build capital is to balance what is known against what might happen. Too much emphasis on the former encourages activity in markets where prices have already adjusted, while too much focus on the latter encourages market timing. But by steering a path between the two, investors can capitalize on the opportunities the current market environment offers without risking permanent capital loss if the future holds unpleasant surprises.

Finally, it’s worth noting that Mr. Roch himself survived three avalanches. Let’s hope the euro is equally fortunate.

© Chess Financial

www.chessfinancial.com