Europe’s debt crisis enters its third year with no resolution in sight. Greece appears as likely to default now as it did in May 2010, when euro zone countries and the International Monetary Fund cobbled together an aid package — coupled with austerity measures — to enable Athens to meet its obligations.
Before that year ended Ireland became the first beneficiary of the European Financial Stability Facility, a bailout fund created in response to the Greek crisis and supported by the so-called troika: the European Central Bank, the European Union and the IMF. Last spring Portugal followed in Ireland’s footsteps and was granted a reprieve, but by the summer fears of contagion — notably in Belgium, France, Italy and Spain — had become so pronounced that the EU asked contributing countries to increase their commitments to the facility, eventually raising the total amount pledged from €440 billion ($579 billion) to €780 billion.
The EU established the EFSF in part to restore investor confidence. In December the ECB stepped up with a historic infusion of cash also aimed at reassuring investors; it agreed to lend more than 500 banks a total of €489 billion for a period of three years at just 1 percent interest. “The difference between December 2011 and January 2012 is striking,” notes Simon Greenwell, who directs coverage of Europe, the Middle East and Africa for BofA Merrill Lynch Global Research. “The large injection of liquidity authorized by the ECB has materially increased the long-term solvency of the EU banking system.”
However, investors’ nerves were rattled anew last month — on Friday the 13th, no less — when Standard & Poor’s cut the credit ratings of nine European countries. France was stripped of its cherished triple-A status, while Cypriot and Portuguese bonds were downgraded to junk (putting them on a level with Greece’s, and fueling speculation that a default by Portugal is all but inevitable). Italy and Spain each was dropped two notches; Austria, Malta, Slovakia and Slovenia were lowered one level apiece.
Three days after these downgrades, S&P cut the credit rating of the bailout fund itself.
“The risk of a sovereign default and the impact of spending reductions taken to avoid this outcome dominated investor sentiment in 2011, and this will extend into 2012,” observes Richard Smith, Deutsche Bank’s director of EMEA equity research. “Politics will have a crucial role to play over the next year.”
Greenwell says policymakers have few options: “They can muddle through, separate or go for fiscal integration,” he explains. “Ineffective muddling through is the most likely scenario as governments appear unable to find a solution to prevent the crisis from spreading.”
And spread it has. Market pundits have taken to employing barnyard allusions to describe the situation. In 2010 they opined about problems with the PIIGS (Portugal, Ireland, Italy, Greece and Spain), and by last year were expressing concern about Europe’s broken EEGs (Everyone Except Germany). The message was clear: Investors need to be careful where they step.
Fortunately, there is no shortage of available guides; many firms have been boosting their coverage to keep clients up to date with all that’s happening. Institutional Investor asked money managers which analysts are doing the best job of providing the direction they find most helpful and thus deserve to be included in the 2012 All-Europe Research Team , our 27th annual ranking of the region’s best analysts and teams. Deutsche Bank reigns supreme for a second straight year, with 44 total positions — seven more than in 2011 — and nearly triples its number of first-place teams, from six to 17.
BofA Merrill adds two positions, for a total of 30; that’s enough to bump the firm up one notch to tie with UBS for second place, the same spot the Swiss bank held in 2011. (UBS holds steady despite a loss of four positions.) Also returning in the same place as last year — in a tie for fourth — are J.P. Morgan Cazenove and Morgan Stanley ; each adds one position, bringing its total to 24.
Survey results reflect the opinions of some 2,200 money managers at more than 760 institutions managing an estimated $5.7 trillion in European equities, or nearly 84 percent of the MSCI Europe index’s market cap of $6.8 trillion at the time of polling.
Citi makes the year’s most dramatic move, picking up six positions, for a total of 16, and leaping from tenth place to tie for sixth with Credit Suisse (which falls from No. 4). “We have totally refreshed our team, with over 60 analysts joining over the last 18 months,” explains Terence Sinclair, Citi’s head of equity research. “We have also focused on revamping our content. We added a new stock to Western Europe coverage every two days. We introduced a new, three-month recommendation alongside the 12-month recommendation, and we invested heavily in emerging-markets research.”
The firm is emphasizing collaboration among its analysts across countries, regions and asset classes. “Undoubtedly, macro is king for the moment,” he explains. “Clients want as much insightful economic research — and strategy and sector research that is joined up to that economic research — as possible.” To meet that need, Citi publishes daily sovereign-crisis updates and a thematic “Euro Weekly” report, and hosts regular investor calls with experts on key developments.
Teamwork is also the order of the day at UBS. “The macroeconomic view continued to be the dominant influence on the direction and volatility of markets in 2011, and this is also likely to be the case at least for the first half of 2012,” believes Mark Stockdale, head of European securities research. “UBS responded with a significant uplift in notes from the economics team as well as from colleagues in fixed-income, currency and commodities research and strategy, to provide a linked-up view of markets.”
Portfolio managers are demanding more research into the connections among regions and asset classes, agrees BofA Merrill’s Greenwell. “In 2011 we developed a multi-asset-class capability to help clients understand the links between equity, credit, commodities, foreign exchange, rates and structured finance — and highlight ways of mitigating market risk,” he says.
Deutsche is employing a similar approach. “A thorough understanding of macro drivers is more important than ever for equity analysts as they formulate their forecasts and recommendations,” according to Jonathan Jayarajan, associate director of EMEA equity research. “We have weekly meetings where the latest views of our economists and our equity, credit, foreign exchange and commodities strategists are articulated for the entire European equity research platform. It ensures that our equity research team always has the latest and most accurate interpretation of events.”
One frequent topic of speculation is whether the single-currency union will survive. Deutsche’s Smith believes it will. “External observers tend to underestimate the determination of euro zone members to defend their currency,” he says. “They also tend to forget that the majority of EU members outside the euro zone want to join it eventually.”
Adds Jayarajan: “There is considerable political will at the heart of Europe to ensure that the currency succeeds, and we expect politicians to move far enough — under duress — to ensure the requisite treaties will be in place to deliver a functional currency.” However, he adds, “we cannot rule out that the member countries of the euro could change.”
Citi’s Sinclair concurs. “We don’t believe that the euro will break up, but everyone has to be positioned in case some countries leave,” he says. “These fears were the biggest drivers of indexes in 2011.”
Stockdale says UBS analysts “do not see the demise of the euro as a central case, but as a risk scenario. Investors were concerned as 2011 unfolded about the sustainability of the euro — with more concern from investors outside the euro zone itself.”
BofA Merrill believes a breakup is a “tail risk for 2012,” Greenwell says. David Hauner, the firm’s head of emerging EMEA economics and fixed-income strategy, modeled a scenario whereby dissolution resulted not in a reversion to single-country currencies, but rather in the establishment of three regional economic unions. “This is a useful structure, to look at the euro zone by geographic approximation, and these could be applied to thinking behind growth rates,” Greenwell adds.
Will the region produce growth? “Unless the sovereign-debt and banking crises are solved, it is a simple no,” he says. “We remain as bearish on the euro zone as we were last year.”
Others are more optimistic. “Our strategists expect European equity markets to be up moderately by year-end, although they see considerable downside risk in the first half as the markets remain jumpy around sovereigns’ refinancing,” Jayarajan says.
Citi is more bullish still. “We are reasonably upbeat on equities and forecast a 20 percent gain in global equities by the end of 2012,” says Sinclair. “We think the market has priced in a global recession, which is unlikely. In Europe we have strategies built around ‘world champions’” — that is, locally based companies exposed to high-growth overseas markets.
That last point is a particular advantage in Iberia; many companies headquartered in Portugal and Spain have strong connections to dynamic markets in Latin America. Mariano Colmenar, who captains his Santander Investment Bolsa team to its third straight appearance in the No. 1 spot in Iberia coverage, notes that 22 of the companies in the benchmark Ibex 35 index have “material exposure to LatAm, and more than 25 percent of the Ibex 35 company revenues are generated in the region. This exposure should allow companies to offset a large part of the revenue slowdown coming from difficult conditions in the domestic market.”
However, emerging-markets presence alone is no solution. “International investors are broadly underweight in the euro zone on the back of poor economic and financial conditions,” the Madrid-based analyst says. “For them to come back, we need more visibility in the Greek situation, and further progress in fiscal coordination, European emergency funds, structural reforms in some peripheral countries and so on.”
Next door, in France, the story is similar. “We are advising investors to buy stocks that have a chance to grow despite this gloomy environment, either because of their exposure to other, faster-growing regions or because of secular drivers in their business models,” explains Exane BNP Paribas’s Vincent Laurencin , who for a third year running leads the team voted No. 1 in French research. “We don’t subscribe to some of the more extreme negative views concerning the sustainability of the euro zone, and we believe that the measures taken by the ECB to provide liquidity to the banking system and ultimately to the economy have been underappreciated. We see the possibility of a short, sharp rally — especially given the very bearish sentiment prevailing around European equities.”
The analyst, who divides his time between London and Paris, doesn’t think a rally will last, however. “One of the consequences of solving the sovereign problem will be a lengthy period of low economic growth for Europe created by the higher taxation and lower government spending necessary to pay down our excessive government-debt levels,” Laurencin says.
Also anticipating stagnation — “at best” — in the euro zone is Rabobank’s David Tailleur , who leads his Utrecht-based team to a second straight first-place finish for coverage of Benelux. “To jump-start an economic recovery in Europe, the sovereign-debt crisis needs to be solved, and consumer confidence and unemployment data need to bottom out,” he says. Belgium took a step in the right direction in December when it finally installed a new government. (It had been run by a caretaker coalition since June 2010.) The move was “a necessary precondition to ensure the required cost-savings measures,” Tailleur explains. “Whether this will be a guarantee to avoid any more severe debt issues is difficult to conclude, as it also depends on the broader euro zone debt crisis — that is, the potential spillover effect.”
Low growth sure beats no growth. Economists at J.P. Morgan Cazenove don’t believe the U.K. economy will revive this year but think it will manage to avoid recession and eke out a real gross domestic product gain of 0.5 percent. Paul Huxford , who was named director of European equity research last May and leads the firm’s U.K. team to the winner’s circle, anticipates “beneficial tailwinds” from a declining euro and stable corporate earnings that should boost cyclical stocks — especially those with exposure to emerging markets. Also standing to gain, the London-based analyst says, are cheap equities ripe for value-style investors.
Carola Bardelli , whose Deutsche Bank team wins top honors for the first time for its coverage of Italy, notes that investors were relatively unfazed by S&P’s move last month. “Credit rating agencies have recently reflected ex post what markets had already anticipated — that is, what prices were already incorporating,” she explains. “For example, the double-notch downgrade came after a 26 percent fall for Italian equities in just over a year. Interest from international investors has actually increased since the beginning of 2012.”
Nor does she believe that the downgrades will prolong the sovereign-debt crises. “Markets are valuing positively both the national government’s efforts on austerity and growth reforms, and the ECB’s support of the European banking system,” says Bardelli, who works out of Milan. “Thanks to the ECB’s three-year, long-term refinancing operation, banks can access cheap liquidity — and a reduced cost of funding should ultimately support the real economy and avoid a credit crunch.”
Bardelli’s colleague Andreas Neubauer agrees. “The power of the ECB’s three-year LTRO is being increasingly reappraised by the market,” says Neubauer, who has led Deutsche’s Frankfurt-based crew to first place in coverage of their home country for a remarkable 16 consecutive years. “At the very least, it substantially reduces financial stability risk. Whether it is also used by banks to drive a sovereign carry trade depends on whether sovereign sustainability has itself improved. The chances of successfully exiting the crisis are rising.”
Ireland is shaping up to be the sovereign-debt success story. As recently as last summer, some analysts were insisting that the Emerald Isle would default, but last month “Ireland pushed out €3 billion of its debt maturity by one year, helping to alleviate what would have been a very big refinancing requirement in early 2014,” says Davy’s Barry Dixon , whose Dublin-based team has been voted No. 1 for coverage of their home turf nine times in the past 11 years. “The fact that the initial offered amount of circa €2 billion was way oversubscribed is a positive sign that investors are gaining confidence on the prospects for the Irish market.”
Given that Ireland has a small, open economy — gross exports account for more than 100 percent of GDP, Dixon notes — “it is easier for Ireland than some of its European peers to address its deficit issues,” he says. The country nevertheless faces a bumpy road to recovery despite being the only market in developed Europe to end last year in positive territory — up 15.1 percent. “On the face of it, the Irish market was one of the best performing last year,” Dixon begins. “But if you strip out the 147 percent appreciation in pharmaceutical stock Elan, the index was down 7.3 percent, bringing the underlying performance more in line with other international markets.”
Stock picking remains essential — and challenging. “Stocks that underperformed last year are the ones that have rallied the most as the market perceives the worst to be over,” he adds. “We don’t believe the worst is over just yet, so we are maintaining our cautious stance.”
Caution seems to be the word of the moment. “Europe is home to some of the best-regarded companies in the world, but it would be impossible to deny that their growth prospects have been impacted by the euro zone crisis and the lack of growth caused by the associated austerity measures,” notes Deutsche’s Jayarajan.
“Sometimes distance can lend perspective to investment decisions, but our main concern has been to explain the difficulty in reaching a solution to the sovereign-debt crisis to all investors — wherever they happen to be located,” adds Smith. “The frustration at the lack of an easy solution seems shared by investors in Europe and elsewhere.” • •
