Finally, a deal! Tail risk of a disorderly Greek default dissipates.

European leaders have finally delivered what looks like a comprehensive plan to manage its sovereign debt problems from spreading to bigger economies such as Italy and Spain and to avert a possibly ruinous banking crisis.

After what seemed like days and hours of deadlock and brinkmanship at the EU ministerial summit, significant progress has been made on three key areas, even if key details are lacking.

On the Greek situation, officials have managed to persuade bondholders, especially banks, to take 50% losses on their holdings of Greek government bonds.

This paves the way for European banks to recapitalise their dented balance sheets to an agreed target of 9% in Tier 1 capital ratio by 30-Jun-2012. The European Banking Authority estimated banks’ capital needs at EUR 106 billion, with Spanish banks requiring EUR 26.2 billion and Italian banks EUR 14.8 billion. It gave them until 25-Dec to submit money-raising plans to national supervisors. Banks that fail to raise enough capital on the markets will first tap national governments, falling back on the EFSF rescue fund only as a last resort.

Finally, they have also agreed to expand the firepower of the euro zone's bailout vehicle, known as the European Financial Stability Facility (EFSF), by four- or five-fold suggesting it could provide guarantees for around EUR 1 trillion. Details are still sketchy but turning this fund into a bank with a credit line from the ECB has been squarely rejected by the Germans. It is likely that the EFSF will be used to insure bond issuance by affected countries, and to create a special investment vehicle that would tap money from both public and private investors within and outside of the euro-zone. 

What does it mean for equities and risk assets? After two months of de-rating driven by perceptions of sovereign defaults and systemic banking risks, we expect the equity risk premium to fall as the tail risk of a disorderly Greek default and banking crisis have been averted. This suggests that the rebound in risk assets that has been underway in recent days may well continue for some time.     

Therefore, we upgrade our tactical assessment of stocks from underweight to neutral. This translates to a three percentage points increase equities in our conservative profile to 18% and five percentage points for balanced and growth profiles to 35% and 55% respectively.

However, we remain cautious in the medium term for a few reasons. For one, it is still critical how all these will be turned into detailed points of action and implemented in the coming weeks. But more importantly, the global macroeconomic outlook remains weak and policymakers having already spent most of their options can't do much about it. Also, investors may just return to focus on the US and the dysfunctional government there just doesn't inspire much confidence either. 

Promising or Just Promises?

Europe appears to be finally gaining momentum in its long and slow struggle towards a solution to the sovereign debt and banking crisis that is threatening its very existence. France and Germany have promised to produce a “comprehensive plan” to end the crisis at this weekend’s European summit on 23-Oct and will present it at the G-20 ministerial meeting on 3-Nov. The plan is expected to encompass three crucial elements: deeper haircut on Greek debt; recapitalisation of European banks; and an increase in the firepower of its bailout fund to prevent contagion to other countries.

Sounds familiar? Sure. The markets have been demanding these actions for some time while politicians were dithering. What is new now and certainly out of character is that a definitive timeframe has been fixed and one that is rather aggressive too. All of a sudden, policymakers in the euro-zone find themselves surfing right up to the curve as markets turned decidedly exuberant in anticipation of a resolution.

Is this the real deal? This is a tough call. That Germany and France have promised to act within such a tight deadline is promising. And markets have rewarded such a bold move with the EUR trading at a 1-month high and equities up more than 10% in the past two weeks. But the devil is in the details and the proof of the pudding is in the execution.

Regarding the amount of haircut, there is still disagreement amongst various countries to accept deeper losses. It was only three months ago that private creditors agreed to a 21% haircut. Germany now wants a 50%-60% write-down while France is resisting because French banks, being one of the largest holders of Greek debt in the region, will be hardest hit. What should the amount be? Too little and the markets will be disappointed. Too much and it will encourage Ireland and Portugal to backslide on their reforms and clamour for a haircut too.

On recapitalisation, what is clear is that banks need more capital. Besides that, little else is clear. There will be new stress tests to determine the extent of additional capital the banking system needs. The stress test scenarios have to be tough enough to be credible but yet at the same time not so demanding that the capital needed to fill the gap is unachievable and risk sending the markets into another tailspin. According to sources, EU leaders are working on a plan to raise anywhere between EUR100 billion and northwards of EUR300 billion. Meanwhile, banks are reluctant to raise capital when their shares are trading at fractions of book value, existing shareholders are resisting calls to pump more capital and governments are weary about using more taxpayers’ money to bail out banks. It is also unclear whether the recapitalisation will be a piecemeal effort on a national basis or a concerted pan-European execution in one go. Germany has stressed that individual countries should take care of its own but France is opposed to that because it could jeopardise its triple-A rating. 

And on more firepower to the EFSF bailout fund, one can only hope that they have achieved a consensus. It is only after a prolonged struggle did the German parliament finally ratified the expansion of the EFSF to EUR440 billion and allowed it to buy bonds in the secondary market as well as to offer credit lines to governments. The same can be said for Finland, the Netherlands and Slovakia. If the EFSF is to be sufficient to backstop the liquidity of the periphery countries including Spain and Italy, it would need to grow to a size of at least EUR2 trillion. And EUR2 trillion implies a coverage ratio of only just about 50%. European officials have to find ways to scale up the fund without requiring another round of voting. They could either turn the EFSF into a “bank” allowing it to leverage up its equity of EUR440 billion through a credit line with the ECB, or alternatively, it could act as an insurer to protect the first 20%-30% of the value of affected sovereign bonds. It is unclear how they will proceed.

One week is a rather short time to manage all these challenges. But then again, this crisis has been brewing for more than a year and a half. With pressure mounting, time running out, European politicians have no more excuses. For once, they have the chance to get ahead of the curve. They should grab it. 

The big question is will they succeed in convincing the markets, or will they disappoint yet again. If the latter, then markets could easily give back all the gains and more, but if the former, then the question is how much more upside can there be. Going by the previous experience in the US in 2009, it can be substantial. In March-2009, US Treasury Secretary Tim Geithner expanded the TARP program to announce a public-private initiative to buy toxic assets from banks paving the way for the banks to be recapitalised. That turned out to be the turning point in the risk markets and equities powered ahead for the next 12 months by more than 80%.

I’m not suggesting we’ll get a similar magnitude of response. For one, while the TARP in 2009 may have removed the systemic risk threatening the banks, the real lifting of financial markets was attributable to the combined global firepower in fiscal and monetary stimulus and quantitative easing.

The world is a much different place now. Governments in the developed world are on an austerity mode even while their economies are moving along stall speed, and central banks do not have much room for manoeuvre with rates already at or near historic lows. The experiment with unconventional policy such as quantitative easing have not yielded much in terms of economic growth but have definitely bloated up the balance sheets of these central banks. And more importantly, investors are less naive. They now know better that you can’t solve a debt problem with more debt. It only comes back to roost at a later time.

For the record, I’m not a pessimist. In fact, as an equity fund manager, my pre-disposition is normally optimistic. I believe we’ll get a strong rebound when we get the resolution. But given the reality, I’m just not as convinced about the sustainability. For me, the best case scenario is that the European crisis is stabilised, developed markets manage a 1-3% annual growth while finding a way to reduce their debts over the medium term without harming the economy too much. But the odds are not high and hence we need to be prepared for a “new normal” in the financial markets with higher volatility and lower returns. This will have strong implications on asset allocation in the next few years. In a high risk-low return environment, the sweet spot in terms of risk profile is skewed towards the conservative. But for now, even though we are cautiously optimistic, prudence would dictate that we change our allocations only when we get more clarity on 23-October.

Asian Equities Held Hostage to External Circumstances

Why so weak?

Asian equities have underperformed since the middle of August as structural problems with the fiscal health of the US and the EU returned to haunt the markets. Once again, Asian and other Emerging Markets (EM) stocks have reverted to their status as the whipping boy when systemic risks rise globally.

 

While the trigger of the weakness was mainly due to external factors, the magnitude of the sell-off especially in the recent two weeks can be traced to positioning. Since the Global Financial Crisis (GFC), investors have piled onto EM assets with impunity. Non Foreign Direct Investment (FDI) capital inflows into emerging markets are at 15-year highs as weightings in market indices gained more prominence for global asset allocators.

It is also understood that the bulk of these investments into the EM were not FX-hedged because of the expectations of currency appreciation due to stronger fundamentals and the need for stronger currencies to contain imported inflation.

In particular, Asian equities have benefited massively from such inflows in recent years as investors are drawn to substantially higher earnings growth as compared to developed markets. Hence, a reversal under current conditions can only exacerbate the magnitude on the downside as investors seek safety and sell both securities and Asian currencies to repatriate their USD money flows.

Impact of capital markets volatility – how it will continue to depress Asian markets

In the near term, sharp market correction posits two immediate impact - margin calls on client positions leading to curtailment of collateral and margins, exacerbating the downside in the near term especially for mid and small-cap stocks, and weaker banks’ earnings, arising from lower client driven capital markets’ activities, lower proprietary positions and higher NPLs. This portends a credit crunch in our view as falling market values force banks to tighten credit further leading to a vicious circle of liquidation.

Value remains undervalued

Where do we go from here? Asian markets have already corrected massively and more so than the US and Europe while valuations have dropped to 10x forward PE vs. 2008 lows of 9x. In terms of value, Asian stocks certainly look attractive. But value alone is an insufficient condition for a sustainable rebound. We need a clear resolution to the European debt crisis. Only then can the markets revert to fundamentals and valuations. In the absence of a resolution, positioning in EM and Asia warns against jumping back into the markets too quickly.

Markets inflexion point will be defined by capital raising/M&A by EU banks

 
Just as the macro events in the developed economies are key culprits for the sell-down in Asian markets, an enlargement of the EFSF and/or a capital call / M&A activities by EU banks should conversely signal an inflexion point in the capital markets cycle.

Expanding the EFSF bailout fund from EUR440 billion to EUR2 trillion should be sufficient to act as a firewall against further contagion in the fiscally weak Europe periphery, while the recapitalisation of European banks will prevent another system-wide credit crunch. Based on IMF’s estimates and assuming 50% write-offs on Greek debt, we postulate at least EUR200 billion is needed for the recapitalisation of the EU banking sector to allay investors’ fears.

Only when the EU banks complete their capital raising (and thereby strengthening their capital position), would investors be more receptive towards potential Chinese policy stimulus, re-expansion of the US Fed's balance sheet, and re-accelerating global growth momentum. Failing which, even with a well-armed EFSF, the EU and developed markets financial sector is likely to enter into a static credit phase, which will manifest itself in economic contraction wrought by financial de-leveraging. We will be patiently waiting for signs of the above inflexion points to redeploying our cash.

The Asian Crisis of 1997-8 and the recent US experience during the 2007-8 Global Financial Crisis (GFC) present valuable lessons on inflexion points. Sovereign defaults were a common theme amongst the Asian economies then as massive devaluations in Asian currencies precipitate massive recapitalisation and numerous M&As in the banking sector as non-performing loans and assets ballooned to almost 20% of the system. In 1998, Malaysia set up Danaharta, an asset management company to remove bad assets from banks’ balance sheets and also, it established Danamodal the same year to facilitate the recapitalisation of banks. In Thailand, the Thai Asset Management Company was set up to handle non-performing assets, similarly Indonesia set up Indonesian Bank Restructuring Agency (IBRA) in the same vein. The Financial Supervisory Service (FSS) led an intensive restructuring of the Korean financial industry. Over a six-year period extending from 1998 to 2003, 840 financial companies – including 14 banks – were removed from the Korean market through M&As or liquidation. Despite these efforts, NPL ratios across Asian countries remained in high double digit until 2004, some 7 years after the onset of the Asian Financial Crisis. Singapore banks, which were the best capitalised with Tier 1 ratios averaging 16% then, saw consolidation in the industry from 6 to 3 banks (between 1998 to 2001). And in the US, at the height of the GFC, it set up the USD700 billion Troubled Asset Relief Program (TARP) to recapitalise its banking system. These examples illustrate the need for an asset management program complete with a recapitalisation model in times of severe economic crisis and we believe that the EU is no different in this regard