Europe’s slow but steady emergence from crisis mode has underpinned a strong market rally in recent months. The good news for Brussels is that most traders expect the trend to continue. The bad news is that bank stress tests and social unrest could rudely upset the euro zone applecart.
The rising confidence stems almost entirely from Frankfurt, where staff of the European Central Bank are beavering away in the Eurotower until their shiny new headquarters next to the Grossmarkthalle, the city’s old wholesale market, is completed. Traders put a lot of faith in the ECB’s willingness to “do whatever it takes to preserve the euro,” as President Mario Draghi put it in July 2012, and very little faith in the ability of national governments to adopt the kind of structural reforms that would put the bloc on solid footing for the long haul.
In our December poll of three dozen global macro traders, the average prediction was 82 percent that the euro zone would muddle through toward deeper integration, with only a very minor risk (13 percent) that a peripheral country would default. The bet on euro zone integrity was up from 78 percent in the June 2013 poll, and just 53 percent at the end of 2011, before Draghi made his famous pledge.
For most of 2013 the equities of European banks were highly correlated with the credit default swap rates of their sovereigns, suggesting that financial markets still perceive the fate of the banks and the sovereigns as connected. That link proved very profitable for those on the right side of the trade as CDS rates tumbled and bank stocks rose smartly. Yet the European banking system has done little delevering since the financial crisis; banks are still chock-full of government debt, nonperforming loans and other assets that have not been marked down to market-clearing prices (see also “Europe’s Banks, Slow to Restructure, Post a Systemic Risk Today”).
This year could provide a turning point as euro area governments take the first big steps toward completing its so-called banking union. In the first half of 2014, the ECB will conduct its asset quality review of bank balance sheets. Then the central bank, in conjunction with the European Banking Authority, will embark on a new round of bank stress tests. Market participants will scrutinize both exercises closely to see if the ECB will really get to the root of the banking system’s problems. “European bank stocks were a great play for us in the fall,” says a London-based hedge fund strategist, “but things could get dicey this spring as the assets get reviewed and reweighted.”
Wolf Piccoli, managing director of Teneo Intelligence in London, says the completion of the banking union will be a difficult process. “Equipping the [European] Commission with some say over whether or not to wind down ailing banks has already caused complicated debates, both at the European and member state level,” he says. “Agreement was tough to negotiate, and the new bail-in rules highlight that any further progress on integrating the banking sector will likely continue to come at the price of a tougher stance toward the financial sector.”
Other structural problems loom on the horizon, including doubts over Greece’s debt sustainability and the sky-high youth unemployment rates in many peripheral countries.
“European leaders will also face several uncomfortable decisions soon, such as an involvement of the official sector in another round of haircuts in Greece, which are inevitable in the medium term,” says Piccoli. “This is not an easy task for the new coalition government in Berlin to start its work with, given Athens’s damaged reputation across the political spectrum in the Bundestag. The same also goes for the task of relaxing fiscal targets, meaning a de facto weakening of austerity, the main selling point of euro zone bailouts in northern core countries.”
“The key question is not whether the euro area is becoming a federal state or not, but rather whether sufficient risk- and burden-sharing mechanisms are being put into place to ensure stability in the system,” says David Mackie, chief European economist at J.P. Morgan in London. “Indeed, outside the contribution of the ECB, which has stepped into the role of the lender of last resort to euro area sovereigns, the appetite for actual burden sharing remains limited.”
Progress on risk- and burden-sharing mechanisms in 2014 will turn on two related sets of political decisions. The first is a delicate negotiation between Germany and the rest of the euro zone, principally France, on bank recapitalization policy. The second involves the ongoing negotiations between the center and the periphery on austerity measures and the selective write-down of unsupportable debt burdens. The negotiations with Greece are likely to be the most contentious, not least because the more solvent it becomes, the less motivated Athens will be to bend to the demands of the Troika, as the bailout team of the European Commission, the International Monetary Fund and the ECB is known.
“Things are looking up in Greece — that’s what Greek ministers have been telling the world of late, pointing to the substantial and rapidly improving primary budget surplus the country is generating. Yet the country’s creditors should beware of Greeks bearing surpluses,” says Benn Steil, director of international economics at the Council on Foreign Relations. “The Greek government has far less incentive to pay, and far more negotiating leverage with its creditors once it no longer needs to borrow from them to keep the country running. This makes it more likely, rather than less, that Greece will default sometime next year. The upshot is that 2014 is shaping up to be a contentious one for Greece and its official-sector lenders, who are now Greece’s primary creditors.”
So far, efforts to preserve the euro have done little for the man or woman on the street, especially if they are young and unemployed. In the June poll traders assigned a 1-in-4 chance of major social unrest — defined as “riots, property damage and more than 100 deaths” — in a peripheral euro zone country in 2013. Ironically, the December poll assigned even higher odds of unrest — 32 percent — this year, although traders bet that the odds of a sovereign default had declined. Either European sovereign credit has decoupled from social unrest, or one of these two bets is wrong.
James Shinn (jshinn@princeton.edu) is lecturer at Princeton University’s School of Engineering and Applied Science and CEO of Teneo Intelligence. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of defense for Asia at the Pentagon. He serves on the advisory boards of Oxford Analytica; Kensho; and CQS, a London-based hedge fund.
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