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With U.S. stocks marching higher and Washington continuing to wrangle with fiscal policies, it is no wonder that the European debt crisis has become an afterthought for many investors. Yet, the recent economic information out of the region has been difficult to ignore and raises questions about future developments of two crucial policies.
The first policy involved a set of more than €1 trillion in long-term loans from the European Central Bank (ECB) to the region's banks, which quelled investors' concerns about an impending liquidity squeeze throughout the banking system. The second policy, now regarded as potentially having the larger impact, was the comment from ECB president Mario Draghi that the bank would do "whatever it takes" to keep the euro intact. For some market participants, this pledge to possibly buy an unlimited amount of bonds from troubled countries seemed to remove the worst-case scenario from the situation. And thus far, the encompassing scope of the statement alone has been enough to stabilize market conditions to the point where a test of the pledge has not been needed.
Economic conditions could change that, however. After the euro-area economy contracted by 0.6% in the fourth quarter of 2012, the annual inflation rate declined to 1.8% in February 2013, below the 2.0% rate that was recorded in January, which also serves as the ECB's targeted rate of inflation. Meanwhile, the euro-area unemployment rate rose to 11.9% in January 2013, which was the highest rate since the data series started in 1995, according to Bloomberg. And if the deterioration in the eurozone economy continues, further monetary stimulus could reinforce an environment of globally low interest rates where there is a distinct disadvantage—an appreciating currency—to a country that is among the first to remove its accommodation.
The region's highly fractured banking system also remains mired in the region's economic stagnation. A window to repay the aforementioned ECB loans recently opened, and only about 20% of the €1 trillion total was repaid as of late February 2013. As these repayments continue, the stronger northern European institutions are expected to be responsible for more than 80% of the loans that may be repaid early.1
The need for many southern-region banks, such as those in Italy and Spain, to retain their ECB funding may be expected, considering the level of bad loans that remain on their balance sheets. After reaching a record of 11.4% of total loans in November 2012, nonperforming loans on Spanish bank balance sheets declined to 10.4% following the transfer of certain loans to a "bad bank." Without the transfer, non-performing loans could have reached an estimated rate of more than 12.5%.2 For reference, the bad-loan percentage for Spanish banks was 7.8% in December 2011.3
Although the bad bank may absorb some of the nonperforming loans on Spanish bank balance sheets, much of which is tied to real estate, this strategy might not provide much general support for the economy. This is in contrast to some U.S. policies that provide loan servicers with monetary incentive to restructure residential loans. It also is another instance of how the European banking system might benefit from more centralized oversight that has been slow in developing thus far.
The trend in bad loans, however, has not been isolated to real estate, thus showing the potential problems for banks that diversified away from consumer-oriented lending. Indeed, the exposure that Germany's 10 largest banks, for example, have to the global shipping industry is more than double their combined holdings of government debt from Greece, Ireland, Portugal, Italy, and Spain.4 With this exposure totaling about 60% of the German banks' capital, Moody's Investors Service has maintained a negative outlook for these banks, citing the overcapacity in the shipping sector, the sluggish pace of global economic growth, and the ensuing potential for shipping bankruptcies.
Unlimited with Limitations
The ECB's single mandate of price stability, as opposed to the U.S. Federal Reserve's dual mandate of price stability and maximum employment, may explain why its benchmark lending rate is at 75 basis points (bps), while the Fed's is zero to 25 bps.5 While the ECB could lower its benchmark rate further, it is unclear whether the extra 75 bps would do much to revive the eurozone's economic slump.
If it came to sovereign bond purchases as part of the Outright Monetary Transactions (OMT) program, the ECB would certainly not be the only major central bank pursuing such a route. But due to the unpopularity of bond purchases in certain parts of Europe, the ECB program carries more conditions than those in, say, Japan or the United States.
For example, a country seeking ECB intervention would also need to seek involvement of the International Monetary Fund, which has imposed tough conditions on countries seeking aid. And the bond purchases will only include maturities of up to three years.6 Thus, it is unclear if the program could lower the long-term rates that generally determine the cost of long-term loans, such as mortgages. The ECB can also stop the program if a country falls out of compliance with its aid package. This is why political turmoil, such as Italy's recent election with participants that do not exactly have a track record of compliance, may cause concern.
If Europe's economic slide continues, the potential constraints of the OMT's conditions raise the question of whether Draghi will indeed do "whatever it takes" by implementing the program and whether the program would actually intend to buy an unlimited amount of bonds.
In one positive scenario, conditions in the European economy could start to catch up with the recent rally in risk assets. But if conditions continue on their current trajectory, the questions about the ECB's future steps could reinforce the perception that the global environment of zero-bound interest rates and quantitative easing has entered another stage. And with most major central banks going to great lengths to ease monetary policy, another phase may eventually begin where uncertainty mounts about how effectively the banks might jointly withdraw this accommodation without undue effects on the global economy.
A Note about Risk: All investments involve risks, including possible loss of principal. The value of investments in debt securities will fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. With respect to certain foreign countries, there is a possibility of nationalization, expropriation or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. These risks can be greater in the case of emerging country securities. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.