martes, 20 de marzo de 2012

"We at PIMCO don’t believe European policymakers have solved their debt crisis...they have bought time"

Transmission Channels
  • ​A disorderly Greek default, if it occurs, would likely shock the eurozone and the globe via at least four transmission channels: the European banking system, European sovereign debt markets, corporate financing markets and regional trade.
  • The shock of a massive Greek default would likely swing investor sentiment strongly toward “risk off,” putting pressure on equity markets globally.
  • In this environment, focus on carefully understanding overall risk within equity portfolios. A lower risk exposure will very likely suffer a far lower drawdown in times of crisis, leading to greater return potential over the long term.
​JP Morgan acquired Bear Stearns over a weekend in mid-March 2008 with emergency rescue financing provided by the U.S. government. The financial crisis that first flared nine months earlier had been getting more intense.  Did the near-failure of Bear Stearns mark a new, heightened phase of the crisis, or did it mark the bottom?

The unexpected failure of a major financial institution can sometimes shock market psychology so strongly that it becomes an inflection point in a crisis. Major failures often happen in isolation, such as Continental Illinois in the 1980s. Or Long-Term Capital Management in the 1990s. 
Perhaps Bear Stearns was a turning point in 2008?  Investors and policymakers weren’t sure.
Equity markets  as represented by the S&P 500 went on to rally 12% in the two months that followed the Bear Stearns rescue, and volatility fell from 32% to 17%. More and more market participants became convinced Bear had marked the bottom; after all, both Lehman Brothers and Fannie Mae were able to raise capital following the Bear rescue.  If those two compromised institutions could raise private capital, markets must have turned the corner. 
Of course, we now know Bear Stearns did not mark the bottom – it was just one flare-up in a long-burning crisis that became almost uncontrollable six months later.
As they were in the spring of 2008, markets today are also breathing a sigh of relief.  Greece has secured its rescue financing and avoided, for the moment, a disorderly default.  The ECB’s long-term refinancing operations (LTRO) programs have stabilized the European banking system.  The crisis appears to be fading.  Perhaps the worst is behind us?
Global equity markets seem to think so – having rallied thru mid-March 2012 – approximately 11% for the MSCI World index and 16% for the MSCI Emerging Markets index.
But is the stock market telling us the truth?  Have the risks been eliminated to the point that the all-clear to pile back into equities is warranted?  What if the crisis flares back up again and policymakers lose control?  What will happen when it becomes clear that Greece can’t deliver the austerity it has promised and needs another bailout?  What if there is a disorderly default of Greek debt and Greece abandons the common currency? What would happen to stocks, and which stocks would be most vulnerable?
The devastating earthquake in Japan last year is a reminder of how complex a massive shock can be. Shocks often propagate through multiple transmission channels – each at its own speed, inflicting its own destruction. Fully protecting against a shock requires managing each transmission channel. In the case of Japan, the earthquake struck March 11, 2011, at 2:46pm local time and lasted about six minutes. Almost an hour later a massive tsunami battered the coastline, killing thousands.  Although officials had prepared for a tsunami, they hadn’t contemplated such a massive one. Nor had they anticipated that floods could damage the Fukushima nuclear facility, triggering a nuclear crisis that would go uncontrolled for weeks.  Finally, with nuclear power now deemed unsafe in Japan, the economic costs of the terrible earthquake will be felt for years.
We at PIMCO don’t believe European policymakers have solved their debt crisis. We believe they have bought time with massive liquidity. If our fears are right, the crisis is likely to flare back up again.  Although we don’t know with certainty whether Greece will ultimately suffer an uncontrolled default and exit of the eurozone, it is worth considering the implications for equities: Such a shock would likely swing investor sentiment strongly toward “risk off,” putting pressure on equity markets globally. But some sectors and some companies would be more directly affected and may not bounce back as quickly when markets ultimately recovered.
To understand which equities would be most at risk, let’s look at a number of likely transmission channels through which such a shock would spread across the eurozone and global economy, consider the speed at which the shock would propagate through each channel and identify which stocks would likely be most affected. This is not meant to be an exhaustive survey, and as the Japanese earthquake reminds us, transmission channels may exist that, in spite of our best efforts, we can’t identify in advance.
1. The European banking system
The ECB’s LTRO program is directly targeted at managing and controlling this transmission channel. By loaning an almost unlimited quantity of euros to European banks against a wide range of collateral for three years at attractive rates, the ECB has largely taken the near-term risk of a European bank failure off the table.
Prior to the LTRO, there was greater risk that depositors would pull their savings from banks doing business in at-risk countries and move it to banks in the core of Europe or in America.  This is a mechanism through which the banking system would transmit the shock from Greece to other countries such as Portugal, Ireland, Spain and Italy.  Thanks to the LTRO, these risks have been substantially reduced, though not eliminated.

In effect, the ECB has clipped the left-tail risk of the European banks, even if there were a disorderly default of Greece and/or a Greek exit from the eurozone.  Does that mean it is safe to pile back into European bank stocks?  No.
European banks that hold sovereign debt of or do business in at-risk countries are directly at risk from a disorderly Greek default and exit.  Even though the ECB is in effect standing behind those institutions, shareholders may still bear massive losses. Regulators could force European banks into costly equity issuances to replenish their capital buffers, diluting current shareholders.  Equity prices of European banks would likely fall very quickly after a disorderly Greek failure in anticipation of such dilutive equity issuances to come.
Slower effects would likely be felt by companies and consumers who borrow from European banks.  Many large European banks are truly global institutions, taking in deposits from European customers and making loans to global corporations. The stocks of companies worldwide that rely heavily on lending from European banks could be affected over time as their borrowing costs rise and the availability of lending becomes scarce. Both scenarios could hurt shareholders as their margins suffer and earnings growth is compromised. 
2. European sovereign debt markets
An uncontrolled Greek default in isolation does not appear to be systemic. But an uncontrolled default would likely not happen in isolation; it would signal to investors that policymakers had lost control of the crisis, and their holdings of other peripheral sovereign debt might also be at risk. The sovereign bond markets are a powerful and rapid transmission channel for a Greek shock to spread to other countries in the eurozone. An uncontrolled Greek default would likely push Portugal and Ireland, and possibly Italy and Spain, out of the private debt markets – perhaps immediately.  Investors wouldn’t want to buy their paper at yields the countries could afford.  In such a scenario, the only balance sheet large enough to fund peripheral Europe is the European Central Bank, which, to-date, has been reluctant to directly fund governments. The ECB would likely have no choice but to act.
The stocks likely to be most affected by this transmission channel are those of large holders of peripheral sovereign debt. Banks and insurance companies doing business in the region would be most directly affected.  Their balance sheets could be impaired from actual losses on sovereign debt, and even though regulators may not require their balance sheets to be marked to market, customers and investors could lose confidence in those franchises.  Financial services often have low switching costs for customers, who would likely move their accounts to or renew insurance contracts with providers in the core of Europe or America. 
3. Corporate financing markets
Companies that regularly need to tap the European financial markets for funding would also be affected, though likely with a lag.   A sharp drop in equity prices, and hence, an increase in the cost of equity capital, would likely encourage companies to defer investments rather than suffer the dilution from a costly equity issuance, if they can avoid it. For such companies, growth plans would be put on hold, crimping profit growth that shareholders had been expecting.  High growth companies that can’t self-finance would be most affected by this transmission channel.
On the bond side, in addition to banks and insurance companies that are regular issuers of euro-denominated debt, large European industrial companies in capital intensive industries would likely be affected. As with equity issuances, facing much higher debt costs companies would likely delay refinancing as long as possible in the hopes that the cost of debt would fall back down to more normal levels. At some point, however, firms would be forced to refinance maturing loans. Increased debt service costs would lower profit margins, increase enterprise risk, and could crimp growth plans.  All of these factors would likely hurt returns for those firms’ shareholders.

4. Trade channels
Companies exporting goods and services to Greece and countries caught in Greek contagion would likely be affected.  Some effects would be immediate – for example if Greece reintroduced the drachma, costs of foreign goods and services for Greek consumers could skyrocket. Other effects may take more time: For example, companies selling goods into Italy may not feel effects until the crisis had taken root in the Italian economy.  Nonetheless, one of the impetuses for the common currency in Europe was to facilitate trade flows throughout the region.  A disorderly Greek default and exit would hamper trade within and to the European periphery, and all companies exporting to those countries would be at risk. To the extent that a Greek exit from the common currency jeopardized trade pacts across the region, damage could be inflicted throughout the continent, potentially over a number of years. The trade effects would likely be felt more slowly than the other channels listed here, but the results could nonetheless be significant.
As described above, the ECB’s LTRO program is only directed at managing one of these transmission channels: the banking system. The other transmission channels are largely unprotected today.  All of these effects, individually and in combination, would hamper both European and global economic growth.  And in the end, it’s likely that no company and no stock would be immune to hampered economic growth in its end markets.
Could there be some winning stocks from a Greek shock?  Yes. The strongest financial services companies in the core of Europe or America could see permanent market share gains.  While their stocks would likely fall during the crisis, they may be positioned to emerge from the crisis in a stronger position.
Companies that are heavy commodity users and sell into the U.S. and emerging markets could benefit in the short-term as their costs would likely fall as the “risk off” environment pushed commodity prices lower.  Such benefits would likely be short-lived, however, as top line growth fell with the global economy.
How is an investor to position for such an event given the need to have equity exposure over a secular horizon? 
First, investors should carefully analyze their portfolios to determine which of their stocks are exposed to these transmission channels.  Some companies have multiple exposures.  We are finding attractive equity opportunities around the world, including in Europe, without having excessive direct exposures to these channels.
Second, we are focused on carefully understanding overall risk within our equity portfolios.  Our research suggests that lower-volatility equity exposure tends to outperform over the long term for many reasons, but one of the biggest reasons is that a lower risk exposure is likely to suffer a far lower drawdown in times of crisis.  This naturally leads to better compounding of returns over the long term when the inevitable rebound comes.  Low-risk equity exposure can be obtained in many ways, whether it’s a focus on dividend-paying stocks, equities with lower financial leverage and higher operating margins, or other measures of quality found across industries in both developed and emerging markets. 
Despite policymakers’ and investors’ best efforts, it’s unlikely that anyone can remain invested and be fully immunized from a disorderly Greek default and abandonment of the common currency.  Political processes, such as upcoming elections in Greece and other European countries, could be the triggers that reignite the sovereign debt crisis.  Citizens are being asked to make painful sacrifices in order to deliver promised austerity measures.  In the coming weeks and months, we will watch closely to see if leaders are able to win the support of the people for these difficult choices, and if their programs can restore economic growth.  Given these global economic and political risks, we remain focused on managing downside risk in our equity portfolios.