The European melt up

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Over the past few years international investors shunned Europe as its economies and banks struggled to reform. But things are changing. The bond markets could benefit.

Alberto Gallo, Head of European Macro Credit Research, RBS

Periphery countries are improving their competitiveness. Greece and Portugal are slowly coming back into the black. Investors are flocking to Ireland and Spain after their regulators cleaned up their banks. Spanish mid-tiers Banco Sabadell and Banco Popular recently raised EUR1.4 billion and EUR500 million in capital. This was all unthinkable a few months ago.

Political risks are receding too. Germany’s chancellor Angela Merkel is opening up to the idea of greater European support for struggling economies, easing core-periphery tensions. Portugal’s coalition resisted a destabilising shakeout this summer after two ministers resigned. Italy’s prime minister Enrico Letta won a crucial confidence vote and sidelined his predecessor Silvio Berlusconi. As green shoots reappear, anti-euro parties like Greece’s Syriza or Italy’s 5 Star Movement are losing ground.

Europe has finally turned the corner. This view is increasingly popular among investors and analysts. What’s not popular yet, however, is buying European assets.

Until recently, buying periphery assets still carried a stigma among investment committees overseas: the surest way to empty out a meeting room was to start talking about buying Greek or Portuguese debt – while French bonds remain among the most popular short trades for US hedge funds.

Over the past two years I’ve taken the other side of these views – being long Europe. As growth mushrooms, many investors are now considering getting back in. So far most have been waiting for entry points to buy European bonds, which still yield a premium over most other assets. Many expected the market to sell-off on uncertainties over QE, the tapering German elections and debt ceiling discussions. This didn’t happen. As Christmas approaches, the finish line for yearly performance rankings is getting closer. Investors now realize they’re missing an opportunity. As a result European markets risk melting-up over the next weeks, as demand rushes back in.

There are two events that could trigger a melt-up. The recent positive resolution to the US debt ceiling debate could unleash demand from US investors which delayed re-allocation decisions. Second, the progress on the ECB’s banking union project will bring the transparency investors need to buy European assets.

The recently-announced ECB bank stress tests and asset-quality review will likely unveil some weaknesses, for example among mid-tier banks in Italy and Spain. But ultimately, the tests will separate good from bad assets, establish a backstop for troubled banks and level the playing field for bank rules across Europe. The result will be a strong positive for Europe. The examples of Ireland and Spain have shown that transparency works: risk premia have receded and capital is returning to both countries. The ECB exercise could make this happen on a wider scale.

Investors eyeing European assets may have another problem going forward: there won’t be enough things to buy.


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