Fending off the euro crisis

Financial markets initially welcomed the victory of Greece’s pro-bailout New Democracy Party in recent elections. However, uncertainty remains, as the government which takes office still has to reopen the terms of bailout and build political support for austerity.

The eurozone’s worsening debt problems are leading to increasing speculation that Greece and other ‘periphery’ countries will exit the euro and reintroduce the drachma and other currencies.

Frustration over political inaction is leading to fear among wealth managers and their clients, who are now diversifying assets away from the euro and into safe haven currencies.

Judging the potential impact of the euro crisis on client portfolios and advising them how to act has been one of the biggest challenges faced by private bankers for many years. The biggest recent gainers have been the US dollar, Swiss franc and Japanese yen, with many European clients buying into baskets of these and other currencies.

Ongoing instability in the eurozone has been the base case assumption for both 2011 and 2012, according to James Butterfill, equity strategist at Coutts. As a result, the private bank has been underweight eurozone and euro-denominated asssets, which is helping mitigate the impact of the weakening euro upon client portfolios.

“For our euro-referenced clients, we are indeed encouraging a more active management of their euro-based wealth,” says Mr Butterfill. “As a first step, we are encouraging euro-heavy clients to better match euro liabilities with euro assets in their wealth portfolios.”

Once these assets and liabilities are better co-ordinated, the bank is encouraging clients to diversify towards income-oriented US dollar denominated assets among major currencies and seek opportunities to build exposure to emerging market currencies via both income and growth-oriented emerging market assets, where the risk appetite is appropriate.

GLOBAL REPERCUSSIONS

But the eurozone’s problems are having global repercussions, with slowing growth and risk aversion reaching far beyond European borders. This has hindered client returns year-to-date. However, Mr Butterfill says low risk assets, like US treasuries, gilts, German bunds, and even high quality corporate bonds have benefited, where Coutts’s exposure on behalf of clients has helped in offsetting the drag caused by Europe on returns.

“We do see attractive value in some Asian asset classes,” Mr Butterfill says, “However, direct exposure to them is a function of risk appetite, which will vary client to client.”

For more conservative clients, Mr Butterfill explains, direct exposure to Asian assets may not be the most appropriate solution. Instead, focusing on large, Western multi-nationals, which do a substantial portion of their business or generate a meaningful amount of their growth in Asia may be an attractive alternative for conservative clients.

“Alternatively, the US dollar or hard currency Asian bonds provide an attractive alternative way to benefit from the strong balance sheets in the region without assuming potentially volatile currency exposure,” he says.

For clients with a higher risk tolerance and appropriately long time horizons, Mr Butterfill believes a diversified portfolio of local currency bonds, equities and direct currency exposure can help provide growth and returns just as growth and return in Western economies and asset classes are increasingly challenging to realize.

The impact of the weak euro will largely depend on how exposed the clients are, and whether this exposure is hedged or not, says Dirk Wiedmann, head of investments at Rothschild Wealth Management. “We took the strategic decision to have a low exposure to the euro in our clients’ portfolios some time ago, as we think the long-term outlook is poor,” he says.

According to Mr Wiedmann, the eurozone debt crisis has finally caught up with the single currency and in the weeks ahead, the Euro will remain under pressure, as investors focus on the prospect of Greece leaving the union, and a larger bailout in Spain.

“There are also growing expectations that the ECB will need to provide more support to eurozone banks, expanding its ballooning balance sheet still further,” he says. “We believe the currency union is clearly unsustainable in its current form, with Greece highly likely to leave the euro and the EU’s existing bailout resources insufficient for both Spain and Italy.”

To diversify away from the euro, the wealth manager feels strong, safe haven currencies in the developed world, such as the Swiss franc, Swedish kroner, and the Canadian and Australian dollars should perform well over the medium.

“Our long-term cyclical view is that given the weak fundamentals, we expect none of the major currencies to outperform. By contrast, we believe Asian and emerging market currencies will appreciate in real terms, boosted by strong growth and high real interest rates,” says Mr Wiedmann, who recommends a globally diversified asset allocation with a bias towards real assets, Asia and emerging markets, ‘safe’ bonds and strong currencies.

Equally positive on Asian assets, Simon Miles, head of Merrill Lynch Portfolio Managers, feels that on a medium-term basis, Asian markets offer value. “Valuations levels are reasonable,” he says. “But there are also currency considerations since Asian economies are no strangers to inflation. If inflation returns, the currency effect can wipe out asset price gains.”

ALL IN IT TOGETHER

However, not all wealth managers are bullish on emerging Asia. “The main risk of investing in non-Japan Asia is that these countries are primarily driven by global economic activity. So if there is a global slowdown, then they will suffer worse than the non-Asian economy, because the Asian ex-Japan countries are primarily manufacturing goods,” says Charles MacKinnon, chief investment officer at Thurleigh Investment Managers.

Private bankers Schroders also prefer the dollar to Asian currencies. “There’s a high correlation between risk-assets and Asian currencies,” says Robert Farago, head of asset allocation, Schroders Private Banking.

As they are not immune from the volatility of Western equity markets, Threadneedle Investments believes emerging market assets should be a structural part of portfolios over the long-term. “Emerging market local debt appears an excellent long-run investment and emerging market equity markets have at last sufficiently de-rated to begin to appear interesting,” says Toby Nangle, head of multi asset allocation at the firm.

Unwilling to take bets on a single currency, most wealth managers are investing in a basket of currencies. “Rather than trying to cherry pick just the Swiss franc, New Zealand dollar, Canadian dollar, US dollar or Norweigan kroner, all of which are good solid currencies or economies, we prefer to invest in a basket,” says Thurleigh’s Mr MacKinnon.

“We hold a significant amount of dollars, a certain amount that will pay in euros, a small amount of yen and other emerging market currencies following the MSCI Emerging Markets Index, so there will be some Brazilian real there, some South Korean won, some renminbi and Hong Kong dollars,” he says.

“For private clients to invest in one currency would be too specific a risk and thinking in a basket of currencies seems to make more sense for us,” says Alan Zlatar, deputy chief strategist at Bank Vontobel.

As few currencies seem to be keeping their safe haven status, the private bank is also diversifying in currencies further afield, such as the Mexican peso, Brazilian real and Indonesian baht. The bank is of the view that no single currency can be hedged. Though the Mexican peso’s status as the only convertible currency in Latin America is making it a popular hedging tool in the region, it is also more vulnerable to the global sell-off. Closer to home, Poland’s higher ratings and lower indebtedness than Italy and Spain and the European Union’s fastest growth is luring investors.

“Eastern Europe isn’t necessarily the safe haven for clients wary of the euro. We’ve seen strong correlations of the zloty with the euro,” says Mr Zlatar.

EURO FACING BLEAK FUTURE

Despite the intial optimism over the outcome of the Greek elections, wealth managers are bearish on the outlook for the euro.

“There are no easy ways to address the eurozone’s deep structural problems, particularly the widespread inability to compete with Germany,” says Rothschild’s Mr Wiedmann. “Yet drastic austerity measures merely exacerbate the downward economic spiral while further bailouts only buy time and reduce the need for politicians to implement the necessary structural reforms that could both revive growth and help tackle the debt problem.”

He believes there is little consensus among EU leaders and the ECB’s governing council at a time when bold and decisive measures are needed to restore confidence in the eurozone’s future.

“We think the euro will be will weaker for weeks to come,” says Vontobel’s Mr Zlatar, with the possible longer term danger of “a number of weak succession currencies in the south” and a high political volatility in 2013, which is likely to cause the euro currency to stay on the ropes for sometime.

Valentin Marinov, head of European G10 FX Strategy at Citibank currently sees the trend of wealth managers offloading euros and moving into treasuries. “We’ve seen the anti-bailout party become a considerable force in Greece, which is a sign of the eurozone disintegration in the coming months,” he says.

Citibank analysts predict Greece could leave the euro by as early as January next year and this would lead to an escalation in risk. “I suspect safe haven currencies, such as the dollar and yen will continue to outperform the risk correlated currencies. The G10 currencies, such as the Canadian dollar or the Scandinavian currencies should actually underperform in the environment,” Mr Marinov says, stating that wealth managers are focusing on liquid safe havens, like the yen and dollar.

He believes Spain will be the prime target in the coming months, with a short-term horizon of six to 12 months after potential Grexit.

“We suspect the risk correlated, smaller currencies, especially the ones that are not geographically as exposed to the crisis are much superior to the developed world.”