Eurozone hedging is tough game to play
By Brian Bollen, at Finantial Times, Investment Strategy, March 30
A break-up of the eurozone might be regarded very much as a tail risk in today’s markets, if only thanks to the European Central Bank’s brace of three-year longer-term refinancing operations in December and February, but it cannot be completely ruled out.
Tail risk is broadly defined as a remote event that few expect to happen, but which is disproportionately significant if it does happen. A recent example is the 84th-minute goal scored by Kilmarnock Football Club in the Scottish League Cup final that beat Glasgow Celtic in a two-horse race that Celtic were white-hot favourites to win. Celtic fans had a particularly harsh crash course in tail risk that afternoon.
Even those investment managers pushing the official company line that post-LTRO a eurozone break-up is exceedingly unlikely are still having to take the possibility into account.
Simple caution suggests challenges lie ahead, most immediately in the form of French presidential elections. The importance of a smoothly functioning French-German axis must never be overlooked, and there are fears that if challenger François Hollande were to win there could be demands for renegotiation of the latest EU fiscal pact.
Structural issues surrounding attempts in Italy and Spain to bring public finances under control could also present further obstacles to progress.
For those who decide to hedge against break-up, one obvious problem is the clear lack of available alternatives. The US dollar, sterling, yen, Norwegian krone, Swiss franc and gold all have their drawbacks, ranging from quantitative easing to a lack of liquidity and downside risk, observes Alan Higgins, chief investment officer UK at Coutts.
“Our core scenario assumes the eurozone remains intact,” he says. “If not, investors will be stretching to find a haven.”
A second, perhaps less obvious problem for aspiring hedgers, would be the legal status of euro-related contracts. There are suggestions that investors, corporations and any other organisations with significant cross-border exposure are beginning to think carefully about the impact that fragmentation might have on their eurozone contracts.
For Ugo Lancioni, head of currency management at Neuberger Berman Investment Management, existing contracts could throw up more problems in the event of a break-up, not least because of the asset-liability mismatches that would be created. “And if you have a redenomination event what happens to not just currency contracts but, for instance, Euribor-linked derivatives?” he asks.
If the euro undergoes any form of break-up, the legal profession is likely to be a key beneficiary. A third problem, articulated robustly by Alan Brown, chief investment officer at Schroders, is brutally simple and, in essence, undebatable. “Some things are unhedgeable,” he says. “This is one of those things.” Alasdair MacDonald, head of investment strategy UK at Towers Watson, broadly shares this view. “There is no place to hide,” he says.
The eurozone is by no means out of the woods, despite the ECB’s much-discussed recent attempts to restore stability, according to James Wood-Collins, chief executive of Record Currency Management. The ECB’s provision of medium-term liquidity merely pushes problems into the future, he says, and he is far from convinced that modern bankers will put the time to good use.
“It would be naïve to assume that there will be an underlying solution in the meantime,” he says. “The real reduction in Greece’s debt has been minimal, the European taxpayer is still on the hook and competitiveness has not greatly improved. Greece’s agreement with creditors will reduce pressure but does not address the eurozone’s failures.”
Myles Bradshaw, a portfolio manager at Pimco, says the EU needs to use the time to accelerate the political union that is necessary for monetary union to succeed.
Ben Funk, a partner at fund of hedge funds Liongate Capital, describes the ECB’s LTRO as a “game changer” for investors’ perception of European bank credit risk, with the removal of the threat of imminent default having driven down corporate and sovereign bond yields. “Yields have come in, equity has risen and volatility has dropped like a rock.”
Mr Funk cautioned, however, that it is far from clear whether the ECB has saved the day or only delayed the inevitable.
In this atmosphere, investors should stay hedged using cheaper and more asymmetric hedging strategies that have been presented by this lull in concern about a eurozone break-up.
Long-dated volatility in equities remains expensive and the cost of sovereign CDS protection is high, but investors can buy investment grade CDS protection at a low cost as zero interest rate policy has pushed investors to accept more risk in search of yield.
Mr Bradshaw prescribes a return to fundamental bottom-up research with an emphasis on the long term and diversification away from traditional sovereign paper. He cautions, though, that this requires a depth of resources that many in the asset management industry do not currently possess.
As is always the case in any debate, some see the situation more clearly than others, and those looking on from the touchline often speak with greater confidence than those scampering around on the playing field.
Among the onlookers is Jerome Booth, head of research at Ashmore Investment Management, brandishing his own form of brutal simplicity. His advice will be of little help to investors with existing eurozone exposure. But it could spare further tears in the future. “The best way to hedge against something is not to invest in it,” he concludes.
