No clear end to Greek drama

Hang on for a rough ride as the European sovereign-debt crisis continues. Investment managers and analysts believe European policymakers will struggle to come up with a permanent solution to the crisis, which has driven stock markets lower as fear of global contagion spreads. “I think anyone looking for an answer is going to wait a long time,” said Bob Doll, chief equity strategist for fundamental equities at BlackRock Inc. “There is no answer to it,” Mr. Doll said. “It's like the housing problem in the U.S.,” which is requiring time to work through distressed assets. “There's a lot of difficulty in working with 17 different [European] countries and legislatures” to find a solution, said George Strickland, managing director for Thornburg Investment Management Inc. and co-portfolio manager of the Thornburg Strategic Income Fund. “It's going to stay messy for the next few months,” and possibly for a few years, Mr. Strickland said. Global markets have been fearful about how sovereign defaults might affect banks in Europe and how that might spread to U.S. banks and the broader financial markets, said Art Steinmetz, chief investment officer at OppenheimerFunds Inc., who unlike most observers thinks the worst of the European debt crisis could be over soon. Proof of the panic came when the S&P 500 fell nearly 3% last Wednesday and over 3% the following day after the Federal Reserve's Open Market Committee warned of “significant downside risks to the economic outlook, including strains in global financial markets” — new wording that observers said referred to the European crisis. The drop took the index back down to near lows set in the August sell-off. Also last week, Standard & Poor's cut Italy's credit rating, deepening concerns about the risks of larger eurozone countries. More than equities are affected by the crisis. U.S. money market funds have eurozone risk, as well, because they hold significant amounts of short-term paper issued by European banks. Money funds have been cutting those holdings since June, “but it's still a big number,” said Peter Crane, president of Crane Data LLC, which tracks money funds. He figures U.S. money funds now have 20% to 30% of their assets in European bank paper. European banks have “massive” exposure to the debt of weak European countries, which hasn't yet been written down to true value, said Daryl Jones, director of research at Hedgeye Risk Management LLC. Not everyone is quite so concerned about the banks, though. “At the moment, it's a liquidity issue, not a solvency issue” with the weaker peripheral nations, said Gary Motyl, chief investment officer of the Templeton Global Equity Group. “If you look at the Spanish debt-to-[gross domestic product] ratio, for example, it's not that bad,” said Mr. Motyl, adding that the same is true for most of the other peripheral countries. And the capital position of European banks “is not that bad,” he added. “They're pretty profitable at the moment — that's being lost here” in the panic.

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Observers expect that European policymakers will continue to come up with a series of half-measures to solve the crisis. “We will see a series of Band-Aids,” Mr. Doll said. “The question is, will they be pretty-enough Band-Aids [for Europe] to muddle through?” Mohamed El-Erian, chief executive of Pacific Investment Management Co. LLC, said last week that the world is on the eve of another financial crisis and that the European Central Bank hasn't put in place a “circuit breaker” to contain the continent's debt crisis. German politicians in particular have been intransigent in committing the resources some observers contend are needed to contain problems in weaker nations and ensure confidence in eurozone banks. “It's a matter of individual countries, led by Germany, to make the decision to act in a concerted fashion,” Mr. Motyl said. European countries need to coordinate fiscal policies, and the European Central Bank needs to step up purchases of bonds, Mr. Motyl added. The ECB could also lower rates, Mr. Doll said, and euro countries could jointly underwrite so-called euro bonds to raise capital. But in the end, those measures will simply “buy time while European banks work through their troubled sovereign-debt exposure,” he said. Observers feel that the eurozone countries will also have to bite the bullet on a Greek default. “The only ones in denial [about a Greek default] are European policymakers who can't admit it [without a] face-saving gesture,” Mr. Steinmetz said. The toughest question will be whether the euro can survive. Euro critics such as Mr. Jones have argued that the single currency was doomed from the start, due to a lack of true fiscal union among euro nations. “The common-interest-rate policy isn't working,” Mr. Jones said. “Spain has 21.2% unemployment, while Germany is at 6.1%. Should those countries have the same interest rates?” Euro critics said currency devaluations and debt defaults are critical tools for distressed nations to begin a recovery — tools that Greece, for example, doesn't have as long as it's stuck with the euro. But other observers said killing off the euro would be more costly than fixing the immediate crisis. UBS has estimated that a euro breakup could cost a peripheral country up to half of its GDP in the year of the split, and a stronger core country up to a quarter of GDP. Analysts have said that a nation such as Germany could see exports drop due to a higher currency and its banks lose from devalued euro-based assets, while poorer countries with devalued currencies would face huge burdens in paying off euro-based debt. Mr. Strickland expects even the weakest nations, Greece and Portugal, to stick with the euro. The costs of a pullout are too high, he said, and the single currency helps trade. “A lot of [European] companies have operations across borders, and the frictionless trading [the euro provides] is a huge benefit,” Mr. Strickland said. Email Dan Jamieson at djamieson@investmentnews.com