Fears that the eurozone could fall apart might turn into one of the biggest bets of the current financial crisis, with huge returns for investors possible on either side.
If the euro holds, wide spreads represent a true bargain; if the single currency group falls apart, valuations could falter further.
For instance, the spread between the 10-year Greek bond has jumped from a tiny 20 basis point in June 2007 to nearly 300 points this week, as fears of a eurozone breakup compounded the impact of Greece's rising debt-to-gross domestic product ratio.
The 10-year French bond now trades at 57 basis points over the bund; in the 10-year history of the euro, that spread has just been 10 points.
Leila Heckman, senior managing director and head of the international equity group at Mesirow Financial, Chicago, said the odds are less than 5% that the eurozone will break up.
Her investment advice: “The European equity markets, and even the Eastern European markets, are pretty much oversold. You don't want to put all your money in one basket just to make one bet on the European market. For U.S. investors to put a piece into some of these markets that are very cheap and very oversold is not an unreasonable thing to do.”
“Some of the Europeans that we would favor would be relatively inexpensive: Austria, which has a lot of exposure to Eastern Europe; Ireland, which is a very cheap; Italy, with one caveat — if earnings are decimated in this environment. Outside of the eurozone, Hungary is a risky market where we have an overweight recommendation. It's risky, but extremely cheap,” Ms. Heckman said. Mesirow has $31.4 billion in assets under management.
There are two main break-up scenarios. Under economic stress, one of the weakest countries in the $12 trillion eurozone economy could not carry its debt burden, drop out of the European Union and let its own currency slide to engage in export-boosting competitive devaluation. Alternatively, Germany, the largest European economy, would feel too much pressure from having to bail out the weakest members and would return to the Deutsche mark.
Either scenario would come with a hefty price. A weak euro dropout, defaulting on its euro-denominated debt, would be likely cut off from future borrowing by the global financing community. Germany, which has pushed a euro policy for two decades, would suffer a political blow and its export-driven economy would suffer amid a Europe in shambles.
Banks in the eurozone have generously lent $1.3 trillion to Eastern European countries, which are now in the grip of a financial and economic crisis that has required several of them to seek assistance from the International Monetary Fund. Austrian banks have the most exposure, having extended $250 billion in loans — or the equivalent of 71% of the country's GDP — to the emerging economies of the East. Credit default swaps indicate a greater risk of Austria defaulting on its own debt as the result of its banks' exposure than other countries, such as Greece, that have a comparatively larger debt shortfall.
“The $1.5 trillion exposure to emerging Europe may be the catalyst for the crisis, in the way subprime was for the U.S., but the real problem of excessive leverage goes much deeper,” said Richard Howard, managing director for global markets at Hayman Advisors LP, Dallas. The bearish hedge fund firm is known for its successful bet on the collapse of U.S. mortgage-related securities, which earned one of its funds a 340% return since it started in 2006. Hayman manages $620 million.
“We believe the problem is so large that it may be unbearable or even prove to be impossible for supposedly strong economies such as Germany and France to provide a bailout for the region. The strain could potentially lead to a breakup of the eurozone, as countries seek to regain control of their monetary policy and fiat currencies,” Mr. Howard said. He estimated Western European banks have $56 trillion in outstanding loans.
Mr. Howard's believes while the odds of a breakup are small, they are real, a view shared by other euro watchers.
“It is at least conceivable that the euro could break up by way of the strong currencies rising out of the euro, leaving Portugal, Italy, Ireland, Greece and Spain within the euro,” Alan Brown, group chief investment officer at Schroder Investment Management Ltd. in London, with $150 billion in assets under management, wrote in a March 4 report.
Currency analyst Manik Nahrain at Standard Chartered Bank Ltd., London, also warned the same day in a note to clients of the “clear and present dangers to the eurozone” posed by the debt crisis in the emerging European countries.
Some managers believe the likelihood of the eurozone breaking down is extremely small.
For Alan Wilde, head of the fixed-income and currency team at Baring Asset Management, London, with $30.4 billion under management, the euro breakup could only come from Germany.
“The costs of legacy debt in euros when a country leaves would be so great as to be prohibitive. The country which would cause the concept to crash is, of course, the most powerful: Germany. Only if and when Germany decides enough is enough should investors fret about a breakup,” Mr. Wilde said.