Just like last summer, when the downgrade of the US government’s borrowings sent investors running for cover, the failure of the Greek election to deliver a government means risk, across the board, is being taken off the table.
It is not a rush for the exit but, at the margin where the price of financial assets is set, it’s been enough to take 10 percent or so off markets. I would be surprised if they recovered that loss very soon and I think the parallel with the summer of 2011 will continue. That means that the bottom of the current slide may well not have been reached yet and that, once it is, markets will bounce around in an extremely uncomfortable fashion for many weeks thereafter. Markets are being driven by politics and they won’t stabilise while the Greek situation is unresolved and, more importantly, while the threat remains that Spain or Italy could go the same way.
My hunch is that this is unlikely. Indeed, a Greek exit from the eurozone (and, who knows, the European Union too, if the leaders that finally emerge refuse to play ball) could be the catalyst needed for the remaining countries to do what is required to hold things together. Greece is being led to the sacrificial altar pour encourager les autres.
Does the market’s reaction to this over the past few weeks or so make sense? Possibly not in fundamental terms, but it absolutely does in terms of investor sentiment. The eurozone accounts for around 10 percent of the value of world stock markets and European companies derive less than half of their profits from within the euro area. What is going on in Greece has no bearing on housing starts in the US (which are picking up) or electricity output in China (which is not). Greece is neither here nor there in the context of a $14trn European economy. But markets hate uncertainty and that is what we must accept for the rest of the summer.
Taking a couple of steps back from the immediate crisis, the volatility of markets is something that we are going to have to get used to. Indeed, the dramatic ups and downs that have characterised the Japanese market over the 20 years of its post-bubble deleveraging could be the template for Europe as the painful process of mending the region’s balance sheets is endured for years to come. This is an extremely difficult environment for investors, especially if your main experience of investing was during the aberrational years between 1982 and 2000, when everything went up and the investment industry’s idea of risk was moving too far from a rising benchmark.
Now the risk is the real one that you lose money and investors quite rightly switch on to the importance of capital preservation. If you lose a third of your money you have to grow what you have left by 50 percent to get back to where you started. A year ago the market fell sharply to a new trading range at the bottom of which investors looked at valuations (especially as indicated by the hard reality of dividend yields) and thought the rewards on offer made the risks worth taking. I expect something similar will happen this time around. European shares are cheap. They trade on around 10 times expected earnings (just nine in the UK), dividend yields are often higher than those on corporate bonds and government debt, cash flow is strong and companies have lower levels of borrowing than for 20 years or so. The corporate sector remains quite strong.
Investors have to make a decision in today’s volatile markets. They can attempt to catch the increasingly frequent waves and protect their portfolios during the commensurately frequent downturns or they can accept that this type of market timing is impossible. In that case they must focus on quality – companies with pricing power, good managements, recurring revenues, a spread of clients and robust balance sheets. They must buy these companies at a sensible price and they must hold them through the inevitable sentiment-driven ups and downs. They must, in other words, follow the likes of Warren Buffett and think like business owners.
European politics and macro-economics are a mess but the region is home to many excellent businesses with fantastic prospects in places such as the US and the Far East, where life is going on even while Europe makes a hash of it. Shares in those companies won’t bounce back immediately but in 10 years you may well look back and think that the summer of 2012 was a pretty good time to be investing in these long-term winners. n
Tom Stevenson is an investment director at Fidelity Worldwide Investment