Germany will lead the recovery within the core eurozone in 2014 while Spain will lead the recovery in the periphery, said Alberto Gallo, head of macro credit research at the Royal Bank of Scotland. The Eurozone faces deflation risk today because there has been too much austerity (government spending cuts) and bank deleveraging.
Germany has already provided extra support to Portugal, Greece and Ireland, and is likely to continue doing so in 2014. The European Central Bank is likely to slow down the deleveraging process next year, which in turn, will help banks to heal. That will solve the disinflation problem and will make the recovery durable.
However, the pace of recovery will not be equal across the currency bloc as countries like France and Italy have fallen behind on economic reforms while Spain has zoomed ahead, said Alberto.
The current political situation is a little unstable in France. If Paris goes for early elections next year, a right-wing coalition government might come to power and may even talk about leaving the euro. Asked if that’s a reason for concern, Alberto said there are two aspects to the problem. The long-term view is worrying because there’s lack of reforms in both France and Italy.
The labor and pension reforms in both the countries only scratch the surface and there have been no structural reforms. However, from an investment perspective, it’s risky to short anything and RBS has been long on France for about two years. The situation in France is worrysome, but it’s too early to take a short-term view on any particular sector. French banks have managed to rebuild their balance-sheets over the last three years and although lack of economic reforms remains a concern, RBS remains positive on France, he noted.
Asked him to comment on his favorite plays for 2014, Alberto said from a growth perspective, Ireland and Spain are doing better, but from an investment perspective, Portugal potentially offers the most upside because valuations are cheap.
Many money managers in Europe are investing in banks because they believe European lenders are likely to provide superior returns when the economy picks up. Asked to comment, Alberto said 15 to 20 percent of banks will fail ECB’s stress test, but overall it will have a positive effect. Past experience from Spain and Ireland have shown transparency separates the good banks from the bad ones.
Also, bigger banks tend to be more transparent. The ECB’s stress-test will separate the bad ones from the good and healthy banks may start lending again by the end of next year. There will be, however, a lending gap in the interim that policymakers will have to face. It’s not a monetary problem alone because the ECB can remedy such difficulties through easing of credit. The European Investment Bank needs to start lending to SMEs across Europe with the support from local governments, he observed.
Asked to comment on bubbles forming in 2014 in sectors like housing and technology, Alberto said there has been too much dependence on central banks to solve problems that were originally created due to faulty fiscal policies. Governments have been reluctant to carry out reforms because of political complications.
For example, central banks in the US and the UK have done a lot of QE but the governments have dragged their feet over reforms. Britain has a budget deficit of about to six percent while Washington has failed to reform healthcare. Record QE has created bubbles in the US fixed-income market while property prices have soared in Britain. RBS foresees downside for most bondholders in the US and the UK next year, he noted.
Asked if UK property bubbles could burst in the next 5-10 years, Alberto answered in affirmative. Because of the government’s “help to buy” program, the Bank of England is constrained to raise interest rates, which in turn, is affecting their independence. The ECB is the only independent central bank in Europe, which is good for European bond investors, he argued.
You can watch the video here.
Contact Ulli