“Things fall apart; the center cannot hold.” –William Butler Yeats
Many Europeans are asking themselves the question today, does the European Union hold up in the face of the worst recession since WWII? The downturn has ravaged budgets and credit ratings across the region.
What’s clear is that some countries will come out of this recession better than others, likely those with larger GDPs, more stable credit ratings, and have adequately stimulated their economies through fiscal and monetary packages. Certainly this is easier said than done…
What has become apparent is that the ECB has not been able to limit collective inflation in the zone, which it set out as a defining principle when the Union was envisaged. Currently the divergence of bond yields across the Euro zone display that certain countries stand to lose more, as their credit ratings are downgrade and yields tick upwards.
For example, Greece’s credit rating was downgraded this week by Standard & Poor’s and Portugal, Spain, and Italy are also under threat. The downgrade has inflated Greek bond yields to record highs. This translates to investors becoming more discerning about who they lend to. After all, shrinking economies force governments to intervene, which in turn increase budget deficits and potential credit risk. A country like Germany with a strong credit rating has relatively little risk, yet one must consider the risk-reward on higher yielding bonds for a country like Greece.
Additionally, because borrowing costs differ per country, ECB cuts in the interest rate have an uneven impact on the Euro area.
As risk managers, we must proactively prepare for tail risk. As it relates to European investing, we need to seriously consider the idea that the EU could splinter should the ECB fail at limiting inflation. In a scenario in which the EU unravels, it is likely that the strong get stronger and the differentiated countries become even more critical in the search for European alpha.