01.11.2012As Europe enters its fifth year of crisis, economic strains are deepening the fractures within some nations such as Spain, where the crisis is fueling separatist tensions. Joe Prendergast, Head of FX, Fixed Income and Credit Research at Credit Suisse’s Private Bank, speaks about Europe’s predicament, explains why the equity market should provide opportunities over the final months of 2012, and discusses the next potential risk for investors: the US fiscal cliff.

Cushla Sherlock: Spain’s economy is sinking further into recession and Catalonia is one of the regions calling for greater independence. How is this internal struggle impacting hopes of containing the debt crisis?

Joe Prendergast: This internal struggle is not new. There has been separatist feeling in Catalonia for quite a long time, but the recession and financial pressure have really brought the issue into the spotlight again. This is a time of transition, and the elections coming up in Catalonia towards the end of November will show the balance of the parties. It’s an issue investors certainly should be monitoring. As we go through time we may see a path towards even greater independence for Catalonia. However, I doubt that there is any immediate risk of secession or departure from Spain.

There’s also speculation about when or whether Spain will ask for a bailout. Is the European Stability Mechanism really prepared to bail out a country as large as Spain?

The short answer to that is no, due to the sheer size of Spain and its debt. However, what we do have in the background is the European Central Bank’s Outright Monetary Transaction facility. If Spain does request help it is likely that they will receive tremendous support from the facility by direct purchases of bonds. That will be conditional upon further progress being made with adjustment within Spain, but we shouldn’t underestimate just how powerful an effect that could have by controlling the level of the interest rate, which could help stabilize the debt dynamics.

Investor uncertainty is weighing on the euro. What will it take for sentiment towards the euro to turn positive?

The euro has rebounded somewhat from its weakest levels. It did get down into the low 1.20s but it’s now around 1.30, indicating some relief of pressure already. And there’s a good possibility that we will see some further follow through on that, as investors are still a bit cautiously positioned on the euro. We have a backdrop of strong monetary action from the ECB which, unlike the unsterilized provision of liquidity that the Fed is doing, is providing a sterilized backstop for the bond market around the periphery of Europe. This reduces the risk premium without really reducing the core yields in Europe. In summary, sentiment on the euro is a little bit better, and we can perhaps proceed to the top of this 1.25 to 1.35 range that we’ve been in, but that’s probably where it will start to run out of steam again. And, if things turn sour, we still have the risk that the euro will weaken again sometime in the future.

We had a bit of a red October with declines across almost all major asset classes. Where are the best opportunities over the final months of the year?

The best opportunities are going to stay in the equity market into the end of the year, in my view. The correction that we had in October occurred against a backdrop of somewhat better economic data, particularly among the larger countries of the world. I think this can give us optimism that corporate earnings, which have been a little bit lackluster in the current earnings season, are going to improve as we go into next year: we’ll have a better base for earnings and this should provide good support for sentiment in the equity market, which should be quite forward looking. The better economic data are therefore underpinning a strategy of buying into weakness in the equity market.

What’s the next big risk that investors need to be aware of?

In the wake of the US election, the big focus will probably be on the US fiscal cliff: this idea that we’re heading towards a significant unwinding of past tax cuts. If that were to occur the deficit would fall, but so would growth, possibly massively, in my view. I think it’s very important that we do get an agreement among the main parties and in Congress to take action to address this fiscal cliff. A moderate fiscal tightening would not be so bad, but if we do not get an agreement then we’re really into quite a big risk scenario into 2013. We don’t think that will happen, and we believe there will be an agreement among the main parties to take action to address this fiscal cliff, but we have to monitor this very closely.