Europe remains a global challenge

If there is one upside to the European sovereign debt crisis, it may be that it allows the U.S. to look quite good in comparison. A “there but by the Grace of God” sense was in full display among the speakers at the recent CFA Institute Conference in Boston, Mass.

On both sides of the pond—but particularly in Europe—there has been a withdrawal of liquidity, which is required for markets to function properly.

“Liquidity is the god of markets,” said Daniel Fuss, vice-chairman, at Boston-based Loomis, Sayles & Co. “Liquidity these days is low, [although] compared to the fall of 2008 it is better. It’s true of Europe and the U.S.”

It is Fuss’ innate fear that when—not if—the tide goes out, all dangers will be exposed.

“If you’re going to deal with a market like this, you become a buffalo hunter,” he said, explaining that it is better to head a problem off, than to chase its tail. “You bring a bid to an illiquid market and live with the consequences.”

Bond investors should brace for “a large element of illiquidity, high uncertainty, [and] low interest rate, but if you’re a good shot, given the peaceful nature of bonds, you’ll survive.”

But Europe’s list of worries doesn’t stop at the lack of liquidity. It includes issues of capital, assets, profitability and regulation, said Mark Kiesel, managing director, PIMCO.

“Europe’s undercapitalized, just like [the U.S.] banks were about three or four years ago,” he said. “Ironically we needed about $200 billion, they need about €200 billion.”

For all the seemingly shared features and effects of the two crises, Kiesel says the housing crisis in the U.S. is different from the crisis in Europe. “Housing takes time to fall; housing prices peaked in 2006 and have fallen 30% in the [following] five years, the Greek and Irish bonds [in contrast] are marked to market everyday and so their capital need goes up and down based on where those bonds are trading.”

In terms of profitability, though, he puts the edge on the U.S. side. “Europe is much cloudier and that also requires austerity and structural reform in Italy for it to be solvent.”

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Much in Europe hinges on the extent of the haircuts to be taken on Greece, Ireland, Portugal and, possibly, Italy. “If you assume a recession in Europe, you’re talking about pretty significant capital need,” said Kiesel. “The ECB hasn’t gone all-in yet; they basically provided temporary liquidity, but they can go a lot further.”

Whether the EU will field a coordinated and powerful regulatory mechanism is still to be determined. “Europe is going to be probably the biggest macro uncertainty in the marketplace, which is why I think this volatility will stay elevated until you see the European situation resolved.”

Fuss said that the more he talks to people in Europe, and the more he reads, the less sure he is of an amicable resolution of the European issues.

“I look at the situation, particularly in Europe—how things might possibly be handled with Greece—and [if] it’s handled really badly, what it might lead to,” he said.

He wasn’t talking about a mere haircut for bondholders or even a bank collapse; he was talking about war and peace. There is a large reserve of natural gas, and some oil, beneath the eastern Mediterranean, and in the worst case scenario, control over this energy resource could be up for grabs.

Fuss rates this danger as very unlikely, however, “as long as Greece stays the member of the EU, [if] not necessarily the currency.”

It doesn’t help that in addition to many “what ifs” there’s the lack of solid political unity, he added. “Maybe the purpose and the drive behind the European Union for the common currency, [and the political] will is going down a bit,” said Fuss.