Problems with Greek debt were certainly a catalyst for weakness in bank shares in April, but now it is clear that the problem for Europe is much broader. The financial sector faces its biggest threat since October 2008, but for the European Central Bank and the euro the challenge is unprecedented. With little learned from the crisis of October 2008, European politicians are handling the current challenge badly.
Initial delays in supporting Greece have been followed by mixed messages from politicians and vague reassurance. The huge intervention proposed by the European Central Bank looked encouraging at first sight, but lacked genuine political will. France and Germany clearly have different ideas of how this plan would operate, and what it takes to restore market confidence. And by failing to let some bad banks fail, whilst protecting savers, the financial sector problems will take much longer to fix. Failing to discriminate now between good loans and bad will ultimately undermine the soundness of the central banks that are buying up the problem debt.
It also seems inevitable that Greek debt will be rescheduled – the polite name for default. Individuals and companies can restructure excessive debt through mechanisms such as voluntary arrangements and administration, so it might be reasonable to allow countries to do the same. Sometimes this is achieved by devaluation, but as long as the euro survives, Greece's only realistic option is rescheduling. Others, such as Hungary, might follow.
Default will hit British banks and insurers. This is not simply a matter of how much they have lent to Greece. Debt from other European nations has also been hit, and even financially sound British and German insurers will see their balance sheets affected. Banks are also now finding it harder and more expensive to lend to each other. The European Central Bank is attracting deposits at higher rates of interest, adding to the freezing up of the banking system.
Confusion has been created by the way in which politicians have reacted. Too much time has been spent blaming everyone from ratings agencies to hedge funds. The authorities have restricted some of the hedging activities that have been integral to the health of the bond markets, making investors distrustful. Unilateral action by the German authorities on trading activities has made investment professionals worry just how deep the underlying problem might be.
The rise in share prices until April reflected confidence in global growth. Undoubtedly the US is growing again, and China has now brought its runaway recovery back under control. These should be good export markets for many British companies. However, the cutbacks in many major economies around Europe could derail Europe's recovery. Even Germany has slashed its budget, tilting the balance of risk in Europe towards deflation.
The problems in the Eurozone take some of the pressure off the pound, and the UK's precarious financial position. The US dollar is viewed by investors as the safe haven globally, but even the pound looks less risky at present than the euro. Britain also has the flexibility to resume injecting cash into the economy this year, provided inflation eases. Many British companies have significant overseas earnings and should benefit from the recovering global economy, even if there are cutbacks in the UK. And the low pound will make some British companies with overseas earnings very vulnerable to bids.
The biggest challenge for investors today is to achieve a sound and growing dividend income. The possibility that BP – which last year accounted for one seventh of all dividends from FTSE 100 companies – might cut its dividend is serious. Payments that looked safe just weeks ago are now under threat. Investors should not hold shares simply for yield, because if dividends are then cut there may be little support left for a share price. Investors may have to accept a lower yield now in return for safety and growth.
The drift in markets could continue over the summer, with risks becoming more evident in financials. Investors now need to be confident about the ability of companies to protect their profit margins. Cyclical businesses will face headwinds, and any that failed to fully restore their balance sheets in 2009 should be avoided. The Eurozone problems will not be quickly resolved, and portfolios should include exposure to other regions.
Colin McLean, managing director, SVM Asset Management