The eurozone puzzle: How should investors position themselves?
Pictet Wealth Management’s Head of Asset Allocation and Macro Research Christophe Donay brings to light the optimal positioning investors should undertake in each of the potential paths Europe may follow on both a short term and a long term basis. The probabilities stated hereunder may evolve over time, as they depend on political decisions.
In order to determine investors’ optimal positioning, we will look at the implicit volatility, which provides a measure of systemic risk. It is for example measured by the level of the VSTOXX index (currently trading at around 32%), that will prevail in each of the three potential scenarios.
1. Greece stays in the EU
In this optimistic scenario, Europe will gain some time, the banking system will acquire some breathing space, peripheral countries will once again be able to finance themselves at a reasonable cost. Thus implied volatility is expected to decline to 25%. In this case, developed equities and the euro are expected to rebound, while Bunds and US Treasuries may correct as they lose their safe haven appeal. The Bund could initially rise by 50-60bp, and may reach 2.5% at a later stage.
2. Greece exits the EU in a disorderly manner
In this catastrophic scenario, if systemic risk propagates throughout the entire periphery, implied volatility is expected to surge to 90%. This would cause developed equities and the euro to decline sharply, while Bunds and Treasuries would rally, with the yields of the former potentially falling to 0.70%.
3. Greece leaves in an orderly manner
In this scenario, implied volatility is expected to intensify initially, reaching 45%, before dropping at a later stage. In such a scenario, developed equities are likely to decline, Bunds and US Treasuries would remain unchanged, and the euro would recover.
How to diversify the euro exposure over the long term?
Given the potential risks to the euro, should an investor wish to diversify his euro exposure, he could do so by investing in currencies grounded by healthy government balance sheets. Countries with a compatible trajectory of public debt and nominal economic growth are considered to be in solvency territory. Thus a healthy balance sheet is defined by a public debt to GDP ratio below 60%, an annual public deficit under 3% and healthy real GDP growth rates. These currencies include the CHF, NZD, NOK, SEK, and the AUD.
The trouble with the aforementioned currencies is that, despite being healthy, they are also cyclical. Thus if there is indeed a breakup of the monetary union, these currencies will be more resistant than the euro but will be weighed down due to their cyclical nature.
Consequently, the optimal situation is a combination of healthy balance sheet countries’ currencies with currencies that may be less healthy, but defensive, and likely to benefit from their market safe haven status. These currencies include the GBP, USD, JPY, and Gold (which may also be considered as a currency in periods of market turmoil).
Strategically, we continue to recommend investors holding well diversified portfolios, built around defensive assets.