Waddell & Reed Market Perspective – November 2011
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The ongoing sovereign debt crisis across Europe hit another difficult patch in early November as attention again turned to Italy. Investors showed they are losing faith in Italy’s ability to fund itself, driving yields on the 10-year Italian bond above 7 percent. This volatile market action took place against the backdrop of a new forecast showing a sharp economic downturn in the region and a recession in 2012.
Rapid changes, uncertain direction
Investors have worked hard for months to keep up with the rapidly changing developments and headlines that swirl across the globe. Europe’s leaders are struggling to implement a long-term solution for the debt problems that continue to plague countries across the euro zone and roil global financial markets.
For example, Italian Prime Minister Silvio Berlusconi initially had pledged to resign as his country’s debt came under pressure, then hesitated after rejecting an interim government. That drove yields to levels considered unsustainable – Greece, Portugal and Ireland required bailouts when their bond yields rose above the 7 percent mark. Unlike those countries, Italy’s $2.6 trillion in debt is thought to be too large for other European countries to rescue. Berlusconi later confirmed he would resign after the Italian parliament approves debt-reduction measures and there is an election to replace him. Italy’s Senate on Nov. 11 approved an austerity package and sent it to the parliament’s lower house for approval, which would clear the way for a new Italian government. Recent news reports named Mario Monti, an economist and former European Union (EU) commissioner, as the front-runner to succeed Berlusconi. There is speculation that Monti may lead a “technocratic” government to implement austerity measures and economic reforms, and ultimately reduce Italy’s debt load.
Earlier this year, the European Central Bank (ECB) began repeated interventions in the credit markets, buying the debt of the so-called “peripheral” European countries. The ECB purchases reportedly have continued in support of the latest problems with Italian debt.
Demands for Greece to meet its commitments for greater austerity measures eventually led to the resignation of Prime Minister George Papandreou, again leaving uncertainty in the market about a solution to that country’s debt issues. Lucas Papademos, the former vice president of the ECB, has been named to lead a coalition government in Greece.
As the fears about debt problems worsened, the EU sharply reduced its 2012 growth forecast for the 27-member bloc of countries, saying it can’t exclude the possibility of a prolonged recession. The European Commission, the EU’s executive arm, said in its semiannual forecast released Nov. 10 that the economy is struggling with weak confidence, financial turmoil, government austerity packages and a slowdown in Europe’s main trading partners. It said the EU’s gross domestic product in 2012, adjusted for inflation, would grow just 0.6 percent, well below its forecast of six months ago of 1.8 percent.
John Maxwell, portfolio manager of the Ivy International Core Equity Fund and Ivy International Balanced Fund, says the recent “alarming” move in Italian yields shows that markets are demonstrating they want action, not further discussion about the debt crisis. “Europe is on the cusp of having to act or running out of time. I think that anything short of unlimited funds and explicit sovereign spread interest rate targeting will fail to calm markets. However, I do believe Europe’s leaders want to preserve the union and thus will act.”
Chace Brundige, portfolio manager of the Waddell & Reed Advisors International Growth Fund and Ivy International Growth Fund, adds that he expects the ECB to intervene in credit markets to support Italian debt. “The ECB is likely to be forced into a Quantitative Easing strategy, in which it promises its support in unlimited amounts,” Brundige says. “I think there is a high likelihood of a sharp relief rally, accompanied by renewed weakness in the euro. While sentiment toward the EU would clearly improve, the value of its currency would be pressured by the new supply – just as with the U.S. dollar in March 2009.”
Our current viewpoint
The worsening situation in Italy adds pressure on EU leaders to take decisive action and resolve the debt crisis. We do not think the dissolution of the EU is likely because the stakes are so high and because all parties understand the consequences of a serious misstep. Ultimately, we think a Quantitative Easing program of some type – a balance sheet expansion by the ECB
– is the only viable solution.
Recent economic data from Western Europe has not been particularly constructive: disappointing production results, budget deficits and inflation rates. We do see significance in the ECB’s decision to cut interest rates two days after Mario Draghi became the central bank’s president earlier this month. Markets have long been of the opinion that the ECB needed to cut rates, not raise them as happened in the spring and early summer. That welcome news was matched by the ECB’s expansion of its balance sheet through support of the credit markets in Europe.
Our general view is for the markets to continue to work slowly higher, as long as there is no major policy misstep in Europe. Again, we do not think that is likely because the stakes are so high. We think it is quite possible that equity valuations will stay low across Europe because of the uncertainty. But as long as the U.S. economy continues to recover and profits stay on a positive trend, which we think is likely, then we think the U.S. equity market should be able to make progress.
Past performance is not a guarantee of future results. The opinions expressed in this article are those of the Waddell & Reed Advisor Funds and its Fund managers, and are not meant to predict or project the future performance of any investment product. The opinions are current through November 11, 2011, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
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