The Euro Zone Crisis & what it means for the Hedge Fund Industry?

April 23rd, 2012
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Contributed by: Shane Brett, Global Perspectives
In this article we will look at the current situation regarding the Euro zone crisis, potential developments over the remainder of the year, and examine what this means for the Hedge Fund Industry, as this crisis moves into its third year.

“If the Euro fails, then Europe fails” - Angela Merkel, German Chancellor, 2011

Current situation
When the ECB launched its avalanche of super cheap three year finance earlier this year, many thought the Euro Zone had bought itself a significant breather to try and get its fiscal problems in order. However only a couple of months later (Qtr 2, 2012) the crisis seems to be returning with a vengeance.
In recent weeks the focus has shifted firmly from Italy to Spain The size and importance of Spain’s economy (12th largest in the World) and the widely held view that it is too large to be bailed out, means it is likely to remain the focus of the crisis for the foreseeable future.

The new technocrat Italian Prime Minister has made good initial progress in starting to open up the economy. Spain on the other hand is in a much tighter situation. The yields on its debt have risen precipitously through the 6% marker. The widely viewed unsustainable 7% rate isn't far away. The federal government recently unveiled an austerity budget (slashing €27 billion) which failed to convince the markets.

Likely developments
Even worse, the extremely devolved nature of Spanish Government means the 17 regional governments of the country enjoy huge power and have traditionally massively overspent. It is not clear the government in Madrid will be able to rein in their spending, even if it wants to. Banks and households in Spain have been pummeled by the property crash and there is widespread fear regarding the health of its regional banks (the “Cajas”).

Unsurprisingly Spain has held some recent debt auctions that have failed to raise the financing required. This has spooked investors and is further increasing the interest rate they want to hold Spanish paper. A vicious circle could easily ensue, culminating in a buyers strike for Spain government debt.
If that wasn't enough two of the three bailed out countries on Europe’s periphery could also spell trouble this year.

In Ireland, despite a general acceptance of the savage cuts required to rescue the economy, an austerity weary populace is reaching the end of its patience. The country particularly wants its enormous (and justifiably perceived to be unfair) banking debts to be renegotiated. The ECB, however, is playing hardball here.

The problem for the Euro Zone is that the Irish are due to vote on the German led "Fiscal Compact" treaty at the end of May. This wills legal bind countries spending. Though the treaty can still pass even if Ireland rejects it, the market upset caused by the only referendum throughout the whole 17 member Euro Zone rejecting the document could be considerable. This would also leave Ireland without access to future bailout funding and cause another fiscal crisis and its possible ejection from the currency.

This referendum will come hot on the heels of a Greek general election at the start of May. The Post-WW2 political party duopoly which has reigned for 60 years looks certain to be coming to an end. This will likely be replaced with a large number of smaller parties, some of which represent either extreme end of the political spectrum.

More worrying is the complete lack of any coalition governance experience in the countries recent history. Given that Greece could very easily (some would say certainly) require a third bailout in the next year, there is huge uncertainty regarding whether Greece can stay the course on its previous budgetary commitments.
None of the above analyses what would happen if Greece left the Euro zone, either voluntarily or was kicked out.

It’s clear that Euro Zone is facing another massively risky year. The question in the Hedge Fund Industry is what this will mean for us?

Effects on the Hedge Fund Industry

The likely affects of the Euro Zone crisis on the industry are the following:

• Reappraisal of risk
While the Hedge Fund Industry is set to enjoy its best year of asset growth since before the global finance crisis, the problems on the Euro Zone will leads to a reappraisal of risk. Institutional Investors in particular may be less willing to make allocations to less transparent, illiquid funds investing into perceived riskier investments (like exotic derivatives), particularly if they are using a lot of leverage.

Investors may also be prompted to move/increase allocations to the larger shops with well known and established brands. The previous experience of having lived through 2008 and come successfully out the other side will carry a lot of credence if the Euro Zone starts to implode.

• Further pressure on investment returns
Hedge funds were down 5% in 2011 - seemingly unable to perform well in times of sharp volatile being caused by the Euro zone crisis. Reuters recently reported that average Hedge Funds have been negative in 2 of the last 4 years. This means the pressure to perform is increasing and the Euro Zone crisis will reinforce this if 2012 is another negative year for Hedge Fund performance. Investors will want to see market neutral funds able to effectively hedge the instability in the European markets and provide consistent returns.

The funds that can perform well in this high volatility environment, regardless of what happens in the Euro Zone, will prosper. Others could see an increase in redemptions as investors move their capital to less risky investments with potentially more reliable investment returns (e.g. T-bills, cash instruments etc).

• Buying Opportunities
On a more positive note, the on-going crisis in the Euro Zone represents a major buying opportunity for many Hedge Funds. European banks are under EU regulatory pressure to significantly increase their capital buffers. Many are selling off portfolios of good quality assets at essential fire sale prices.

Many US Hedge Funds have started to open their first European offices in London specifically to take advantage of this trend over the next couple of years, as Euro Zone banks retrench to their home countries and return to focusing on their core lending markets.

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