Can the Eurozone survive?

The more time goes by, the worse it looks. The Eurozone frailty is getting more difficult to manage by the day and to understand why, we need to dwelve into the mechanism behind the Euro. Both Europe and the U.S. are in deep trouble but the source of their troubles and, in turn, the approach to resolve those troubles are very different.

The Euro project, from the very beginning, was meant to unify Europe on the economic front only. By creating a single currency, it was believed, trade would flourish and mobility would increase. A single currency makes it far easier and less costly for industries to plan ahead with production.

What everyone seems to forget is that there is also an implied cost to this, which may not seem evident when things are going well. A single currency without a political overlay can be problematic in certain situations like the one that is currently unfolding in the European continent. By joining a single currency, a country is effectively giving up independence on the monetary front. Without political unification, however, fiscal policy stays local. This is in stark contrast to the U.S. with its federal government in which both monetary and fiscal policy is managed at the federal level. What this means is that a state is unlikely to find itself in a situation like many of the peripheral European countries are facing today, having trouble raising capital to pay for maturing debt. This is because such issues are dealt with at the federal level.

So what actually happens when you lose monetary independence but keep fiscal independence and you are facing the type of challenges that we are seeing today? Well, you get hit by a so called double whammy. Let me explain: The booming years inflated prices and now that the crisis has hit and the asset price bubble burst, costs such as wages need to come back down. For a country with an independent monetary system the solution is rather straight forward. Instead of cutting wages, you just depreciate your currency and the problem is pretty much resolved as it is the equivalent of cutting wages. In a country that does not have monetary independence the only real solution is to cut wages, and if history is any guide, this can be a slow and painful process. Prices tend to be sticky on the downside, producers will wait for wages to come down before cutting prices (to preserve margins) and workers will wait for deflation to hit before agreeing to have their wages cut. This is exactly the problem facing a highly unionized Europe, which, through austerity will have to apply the painful cost cutting process as it is the only possible solution at their hands short of regaining monetary independence or defaulting on their obligations which are unlikely to happen any time soon.

Stagflation in Europe?

The euro zone's annual rate of inflation hit a 2 year high in December, driven by fuel, food, alcohol and tobacco prices at a time when the ECB is dealing with a major sovreign debt crisis.
Consumer prices rose 0.6% from November, pushing the year-to-year rate up to 2.2% from 1.9% the previous month, the highest annual rate since October 2008 when it stood at 3.2%.

A surge in cost price inflation that is likely to be passed on to consumers, just as European governments are embarking on an austerity program limits the ECB's flexibility on the monetary front somewhat. But at the same time it should not be forgotten that price stability (i.e. low inflation) is the primary objective of the ECB, in contrast to the Fed that targets both price stability and unemployment.

Applying the brakes at a time when stimulation is most needed could bring Europe closer to the brink of stagflation. Considering the sovreign debt related uncertainty surrounding Portugal and especially Spain, the austerity measures and a whole lot of other problems, a rate hike might just prove too much to handle.

Risk vs. structure based asset allocations

2008 reminded us that diversification can fail spectacularly when risky assets are clumped together. This is because when panic sets in, there is a sort of hoarding activity in the markets as investors jump ship from risky to less risky assets. By doing so, the correlation between risky assets spike, leading to simultaneous losses from investments of different asset classes. This is why, for example, at the peak of the crisis, high yield and emerging bonds and commodities followed the exact same path as equities at the very moment when the benefits of diversification were most needed. What use to be diversified suddenly becomes concentrated.

How can we avoid or at the least minimize such serious pitfalls? One method would be to implement a risk based asset allocation, grouping together investments according to their risk characteristics.

The traditional approach to asset allocation has been to classify assets according to their structure. Genotype/phenotype are good biological analogies to help illustrate the differences. Genotype describe hereditary characteristics (structure based classification) whilst phenotype are the observed properties (risk based classification). As an example, grouping together fixed income investments comprised of bonds with characteristic cash flow streams that include coupons and a final payment at maturity would belong to a traditional structural classification. The problem with the traditional classification is that the investment landscape has changed substantially over the last decade. The risk spectrum of investments with a similar underlying structure has broadened substantially. Today, for example, bonds can include low risk, short duration treasuries as well as high yield/emerging debt that share risk characteristics that are comparable to that of equities.

There are effectively two ways to tackle this problem:

• Managing the risk internally, within the asset class by implementing strict guidelines
• Defining risk at the asset class level

The first method would involve limiting the choice of underlying investments for more effective risk control. One such approach would be to implement a core/satellite approach in which the "larger" core would comprise of less risky investments in contrast to the satellites.

The second method is best explained as a target based approach in which the asset classes are defined as targeting specific objectives. We could very well imagine, for example, a portfolio comprised of four "asset classes" with the following defined objectives:

1. Longer term high returns (equity like risk/reward characteristics)
2. Hard assets (namely for inflation protection)
3. Liabilities matching (high quality low duration fixed income)
4. Pure excess return (de-correlated to the rest of the markets)

This method has the advantage of providing greater transparency and better risk control, at the same time allowing for a greater degree of specificity in matching investor objectives and constraints. A person close to retirement, for example, would typically allocate a large portion of their wealth to liability matching instruments in contrast to someone at the prime of their career, in which case the attributions would probably be more balanced between the four classes.

The two proposed methods aim for the same objectives, the big difference is in the approach.