Eurozone inflation is continuing to soar to record highs, with Eurostat (the EU’s statistics body) recently announcing that the inflation rate was 9.1 per cent in August 2022. Embedded in that result, is a 38.6 per cent energy inflation rate (as shown in the chart below).
With its roots in COVID-19, the energy crisis in Europe and now the growing economic fallout from the conflict in Ukraine are just the latest issues in a long list (think GFC, the ensuing European Debt Crisis, Brexit etc.) that have created a climate of stress in Europe. Then, when you add the removal of the unprecedented fiscal and monetary interventions, the potential for recession looms large.
This presents opportunities for investors with an appetite for risk.
For a long time, European banks have stuck to their knitting of originating loans, and then holding those loans on their balance sheets until maturity. This is in contrast to other banking systems, like the US and Australia, where banks have adopted an ‘originate and syndicate’ model in which they continue to originate the loan but then arrange a syndicate to take on that loan. This has led to the European financial system being dominated by banks.
The ECB noted in its Financial Stability Review of June 2012 that the GFC “exposed a number of unsustainable features of some EU banks’ business models – such as a heavy reliance on short-term wholesale funding, overly complex group structures and insufficient capital buffers – which banks need to adjust to ensure long-term viability”.
Since that time, there has been increased pressure on banks and other financial institutions to sell-off assets in order to optimise their balance sheets and existing asset portfolios in terms of quality and size allowing them to free up capital to be deployed into new, higher margin businesses. This has resulted in a relatively consistent flow of non-performing, non-core and capital inefficient whole loans, real assets and other asset-backed credit and credit-like instruments being offloaded.
The current inflationary environment will create new vulnerabilities for borrowers most exposed to those pressures, for instance, in relation to energy prices, food and other raw materials. This will be further exacerbated by the withdrawal of fiscal and monetary stimulus, and an increasing debt servicing burden with rising interest rates. This will ultimately lead to a growing number of stressed assets, a higher level of non-performing loans, and increased pressure on European banks and financial institutions to clean up their balance sheets. As the volume of such stressed assets increases, deals are likely to be struck at attractive risk-adjusted values to purchasers.
Whatever the strategy may be, we’re often asked whether a strategy makes sense in the current environment. Our response will often be “it depends”, because it does depend on an investor’s specific circumstances.
Investors will need to consider (amongst others) their investment horizon, how that particular strategy fits into their overall portfolio, will that strategy improve the diversification of their portfolio, will there be sufficient liquidity in their total portfolio if they include the strategy, are the expected risks justified by the expected returns, how will that strategy be accessed etc.
While we can’t answer all of those questions, we can comment on the diversification and access considerations:
Therefore, for investors seeking ways to take advantage of the current market environment, it may be worth considering whether the opportunities presented by Europe’s latest issues makes sense for their portfolio.
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