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Balancing act

Governments need to tackle their deficits without damaging fragile economic growth

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The threat of a sovereign debt default continues to dominate the headlines. Concerns that an European Union member country could go bust are very real – and are keeping policy makers awake at night. Greece, Spain, Portugal, Italy and Ireland’s public finances are all in a mess.

Fears of contagion to the wider eurozone are rife. Bond markets are jittery. Some of the more pessimistic commentators are even fretting over the viability of the single currency project.

How this plays out could have ramifications for equity markets over the coming year.

But with periods of uncertainty and volatility come great opportunities. We believe that through judicious stock selection a fund manger can
still achieve robust returns.

Greece is in trouble: its deficit is 12.7 per cent of GDP, four times more than the EU rules allow. But politicians have pledged to tackle the problems before they morph into fullblown tragedy. Whether they have the political will to do what is necessary in the face of fragile economic growth and rising unemployment remains to be seen.

In March, however, it appeared that help was at hand, with negotiations between the European Union, the European Central Bank and the International Monetary Fund eventually yielding a bail-out plan.

Since then though, political infighting and point-scoring has threatened to derail the accord. Germany, for one, is demanding the Greece pay a
higher price than is currently being proposed for the EU’s assistance.

At the time of writing, the spread of the Greece’s ten-year government bond yield over its German counterpart widened to its highest level since Greece joined the euro in 2001.

The Pandora’s Box opened up in Greece has also assumed global significance. First, it has shown that while the EU may be a single entity, it contains economies with a high variance of risks.

Second, the crisis has undermined global investors’ confidence in the euro and the currency has lost around 10 per cent of its value against the dollar since the end of November.

Third, it has highlighted to investors the lack of policy structures in place in the eurozone to deal with country-specific problems.

There is, however, a silver lining. The crisis has brought the subject of deficit reduction to the fore.

Governments around the world – in the US, Japan and closer to home in the UK – now acknowledge the need to take their own fiscal positions
seriously and communicate their plans effectively to the investment community and their electorates.

There are also positive signs elsewhere in the eurozone. Forward-looking indicators are encouraging. Economic sentiment improved in March, with morale in the construction and industry sectors on the rise.

The recovery in confidence among the region’s consumers also continued apace. The business climate is improving, and we are witnessing the
return of inventory rebuilding by a number of companies.

Further, firms are still being rewarded by the market for meeting or exceeding their earnings forecasts. Many have rebuilt their balance sheets and have strong cash flows. We are also starting to see a genuine pick up in demand. Nonetheless, the sovereign debt issue will not go away over night and no matter how unpopular subsequent austerity measures are, policy makers will have to take them to tackle their deficits.

Confidence needs to be restored. Their own long-term funding depends on it.

But massive cuts to public spending and higher taxes could also adversely affect business and consumer confidence, stymieing any economic growth.

It is a tricky balancing act. A period of austerity lies ahead for many countries. During this time, we expect equity markets to be fairly volatile. Good stock selection will remain key.

Kathleen Dewanderleer is investment director for European equities at Swip

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