Why the sovereign debt crisis was inevitable

With the eurozone representing almost 20 per cent of global GDP, it is understandable that the European sovereign debt crisis continues to take centre stage and send shockwaves through financial markets. The euro’s conception was driven by politics rather than by economic policy.

It should be of no surprise, then, that the monetary union is today being pushed to its limits.

Economic proponents argued that a common currency would increase cross-border trade and that the theory of comparative advantage would ensure prosperity for all. Politicians were highly receptive to such rhetoric. The argument however is far more idealistic than realistic. It naturally assumes pre-conditions that are unachievable, such as perfectly competitive labour and product markets. It also ignores the lack of a common language as a barrier.

The ultimate success of a common currency area is determined by the degree of economic convergence between its member countries. In the absence of fiscal unity as well as free labour and product markets, convergence is difficult to attain.

Stresses will therefore naturally build as a result of competitive imbalances. In order to ensure long-term stability, productivity growth must be shared across the bloc and real exchange rates must not diverge.

Unfortunately, the euro area witnessed large divergences in productivity and real exchange rates. Countries such as Greece and Portugal gradually became less and less competitive as productivity growth proved weak. These countries therefore found themselves with too strong a currency. Imports consequently exceeded exports which led to unsustainable current account deficits. Budget deficits also persisted as domestic governments attempted to prop up aggregate demand.

The benefit of a free floating currency is that it can carry the burden of any necessary adjustment in a country’s real exchange rate. Without one, a lower general price level in the economy is needed instead in order to restore competitiveness. This, however, requires lower wages and an associated drop in the national standard of living. Clearly, this is not palatable and hence why such monetary unions will always be vulnerable to crises in the long-run.

Eurobonds, fiscal unity and supply-side led economic reform aimed at boosting productivity and restoring competitiveness are needed in order to remedy the crisis. Proposals so far, however, fall short of this. As a result, we believe that economic growth will remain sluggish and that downward pressure on interest rates will continue. Confidence will remain fragile and consequently markets will be volatile and relatively range-bound. So, how have we positioned our portfolio accordingly?

Firstly, we believe that investment cycles are likely to be shorter in a policy-led environment in which tail risks continue to linger. Maintaining a high degree of portfolio liquidity is therefore of paramount importance so that we can move in and out of asset classes quickly and generate Alpha through tactical asset allocation.

Secondly, we have a bias where possible towards yield-generating assets offering "bankable returns". This means that in UK equities we favour companies with progressive and sustainable dividend policies such as GlaxoSmithKline, Unilever and Imperial Tobacco, while in regions such as Asia we invest in funds such as the Prusik Asian Equity Income Fund.

We also have 20 per cent of the portfolio in fixed interest assets as a result, which is also an area of the portfolio that we use to express our theme of favouring creditor nations over debtor nations. This leads us to have an investment in the New Capital Wealthy Nations Bond fund and significant exposure to the Norwegian kroner and Singapore dollar.

Thirdly, market volatility requires risk-control measures to be taken. We actively use short index ETFs in order to dampen portfolio volatility, reduce equity market Beta and minimise draw-downs. We have also identified liquid UCITS III ETFs that can provide long exposure to volatility as an alternative method for further protecting the portfolio.

Lastly, we continue to have exposure to those assets and asset classes that reflect our positive view of the secular trends that will shape the world in which we live. Such trends include finite commodity supply within a world of strong population growth and emerging market consumerism. We are overweight emerging markets and Asia, where the economic outlook for those regions is more favourable. Strong population growth, favourable demographic trends and superior productivity gains provide a healthy backdrop for risk assets, especially when accompanied by easing monetary policy.

Mark Wright is manager of the CF Midas Balanced Growth fund. The views expressed here are his own.