LONDON (Reuters) - Standard Life Investments expects the euro will survive intact in 2012 but it has been stress-testing its portfolios and planning contingencies for all scenarios, including a euro break-up, its top investment officer said on Wednesday.
Speaking at Reuters 2012 Investment Outlook Summit — being held this week in New York, London and Hong Kong — SLI’s (SLI.L) Head of Investments, Rod Paris, said advice from the UK’s Financial Services Authority (FSA) on contingency planning for a possible euro break-up was well heeded.
Paris said the Edinburgh-based asset manager, which has 150 billion pounds ($234 billion) of assets under management, had run several possible euro crisis outcomes through its portfolios and examined issues like the geographical location of assets as well as counterparty and liquidity risks.
“We take all of these discrete scenarios and then we stress test our portfolios against it,” Paris told Reuters. “It’s quite well known that the FSA has asked banks and insurance companies to look at contingency planning.”
“We’re fortunate that we have a natural hedge of having one business in Ireland and one in Germany. That starts to tell you how we’re looking at it,” he said. “The place that assets are geographically positioned starts to become very important in the threat of a break-up.”
Paris said the fund had been reducing banking counterparties over the past 12 months anyway.
“We tend to look at national champions, banks that are central of the payment system of that country,” he added. “It’s very easy to be very risk averse and not deal with anyone, but we have a business to run.”
Paris said a big theme through 2012 would be falling liquidity in markets as banks have less capital to commit to trading activities. Although derivatives markets in general had performed pretty well through the crisis so far, he said there is concern about liquidity in areas like over-the-counter derivatives.
“There are many products that are dependent on derivative overlays that have become more expensive. It may invalidate all sorts of activities,” Paris said. “The bid/offer spreads become very wide — where you once had six market makers giving you a quote, it’s down to two.”
On the other hand, there may be upsides to falling liquidity too. “It might encourage more long-term investment behavior, because the costs of coming in and out become too expensive. It may well take some of the froth out of the market.”
Paris said markets at large were expecting agreement on a credible roadmap for euro zone reform and stability from Friday’s European Union summit and would be encouraged going into next year if that emerged.
Right now, the firm was broadly overweight U.S. equities and underweight Europe, with a neutral position on Britain. More generally it likes top quality dividend stocks, corporate bonds and the income characteristics of commercial real estate, such as prime London property.
Paris said Standard Life was seeking trading strategies that see through the current high-drama and binary nature of the crisis.
For example, a falling euro against the dollar might be expected in the event of extreme stress and safe-haven demand but may also be the result of a resolution that involves the European Central Bank printing money via quantitative easing (QE).
“The dog that hasn’t barked has been a weak euro,” he said.
Similarly, German government bonds also may look expensive relative to U.S. Treasuries in either scenario — a resolution involving QE would undermine Bunds’ safe-haven bid and a euro break-up would hit credit quality across the zone.
“You could question whether the very expensive relationship between U.S. Treasuries and German bonds is justified.”
Paris added that it was also important to consider all possible outcomes longer term, especially those far out of consensus at the moment — even the debate about Britain’s potential membership of the euro.
“What’s interesting to me is just let’s say the (EU) treaty changes are made and we do get a much stronger fiscal regime in Europe then I think there are very interesting debates like the UK’s position on the euro from an economic perspective,” he said. “Finally, maybe, we then have a euro that is fit for purpose.”
For summit blog: blogs.reuters.com/summits/; Editing by Susan Fenton