Investors Bet on Euro Assets in 2013 Despite Risk

Major investors are preparing to dip their toes deeper into the turbulent waters of the euro zone in 2013.

A year ago, investors were bracing for a possible collapse of the currency area, dumping bonds from its ailing south, hammering stocks and seeking safe haven in cash, abroad, or, if they had to stay in Europe, in rock-solid German bunds.

With Thursday's deals to create a single banking supervisor and give fresh aid to Greece, euro zone assets are set to finish the year on a high.

The bloc's bluechip index, in a steep fall until the European Central Bank pledged in July to do all it takes to save the euro, has rallied over 13 percent on the year. Italy sold one-year bills at the lowest yield since March this week and Spain has already started funding itself for 2013.

After so many false dawns in the three-year old debt crisis, EU leaders hope investors are prepared to believe this is more than yet another short-lived respite. The bloc's top economic official Olli Rehn said Cassandras predicting disaster for the euro and Greece had been proven wrong.

But risks abound for next year, from Italy's political turmoil to Spain and France's struggle with austerity, Greece's fragile politics and forecasts that recession may drag on. Germany's September general election also casts a long shadow.

Many leading investors see reasons to believe the euro zone stocks rally will continue in the new year.

The easing of the crisis opens the way for a closer look at companies' fundamentals and cherry-picking among assets "unjustifiably punished for being European", said Wouter Sturkenboom, strategist at Russell Investments.

Spanish, and even Italian sovereign debt are increasingly popular, and yield-hungry asset managers say they will avoid expensive debt from the "safe-haven" core around Germany.

Goldman Sachs predicts euro zone sovereign spreads will continue to tighten and has urged investors to go long on Spanish bonds. "The process is unlikely to be linear given the political and economic cross-currents involved, but Spain in our projection looks set to outperform other peripherals," the investment bank wrote in a research note.

Societe Generale headlines its outlook for next year: "2013: European assets strike back." It advised investors to head for the periphery across assets, for sovereign bonds, credit and stocks and also favours Spain over Italy.

After being pummelled through most of the crisis, periphery assets have become cheap and offer higher returns and risk premium. Very tempting in times of very low to negative returns on "safe" assets such as German Bunds or U.S. treasuries.

EURO ZONE STOCKS CHEAP

The single currency's stocks have rebounded this year are still more than 13 percent cheaper than U.S. stocks based on 12-month forward earnings, Thomson Reuters Datastream data show.

The equity risk premium for euro zone stocks is 9.8 percent versus 7.9 percent for U.S. stocks, Datastream data show.

"The risk of euro zone collapse has very considerably reduced with all the policy decisions taken since July last year, there is no doubt about that," said Alain Bokobza, head of global asset allocation strategy at Societe Generale.

"Considering the very cheap valuations we expect to see a continuing of the return to euro zone assets next year."

Hedge fund managers have grown wary of large directional bets on euro zone bonds. In part they are nervous of losses that could wipe out their meagre profits this year. But many are also wary of betting against the ECB stepping into the market.

"I don't think anyone wants to be (short)," said Andrew McCaffery, global head of hedge funds at Aberdeen Asset Management. "Most participants are taking a more sanguine short-to-medium-term view because of the ECB."

Yet some are still willing to hold positions in Greek bonds, spurning Athens' debt buyback in the hope of higher profits.

The ECB warned on Friday there was no room for complacency.

The temporary halt in a three-week rally on the Euro STOXX 50 and a spike in Italian bond yields on Monday due to concerns about Italy's political stability served as a reminder that buying euro zone assets is far from risk-free.

The stock rally resumed on Tuesday in a sign that investors may be more resilient about bumps on the euro's rocky road.

"The market response was contained, while if it had happened six months earlier we would have expected to see contagion across broader European markets," said John Bilton, European investment strategist at Bank of America/Merrill Lynch. "Markets are prepared to look through issues such as this."

That resilience will be repeatedly tested next year. The year will begin with continuing uncertainty over whether and when Spain may apply for a euro zone credit line.

A bailout request would open a period of wrangling over the conditions. Once the European Central Bank stepped in, there are likely to be shrill calls in Germany for strict limits on bond buying. Markets may question the ECB's resolve to keep going.

"The downside risks are less than they were, but they have not been removed," said Standard Life Investment's head of global strategy Andrew Milligan.

Worries over meagre economic growth mean that euro zone stocks are interesting only up to a point.

"The interesting part about euro zone equities is their valuation," Russell Investments' Sturkenboom said. Many could lose interest if a Spanish bailout request spurs a strong rally.

"If the valuation gap is closed we would become cautious on European equities again because the underlying economic dynamics are still very worrying and they do warrant a valuation gap," Sturkenboom said. "Europe is going to be in a tug of war between policy action and real economic weakness".

Many are also worried about France, although some hedge funds are calling it quits on one of their biggest trades of the year - shorting French government bonds.

A potential concern for investors could be if the German election resulted in a government with a slim parliamentary majority vulnerable to eurosceptic rebels.

On the other hand, a grand coalition of the two major parties led by conservative Chancellor Angela Merkel, seen as the most likely option, would have a strong mandate to push ahead with further euro zone integration.

If risks surrounding Italy and Spain are cleared in the first quarter, that might lure in more investors towards Europe.

Bank of America/Merrill Lynch is "reasonably defensive" on euro zone peripheral bonds for the beginning of the year because of volatility risks but could become "gradually more constructive after the first quarter once Italian elections are over and if and when Spain asks for a bailout", said Ralf Preusser, head of European rates research.