Investors should look out for three scenarios emerging from the euro-zone policy meetings this month and should opt for different ways of positioning depending on the outcome, analysts at Swiss bank UBS wrote in a market note.
On Friday, leaders from the euro area meet in Brussels to talk about new measures to fight the deepening debt crisis, but no decision is expected until a summit of European Union leaders taking place between March 24 and 25.
The first – and most likely – scenario would be increasing the size of the European Financial Stability Facility (EFSF) to allow it to lend at its full capacity of 440 billion euros ($607 billion).
The EFSF is funded by issuing bonds and rating agencies require additional cash reserves to be held for each bond in order to grant it the much-coveted Triple-A rating. That means that the effective lending power of the EFSF is much lower than the 440 billion euros.
A decrease in the interest rate charged by the EFSF for its loans to about 5 percent for a three-year loan from the current 5.8 percent is also part of UBS' first scenario.
The second scenario is an optimistic one, which includes more measures such as the EFSF buying bonds on the secondary markets or it being accessible without the need to call in the International Monetary Fund.
The third is a negative scenario in which no agreement is reached.
What To Buy
Investors should buy covered bonds – bonds backed by either mortgage loans or public sector loans and issued by European banks – in peripheral euro-zone countries, as well as protection on these countries' sovereigns in the form of credit default swaps ahead of the EU summit at the end of March, according to the UBS analysts.
"We believe the attractive spreads of covered bonds represent a great way to 'fund' the purchase of sovereign CDS," they wrote.
If EU leaders fail to deliver, sovereign CDS will likely sell off, but covered bonds should be stronger "because of the high quality of the underlying assets," the UBS analysts added.
In the stock markets, investors should pay attention to the three scenarios, they said.
The first one is largely priced in and it is a "non-event" for stock markets; markets will sell off in the negative scenario but not a lot, as there is still money on the sidelines; the optimistic scenario would spur a rally.
UBS analysts said their favorite stock markets are France and Italy, because they tend to sell off along with the periphery markets of Greece, Ireland, Portugal and Spain when investors get nervous.
"We like Italy and France and reiterate they are the first- and fourth-cheapest markets in Europe, earnings momentum is turning and Italy is a nation of net savers with well capitalized banks," they wrote. "It should do well in an environment of rising rates."
In sectors, financials are the most likely to sell off on any disappointment arising from the meeting and this might provide a good opportunity to get in, according to the analysts.