Clearly, eurozone solvency has been a major concern and remains a key risk but it is the slowdown in growth that tipped investors over the edge.
Weak GDP growth for Q2 in the US was below expectations but it was the downward revision to Q1 growth that really shocked the markets – implying an annualised growth of below 1% for the first half. The chances of another recession have increased significantly.
The reaction of the markets was to be expected. Risk assets have fallen by around 20% and investors have rushed into defensive investments such as government bonds, pushing yields down in the US and UK.
Tax-led growth
The concern now is that the knee-jerk rush into government bonds is misguided. Given the state of government finances on both sides of the Atlantic, governments are just as reliant on economic growth as companies and consumers and they need growth in tax revenues to meet their fiscal repair plans. Without that growth, budget targets will be missed and bond issuance will be higher than expected.
For how long can the markets continue to accept yields at such low levels, well below the level of inflation? Investors should be demanding a higher risk premium in exchange for the uncertainty in achieving fiscal stability, and a return which is positive in real terms.
US Government bonds have increased in price, despite having been downgraded by S&P, because the dollar is still perceived to be a safe-haven currency. However, we know that confidence in financial markets can be low and the apparent appetite for US Treasuries might just reflect a lack of obvious alternatives.
The underlying fundamentals for the US are not hugely different to those in Italy except for the fact that a higher proportion of Italian bond issuance is domestically funded, whereas the US is heavily reliant on overseas investors. For a ten-year investment, Italian bonds still offer 5% versus the 2.1% in US Treasuries.
There is little value in any global bond markets, but for risk-averse investors the ultimate safe havens should be Asia and countries like Norway and Sweden – where the underlying fundamentals are much more robust. These markets are much stronger fiscally and their currencies have not been pushed to the extremes seen in the Yen or Swiss franc.
