In recent months the change in government in Spain, the victory of the socialist candidate Francois Hollande in France and the inconclusive general election in Greece have created doubt that the route to solving the debt crisis is through the type of austerity envisaged by the ‘fiscal compact’ agreement reached in December 2011.
Governments missing targets
It has become less clear whether or not targets for reducing government budget deficits will be met on time, whether planned structural reforms will take place and whether the political unity created in December can hold in the face of increased demand for a relaxation of austerity and for more pro-growth economic policies.
The increased uncertainty has led to an increase in sovereign credit risk premiums in Europe. The spread between Spanish and German government bonds has increased to almost 500bp after being as low as 300bp during Q1 when the markets benefitted from the ECB’s massive long term repo operation.
The spread on Italian government bonds has followed a similar path while spreads on European bank debt have widened, European equities have underperformed and the euro has lost ground against the dollar, sterling and yen in the foreign exchange markets. While banks have been trying to deleverage, they remain significantly exposed to sovereign debt and to asset quality deterioration in many parts of Europe should the economic climate worsen.
While Tier 1 capital ratios have increased, the pricing of bank debt suggests that, in extreme, equity and retained earnings may not be sufficient to cover any losses resulting from a major banking or sovereign payments crisis.
Uncertainty and caution don’t help
From the bond market point of view all this uncertainty and the ‘What if..?’ scenarios being debated are overriding everything. US Treasury, German bund, Japanese and UK government bond yields are hitting new all time lows, while CDS indices have widened (not helped by the JP Morgan trading losses).
Valuations are extreme but it will require some event to reverse recent trends. On the macro front the already fragile outlook for weak global growth with significant regional divergences is at risk from continued investor, corporate and consumer reluctance to move away from very cautious behaviour. It was encouraging earlier this week to see German GDP growth at 1.7% but for the whole of the eurozone growth was zero in Q1. Germany can do a lot to support growth in the region but it can’t carry Europe by itself and with concerns about the strength of the Chinese and US economies, German growth is also at risk until confidence improves.
It remains hard to believe that the rest of Europe will stand by and let Greece collapse, given the potential social and political risks associated with such an event. Yet it is equally difficult to see how Greece can continue to receive funding and not meet its obligations to the rest of the Union.
The muddle-through option is still possible but needs a government in Greece to be put in place quickly. Markets need more clarity.
Fixed income views:
- Interest rates on hold through 2013, possibly more QE, but core government bond yields are unattractive;
- Risk aversion likely to keep risk spreads high and risk-free yields low until more clarity on Greece;
- Investment grade credit premium is still supported by corporate fundamentals;
- European investment grade allows investors to diversify credit risk to a much larger extent than the opportunity in government bonds;
- However, European sovereign stress will impact on returns from credit, in Europe and elsewhere;
- Yields still attractive in UK investment grade, corporate fundamentals are solid and sensitivity to Europe is less in US investment grade;
- High yield and emerging market strategies are still able to boost overall yield to investors.
