David Scammell, Head of UK and European Interest Rate Strategies, looks ahead into 2011...
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Just two words are needed to sum up 2010: sovereign risk. After Greece in May and Ireland in November, it is clear that Europe’s problems are not going to vanish without decisive action. While bail-outs, designed to ring fence trouble before it spreads, can temporarily calm the markets, we end a tumultuous year with many unanswered questions. Will the public accept austerity measures, and will the political commitment to tighter fiscal policy be sustained ? Will sovereigns be able to finance themselves? Will bondholders be forced to take losses? Will the European Central Bank (ECB) move to withdraw the subsidised liquidity support or will it be pushed to implement large-scale quantitative easing (QE)? While we don’t have a crystal ball, the important lessons of 2010 have enabled us to identify the key market drivers in 2011 and inform our strategic view.
The ultimate cause of sovereign troubles in the Eurozone is a subject of complex debate, but it is clear that the global financial crisis left the peripheral economies with weakened banking sectors and rapidly rising levels of public debt. Uneven economic growth is a key factor and Europe’s chosen route of fiscal consolidation has compounded the problem, with the risk that aggressive fiscal tightening in these countries creates a negative feedback loop as it produces yet slower growth. The peripheral countries have seen interest rates, and thus borrowing costs, rise dramatically in response to these concerns. In addition, the market remains fearful of further bank recapitalisations, which would only worsen the situation. It is no surprise that many now question the solvency of some of these sovereigns.
What positives can we take from 2010? Whilst the path to debt sustainability looks daunting, there are three key positives we can take from 2010. Firstly, Europe now has a framework (of sorts) to deal with sovereign crises, and the lessons learnt by policymakers may prove to be invaluable in 2011. Second, albeit reluctantly, the ECB has begun to participate in bond purchases buying €70bn in the secondary market. Thirdly, throughout the year the ECB has gradually removed its emergency liquidity measures – a sign of confidence in the sustainability of the economic recovery and recognition that the banking sector now looks in better shape. While the removal of liquidity is a positive step, there is a caveat. The ECB have made it clear that zero interest rates cause distortions, and they would ideally like to normalise interest rates as soon as possible. This will be done either through the elimination of
unlimited funding to the banks, or by increasing the refinancing rate. While this may not suit the periphery, it does suit the strongest members of the Eurozone – the traditional drivers of policy. The risk is creating a tougher situation for financial institutions in peripheral economies, when what they require is further support.
Will the ECB embark on quantitative easing? Some on the ECB Governing Council (most notably the German members) are ideologically opposed to the mass purchase of bonds for fear of stoking inflation. This fear can be traced all the way back the hyperinflation of the Weimar Republic in the 1920’s. If the ECB were to embark on QE, they could arguably solve Europe’s problems overnight. The Federal Reserve QE purchases amount to approximately $2 trillion, or 14% of GDP. Similarly, the Bank of England (BoE) has bought £200 billion, or 13% of GDP. Applying these ratios to the eurozone, a €9 trillion economy, and the ECB could purchase €1.2 – 1.3 trillion of government bonds. If targeted at the periphery, a €1 trillion purchase could buy the total outstanding debt of Ireland, Portugal, Greece, and Spain (approx €850bn) and still have plenty left over to buy a sizable chunk of Italy’s outstanding bonds (approx €1.4trn).
The ECB has the firepower, but opening the printing presses and monetising more debt would outrage the German establishment. Europe has options – the question is: is there the political will to take them? We believe the ECB could embark on a mass bond buying programme, but their hand would have to be forced by further significant increases in peripheral yields.
The fate of Europe is in Europe’s hands Sovereign risk will remain top of the agenda in 2011. The structural adjustments required in peripheral nations will take years. Greece and Portugal have failed to meet their 2010 fiscal targets, and policymakers must restore fiscal credibility as soon as possible if they are to avoid peripheral contagion.
However, if you take the eurozone as a whole its finances are actually in better shape than those of the US or the UK. The problem Europe has is the lack of fiscal transfers between member states. Without fiscal transfers, real interest rates across the single currency block encourage states to diverge. Consider German growth. We expect German data to impress into 2011, which will put pressure on the ECB to increase interest rates. The peripherals, however, are likely to experience low or negative real growth, thus require continued ultra low rates. To then impose higher rates on shrinking deflationary economies subdues growth further and increases debt to GDP ratios, creating a situation that quickly becomes unsustainable (see Greece and Ireland). Taking the UK as an example, if Scotland is experiencing slower growth than England, then fiscal transfers take place to address the imbalance. The capital expenditure comes in the form of benefits or infrastructure spending, to name but a few examples. These transfers enable effective uniform monetary policy for the whole of the UK. In Europe, the exporting nations, such as Germany, are performing well. Those that rely on domestic demand, the peripherals, are suffering. The prospect of fiscal transfers from Germany to peripheral Europe is riddled with political risk, and at present, neither politicians nor the electorate appear to be ready.
Who pays for government bailouts? Amid the uncertainty, we can be sure of one thing: either taxpayers or bondholders will shoulder the burden of sovereign debt. Politicians, in the face of social upheaval as people refuse to accept a lower standard of living, would like bondholders to accept haircuts. Default and debt restructuring is thus an option, but would likely prove very disruptive, and runs the risk that if government bonds are no longer deemed ‘risk free’ assets then yields could be sent permanently higher. While we are unlikely to see explicit burden sharing clauses incorporated into new bonds, the inclusion of collective action clauses is possible.
Will sovereigns and banks be able to fund themselves through 2011? Although there will be less supply in 2011, there will still be funding risk for the periphery as demand has clearly cooled. A lot depends on the extent to which the market attacks them – ratings agency downgrades could exacerbate any funding difficulties. As international money moves away from peripheral debt, countries will have to rely more on domestic demand for their bonds. This leaves countries like Italy, which has a high percentage of government debt held domestically, in a stronger position than those that do not.
The pace of peripheral folding has actually been quite a surprise, with the markets clearly in no mood to tolerate fiscal slippage. This informs our view that Portugal will require help. The country has failed to meet its targets for this year and structural low productivity and low competitiveness will take years to address. Of more significance is the extent to which Spanish debt comes under pressure next year. The government bond supply calendar is onerous and the underlying weakness of the banks is still evident. That said, the government has taken steps to reign in public spending and some of the banks have successfully returned to the markets in recent months. Ultimately, the greatest risk to any country embarking on a sustained path of fiscal consolidation is a sharp rise in borrowing costs, and thus investor confidence/scepticism will be a key driver of future events.
To solve Europe’s problems we need one of the following: more dynamic growth, better fiscal numbers or a more aggressive policy response from the ECB. Given that the first two are questionable, we believe the ECB might have to do more to ensure the survival of the Euro. Without a firmer response, divergence within the Eurozone will continue.
So where does all this leave our strategy? Similarly to 2010, 2011 will bring near potential growth (for core countries), and subdued inflation. In this environment, the ECB will be under few pressures to tighten. The subsequent anchoring of the front-end of the yield curve should provide a degree of support for bonds, but does not detract from the underlying point that yields are at unsustainably low levels. In the absence of large scale Central Bank support, valuations would suggest that yields need to rise from present levels. Spread volatility is likely to persist and we would anticipate that non-core spreads will widen versus Germany as peripheral yields increase and Germany outperforms. Among the core countries, we are cautious of French government paper having identified a number of structural vulnerabilities to the economy In terms of our strategy, this leaves us overweight Germany, underweight France, and with zero exposure to peripheral debt.
What about the UK? The markets welcomed the coalition government’s austerity measures, and as a result gilts have performed relatively well in 2010. While the UK will not become embroiled in Europe’s problems, domestic issues remain. Stubbornly high inflation is a major headache for the BoE, and when viewed alongside anaemic economic growth the relative strength of gilts is questionable. Despite the stickiness of inflation, the market is reluctant to rule out the possibility of further QE in the UK. This is because the BoE has made it clear that it views QE as an insurance policy, and if growth slows more than is currently expected, they could pull the trigger again. However, this is not our central view. Indeed – we believe that the BoE will be the first of the Western developed central banks to raise rates next year.
Source: BONDWorld – Schroders
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