Andreas Utermann :
Should we share José Manuel Barroso’s confidence that the eurozone will put the worst behind it this year? Certainly, the success of Ireland’s return to the bond market and Portugal’s recent bond issuance are grist to that mill, but a more nuanced view may be warranted.
Throughout the eurozone crisis, we maintained a conviction the single currency was likely to remain intact and, some months before the pivotal “whatever it takes” statement by European Central Bank President Mario Draghi, identified three conditions for putting the euro on to a sustainable footing. These were: the introduction of an effective banking union within the eurozone; the establishment of greater fiscal alignment between member states; and the ECB assuming the role of lender of last resort.
Progress has been made in each of these areas, and in response, credit default swap spreads across Europe, including the periphery, have contracted markedly over the past 12 to 18 months. Despite recent market volatility, Spanish, Portuguese and Irish bonds are now trading at spreads of just 135, 293 and 105 basis points, respectively, down from peaks of 630, 1,527 and 1,192 basis points.
However, progress towards the necessary institutional framework is not the same thing as completion. While there is agreement on a bail-in scheme for banks that will involve creditors if a bank fails, there is no pan-European deposit insurance or resolution scheme. In terms of fiscal integration, the absence of a permanent burden sharing agreement points to how far we are from a deep agreement.
Unfortunately, the improving market conditions increase the risk of complacency setting in among policy makers in member states. Indeed, the momentum for change already appears to be receding while other important risk factors serve as a reminder we are not yet out of the woods.
First, the process of deleveraging public balance sheets still has a long way to go. In most eurozone countries (and indeed most developed markets globally), government debt as a proportion of GDP continues to creep up from already elevated levels. The affordability of such levels of sovereign debt depends on very low borrowing costs, but ultimately also the resumption of meaningful growth, which has been left wanting.
Second, the extent to which eurozone members are drawing on domestic banks for funding is a sign of financial disintegration, quite at odds with the single currency project, and could create a false sense of security in terms of demand for certain bonds.
True, 88 per cent of Portugal’s recent issue was taken up by foreign investors, but the general trend has been for re-domestication of bonds. The proportion of outstanding Spanish debt in domestic hands now hovers around the 65 per cent mark, up by around 20 percentage points since the start of the crisis. In France, too, the number could rise above 60 per cent in the coming years.
Third, the spectre of political risk cannot be discounted. It is worth noting that despite its bond issue approaching four times subscribed, Portugal’s constitutional court has rejected important government reforms on three occasions. Likewise, Germany’s constitutional court could yet derail some of the progress on the institutional framework.
This year’s European elections could also generate surprises on the extremes. And the independence vote in Scotland could have pronounced knock-on effects across the EU should it succeed.
Given the work still to be done at the institutional level and the risk of surprises on the downside, some pricing looks hard to justify. With bonds in some core European markets such as Belgium, the Netherlands and France near pre-crisis spreads they possibly do not reflect financial and economic reality. Have we already forgotten the lessons of the great financial crisis that risk was not adequately priced?
To the extent that politicians may have lost their appetite for reform, the ECB is doing its best to fill the policy vacuum. In so doing, it is more concerned about the prospect of deflation than the build-up of inflationary pressures. Consequently, our core assessment is that ECB monetary policy will remain looser for longer.
What this means for investors in Europe – barring any accidents along the way – is that risk assets in general should continue to do well. For eurozone bonds, peripheral markets are likely to do better than core markets, in particular those such as Spain, Ireland and Italy that have made most headway in terms of restructuring yet are still being priced with a notable risk of default. As for the Bund, this continues to be overpriced despite a yield pick-up since May, and is one to avoid over medium to longer durations.
(Andreas Utermann is co-head and global chief investment officer at Allianz Global Investors)
