Friday, October 30, 2009

No easy way out for Eurozone peripherals

Earlier this week, I made the case for a multi-year outperformance of the German economy (see A German history lesson). The restoring of corporate competitiveness over the current decade coupled with some structural reforms and a relatively healthy situation in government finances before the crisis hit has brought Germany out of its place as the 'sick man of Europe' and has restored the ability to conduct an accommodative monetary as well as fiscal policy to counteract the economic downturn.
However, just as Germany has improved its relative position, the former high-flying Eurozone peripherals look as bad as Germany at the start of this decade, if not worse. In general, the Eurozone peripherals joined the Euro at an undervalued exchange rate and with a below-average price level. Both helped the corporate sector via an effectively easy monetary policy stance. Furthermore, the lower price level meant a higher than average inflation rate and therefore low real yields. This in turn fuelled a housing and construction boom and overall peripheral countries in general exhibited high growth rates. But now the price has to be paid for this artificial boom created via easy money and high lending growth. The general price level increased faster than for the trading partners, meaning that corporates over time lost their competitive position. Furthermore, corporates suffer from a significant financial deficit, which is especially worrisome during a period where banks are unwilling and unable to lend. Households also piled massively into debt and are now left overindebted and in possession of depreciating housing assets. Finally, governments have in general not made enough use of this artificial boom to bring their fiscal house in order. And just as Germany had to learn at the start of this decade, a high price level and a poor fiscal situation take away the ability to generate an easy monetary and fiscal policy environment just at the time where cash-strapped corporates are cutting back sharply and the resulting surge in unemployment pressures the overindebted households ever more to restrain consumption.
Unfortunately there is no easy way out of this situation as Germany had to learn and it will take years to improve the underlying economic fundamentals. A subdued absolute economic showing as well as economic underperformance vs. the core of the Eurozone promises to be with us for several years. The fundamental health of the sovereign will deteriorate further in the foreseeable future not least because as of yet the acceptance that harsh structural reforms have the potential to speed up the healing process still seems to be low. In turn, the downward rating cycle has further to run and the latest negative rating actions do not promise to be the last ones by far. Last week Fitch downgraded Greece's sovereign rating to A- from A with a negative outlook and just yesterday Moody's put Greece on review for a possible downgrade as well (currently A1) and changed the outloook on Portugal's Aa2 rating to negative.
Eurozone govy spreads vs. Bunds: watch out for increasing discrimination between issuers
Source: Bloomberg, ResearchAhead

These negative rating actions have also not gone unnoticed by the bond markets. As the chart above shows 10y Greek government bonds have been underperforming again significantly over the past weeks, not only vs. Bunds but vs. the rest of the Eurozone. But what should investors do? The yield pick-up available by swichting from Bunds into Greece is high with some 140bp. Compared to the 3.25% yield on the 10y Bund that is equal to a yield enhancement of roughly 40%. However, I think that over the medium-term spreads for several peripherly issuers will remain high and risk widening again amid the increasing rating differences vs. the core of the Eurozone and ongoing high refinancing needs. I think that before significant structural reforms are undertaken switching back into some of the 'high-yield' Eurozone sovereigns is premature. Rather I would be switching into high-grade corporate bond issuers of the core countries to achieve a yield pick-up.
Overall, I stick to my view presented on Oct 1 in Rates Strategy: A look at credit yields and spreads: 'Within the Eurozone government realm, fundamentally I favour Germany & France given that I think in economics terms they will outperform over the medium term. However, also here the need for carry is a strong spread-depressing factor and will act to tighten spreads further despite relative poor fundamentals of some sovereigns. Overall, I would suggest an overweight in Italy, Austria and Belgium and be neutral on Spain (amid the poor fundamentals) as well as Germany and France (amid the lack of yield pick-up). On the other side I would be underweight in Ireland, Greece and Portugal amid poor fundamentals and a lack of liquidity despite the yield pick-up. Finally, I would continue to overweight covered bonds in general as well.'
The only change at the moment would be to move Spain to a small underweight as I see an increasing risk for a renewed period of underperformance.

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