Tuesday, November 24, 2009

Greek Fire - Part II

This is a follow-up to the original post Greek Fire dated November 17.
The underperformance of Greek assets has continued over the past days. In the bond market, 10y GGB-Bund spreads have widened sharply to currently around 174bp from 132bp just two weeks ago and a low of 108bp in early August. As the chart below shows, this spread widening has been mirrored by wider CDS spreads for Greece. Interestingly, the absolute level of the Greek CDS seems to top and bottom ahead of the GGB-Bund spread. In early March it peaked 9 days ahead of the top in the 10y GGB-Bund spread and in early August it bottomed 7 days ahead of the low in the cash-bond spread. What is more, the relative performance of equities seems to lag the developments in the bond markets (I used the difference in the percentage-performance since the lows in the equity indices on March 9). Greek equities have only really started to underperform since late October, i.e. more than two months after the outperformance of Greek GGBs came to a halt and started to revert.
Greek assets remain under pressure
Source: Bloomberg, Research Ahead

This highlights once again that equity investors ignore the developments in bond markets at their own peril. Furthermore, given that the underlying problems responsible for the latest underperformance are also present in a host of other countries, bond and equity investors should take note. First, Greece is suffering from a structural weak economic position (significant imbalances, low relative competitiveness etc.) coupled with limited room for an ongoing environment of stimulative fiscal as well as monetary policies. Fiscal policy is seriously constrained by the high level of indebtedness and the exorbitantly high budget deficits. In turn, fiscal policy needs to be tightened significantly just to stabilise the deficit near 10%. This, however, will further harm the economy. Moreover, monetary policy is far from exerting the same level of accommodation as in other countries. The level of longer-term interest rates is higher with 10y Greek government bonds yielding 170bp more than their German counterparts (vs. a pre-crisis level of roughly 35bp) whereas the inflation differential has decreased (currently 1.2% difference in headline inflation rates vs. an average of 1.55% over the past 10 years). In turn, the monetary environment for Greece is significantly less accommodative than it is for Germany. Moreover, Greek banks seem to rely relatively more on the ECBs liquidity providing measures. As this FT article suggests - citing a BNP Paribas research piece - 7% of excess reserves provided by the ECB have gone into Greece which only represents 0.9% of EMU GDP. Furthermore, Greek banks seem to have used this liquidity to buy local government paper helping sovereign spreads come down.
However, similar problems (significant structural imbalances, high deficits which will need to be reduced via fiscal tightening, lower level of monetary policy accommodation than for the Eurozone average, high reliance on ECB liquidity providing measures) are apparent in a host of Eurozone countries. I continue to see the largest problems - besides Greece - for Ireland, Portugal and Spain. I still remain a little less worried with respect to Italy (largely because the deficit still appears relatively low which means that there is no need to actively tighten fiscal policy as of yet).
Given the structural economic imbalances coupled with the need to tighten fiscal policy, monetary policy would be more important for those countries to deliver ongoing policy support. But again, the level of interest rates in these countries is significantly higher (especially in Ireland) than in the core of the Eurozone. Coupled with lower inflation rates than for the Eurozone average (-1.5% for Portugal, -0.7% for Spain,-6.5% for Ireland vs. -0.1% for the Eurozone) this means that real yields are much higher. Furthermore, this high level of real interest rates is especially apparent at the long end of the curve given the high level of credit spreads on top of the already steep undlerying yield curve (as measured via Bunds or swap rates). This renders it much more attractive for the banks located in these countries to use the short-end of the yield curve to refinance than locking in rates at the longer end. As a result, I assume that the dependency on the ECBs liquidity provision measures tends to be higher in those countries on average (this is not to say that for example also some weak German Landesbanks do not rely extensively on ECB liquidity). In turn, as the ECB starts to withdraw this liquidity, it will be especially the banking sectors in those weak countries which will suffer significantly, leading to further underperformance of respective bond and equity markets.

Given that the ECB should start to embark on its exit path - even if only at a gradual pace - it becomes even more important to shy away of investments in the structuraly weak Eurozone countries such as Greece, Ireland, Portugal and Spain, be it in sovereign or corporate bonds as well as in equity markets.

1 comment:

  1. Get ready for some new subs, you got ZeroHedged (Slashdotted for the financially inclined).