In many ways, developments surrounding the EMU have had the greatest impact on many key trends across the sectors covered.The turmoil in the EMU took on a decidedly different shape as Italy has become the latest country to become embroiled in a situation with borrowing costs in excess of 7% - albeit briefly.
With the resignation of Prime Minister Silvio Berlosconi in Italy and Prime Minister George Papandreou in Greece, the subsequent caretaker governments installed in each country with former EU Commisioner Mario Monti and former European Central Bank vice-president Lucas Papademos at the helms, respectively, a new stage has been reached in this crisis as technocrats move in to take the place of democratically elected leaders.
Our report highlights the current effects of the crisis with our Fixed Income section providing an overview of bond yields in the Eurozone, and our view on the likely trend in subsequent events, along with key developments in across the sector.
The larger question looming in the background is whether or not the Eurozone crisis will, if it has not already, lead to a significant impact on global output. As examined within our Commodities section, the impact of the Eurozone crisis needs to be seen within the larger framework of continuing strong demand from emerging markets for key commodities whilst keeping in mind the slowing down of growth in China.
Our Currencies section highlights how the crisis has actually provided significant opportunities for investors willing to ride out the volatility, particularly on pairs of currencies on opposite ends of the risk appetite spectrum and exposure to the Eurozone.
Fixed Income: Sovereign
The Spanish bond auction on the 17th of September projects a negative outlook on the economy and will be worrying for Spain and the ECB. It paid out close to 7% for its bonds that will fall due in 2022 with a very low cover ratio of 1.015. This compares to its auction in October where it issued bonds at 5.43% yield with a much higher cover ratio of 1.76. Their 10-year bonds now traded recently at a new high of 6.49% on the back of worry over Italian contagion. It will be left to seen what the new government, most likely the Mariano Rajoy’s Popular Party, can bring in in terms of austerity measures and confidence in Spanish markets.
One of the main factors in Italy is its ability to roll over its debt, of which €300bn worth is to be repaid over the next year. To do this at levels over 7% would be to cripple Italy and is completely unsustainable. Hans Redeker from Morgan Stanley said the ECB, be it themselves or through the EFSF, must cap Italian yields at 6.5% by starting a policy of buying debt to keep it at a sustainable level, allowing Italy to roll its debt over successfully. It is rumoured that the ECB has started to do this since the 17th of November. This should allow time for Monti’s technocratic government to get the necessary reforms through government and put the country’s finances in order. Italy managed to sell €3bn worth of five-year bonds at a yield of 6.29%, up from 5.32% last month, with a cover of 1.47. David Schnautz of Commerzbank notes that while this is encouraging it can only be done for a limited amount of time.
One situation that is very possible, and as seen by CDS contracts inevitable, is the default of Greece and their withdrawal from the Euro. With the recent haircut of Greek debt this would not be as bad as it would have been a number of months ago but would still be a huge blow to the Eurozone. It would be worse for the Greek people as it would see the inevitable collapse of their banking sector and economy in addition to being locked out of the markets for years. The lack of public acceptance for austerity measures and the slow reactions of their government could be a crippling factor to get back on their feet. Without swift fully accepted reforms, which is very unlikely, the country is sure to be looking at some level of (further) default on their debt in the near future.
It is our opinion that it is not Spain that people should be looking at from a contagion point of view, it is France. France and its banks are hugely exposed to debt from both Greece and Italy. BNP Paribas has €27.1 billion exposure to Greece and Italy with a market capitalization of €33.68 billion with France’s other banks also holding large amounts of debt, this poses a huge threat to France’s banking system. France alone holds roughly €54bn worth of Greek debt (16% of total) and €365 billion (20% of total) of Italian debt. They have also faced increased borrowing costs with yields on their €3.3 billion July 2016 bonds at 2.82% in comparison to 2.31% at its last auction. This is in addition to their spread on 10-year debt reaching a historical high of 2% over Bunds on secondary markets.
EUROPEAN FINANCIAL STABILITY FUND (EFSF)
EFSF cannot be taken alone as a solution to the crisis as it could lead to loose financial policy by the countries it is effectively funding. Tight fiscal policies must be introduced and more importantly accepted by a countries population. Without the acceptance of reforms, countries such as Italy and Greece will be hard pressed to build their economies up and to begin borrowing from the market at economically sustainable rates. In our opinion it is this acceptance of reform that will be the leading catalyst in economic reform. It can be seen in Ireland where austerity measures, while argued against, were largely accepted by the general public. Its 10-year bonds are now trading around the 8% mark in comparison to 14% last July. While the country is a long way from recovery it is on the right track. Compare this to Greece where the vast majority of reforms that the government have tried to bring in are met with protests, strikes and with public refusal to accept certain measures. Their bonds now trade near 30% while the cost of Credit Default Swaps on their debt is predicting certain default.
As a last ditch effort the ECB could act as a lender of last resort by guaranteeing new bonds auctions beyond a certain point to keep rates at sustainable levels. From the high levels of uncertainty and the self-fulfilling prophecy element of a Euro collapse this policy could be exactly what the Euro needs. For the ECB to step in and guarantee that new issue bonds yields will not go above a certain level could be the assurance investors need to restore their confidence in the Euro. In reality the ECB may not have to buy any bonds; the threat alone, like that of the SNB with its statement it will keep the EURCHF above 1.20, may be enough to inspire confidence. Obviously it is not as simple as this and moral hazard has to be taken into account when introducing something like this with Article 123 of the Treaty on the Functioning of the EU preventing the ECB doing something as direct as this. Additionally, this policy of printing money and buying bonds, effectively quantitative easing, could have implications on the value of the Euro and cause higher inflation (as further examined below). Although this is contrary to one of the founding principles of the Euro it could be least of all evils that the Euro now faces. Better to have higher inflation which can be brought under control in time then to have no currency at all.
On a side note it would be interesting to see the ECB balance sheet so far and what debt it holds. By buying bonds at such high yields which have no retracted, such as Ireland and Portugal, it looks to have made a gain on its investments. If they should manage to contain the crisis and reduce yields across the PIIGS it could stand to make a large profit from its holdings of this debt.
Fixed Income: corporate
Corporate debt in America is showing strength and companies are using growing confidence in the economy to bolster their levels of debt. Investment grade companies alone issued $25 billion worth of debt in last week alone (13th-20th November), with junk bonds selling over $4 billion, for a total of $20 billion this month. This is a large step up from October in which it sold only $9 billion.
Fixed Income: Municipal
The $2.9 trillion municipal bond market has seen a recent influx in capital as the European Crisis continues as investors look for safe havens. In the past they have seen to been good investments from their tax status, the ability of their issuers to raise capital through tax and the ability of them to raise these taxes. Now however this ability to raise taxes is in danger as they find it harder to push through higher tax reforms. Combining this with other factors has led to the ratings agencies downgrading many bonds, some of which are super-downgrades of ratings cuts of three notches or more.
As of the 21st of November investors are now able to access free ratings on municipal bonds through the Electronic Municipal Market Access, which posts S&P and Fitch ratings giving investors more information. Moody’s is yet to reveal if it will partake in the scheme.
Fixed Income: Emerging Markets
Growth is unlikely to been seen in the developed markets for the foreseeable future and as a result we could see the emergence of stable emerging markets become a new safe haven for investors. Emerging markets, unlike their northern counterparts, have kept their economies growing while maintaining a better balanced budget than many developed countries. While northern safe havens such as Germany, the UK and the US yield little to investors, emerging markets, such as Brazil, are showing good growth (and future growth projections), high yield returns and consistent upgrades in their ratings. These factors lead to good investment and return opportunities for investors looking to diversify their risk and increase return.
Fixed Income: Mortgage Bonds
Yields on mortgage bonds, ranging from one year ARM Jumbos to 30-year fixed, have seen consistent decline over the last year and currently range from 2.76% to 4.68% in comparison to 3.08% to 5.24% last year. Additionally, there has been an increase in U.S. home sales of 5.7% this September due to falling house prices and the effect of lower mortgage rates. However, total sales are still 0.9% lower than last year.
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