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The Great Compression of peripheral to core European risk premiums

Are investors still compensated adequately for investing in peripheral rather than core European debt, or has the on-going convergence eroded debt valuation differentials altogether? In his latest blog entry, James highlighted five signs indicating that the bond markets consider the Eurozone crisis resolved. Inter alia, James pointed out that risk premiums for peripheral vs. core European high yield credit had essentially disappeared over the past two years. Here I would like to extend the periphery/core comparison by taking a look at investment grade (IG) credit and sovereign debt.

First, let’s have a look at the spread evolution of peripheral and core European non-financial (i.e., industrials and utilities) IG indices over the past 10 years. In addition to the absolute asset swap (ASW) spread levels, we plotted the relative spread differentials between peripheral and core credit. The past ten years can be divided into three distinct phases. In the first phase, peripheral and core credit were trading closely in line with each other; differentials did not exceed 50 bps. The Lehman collapse in September 2008 and subsequent market shocks lead to a steep increase in ASW spreads, but the strong correlation between peripheral and core credit remained intact. Only in the second phase, during the Eurozone crisis from late 2009 onwards, spreads decoupled with core spreads staying relatively flat while peripheral spreads increased drastically. Towards the end of this divergence period, spread differentials peaked at more than 280 bps. ECB President Draghi’s much-cited “whatever it takes” speech in July 2012 rang in the third and still on-going phase, i.e., spread convergence.

As at the end of March 2014, peripheral vs. core spread differentials for non-financial IG credit had come back down to only 18 bps, a value last seen four years ago. The potential for further spread convergence, and hence relative outperformance of peripheral vs. core IG credit going forward, appears rather limited. Within the data set covering the past 10 years, the current yield differential is in very good agreement with the median value of 17 bps. Over a 5-year time horizon, the current differential looks already very tight, falling into the first quartile (18th percentile).

Peripheral vs. core European non-financial IG credit

Moving on from IG credit to sovereign debt, we took a look at the development of peripheral and core European government bond yields over the past 10 years. As a proxy we used monthly generic 10 year yields for the largest economies in the periphery and the core (Italy and Germany, respectively). Again three phases are visible in the chart, but the transition from strong correlation to divergence occurred earlier, i.e., already in the wake of the Lehman collapse. At this point in time, due to their “safe haven” status German government bond yields declined faster than Italian yields. Both yields then trended downwards until the Eurozone crisis gained momentum, causing German yields to further decrease, whereas Italian yields peaked. Once again, Draghi’s publicly announced commitment to the Euro marked the turning point towards on-going core/periphery convergence.

Italian vs. German government bonds

Currently investors can earn an additional c. 170 bps when investing in 10 year Italian instead of 10 year German government bonds. This seems to be a decent yield pick-up, particularly when you compare it with the more than humble 18 bps of core/periphery IG spread differential mentioned above. As yield differentials have declined substantially from values beyond 450 bps over the past two years, the obvious question for bond investors at this point in time is: How low can you go? Well, the answer mainly depends on what the bond markets consider to be the appropriate reference period. If markets actually believe that the Eurozone crisis has been resolved once and for all, not much imagination is needed to expect yield differentials to disappear entirely, just like in the first phase in the chart above. When looking at the past 10 years as a reference period, there seems to be indeed some headroom left for further convergence as the current yield differential ranks high within the third quartile (69th percentile). However, if bond markets consider future flare-ups of Eurozone turbulences a realistic scenario, the past 5 years would probably provide a more suitable reference period. In this case, the current spread differential appears less generous, falling into the second quartile (39th percentile). The latter reading does not seem to reflect the prevailing market sentiment, though, as indicated by unabated yield convergence over the past months.

In summary, a large portion of peripheral to core European risk premiums have already been reaped, making current valuations of peripheral debt distinctly less attractive than two years ago. Compared to IG credit spreads, there seems to be more value in government bond yields, both in terms of current core/periphery differentials and regarding the potential for future relative outperformance of peripheral vs. core debt due to progressive convergence. But, of course, on-going convergence would require bond markets to keep believing that the Eurozone crisis is indeed ancient history.

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5 Signs That the Bond Markets (rightly or wrongly) think the Eurozone Crisis is Over

Regardless of your opinion on the merit of the ECB’s policy, there is little doubt that the efficacy of Mario Draghi’s various statements and comments over the past 2 years has been radical.  Indeed there are several signs in the bond markets that investors believe  the crisis is over. Here are some examples:

1)      Spanish 10 yr yields have fallen to 3.2%, this is lower than at any time since 2006, well before the crisis hit, having peaked at around 6.9% in 2012. This is an impressive recovery, almost as impressive as …

Spanish 10 Year Government Bond Yields

2)      The fall in Italian 10 year bond yields, which have hit new 10 year lows of 3.15%, lower than any time since 2000. The peak was 7.1% in December 2011. To put this in context, US 10 year yields were at 3% as recently as January this year.

Italian 10 Year Government Bond Yields

3)      Last month, Bank of Ireland issued €750m of covered bonds (bonds backed by a collateral pool of mortgages), maturing in 2019 with a coupon of 1.75%. These bonds now trade above par, with a yield to maturity of 1.5%. The market is not pricing in any material risk premium relating to the Irish housing market.

4)      There is no longer any risk premium within the high yield market for peripheral European risk. The chart below (published by Bank of America Merrill Lynch) shows that investors in non-investment grade corporates no longer discriminates between “core” and “peripheral” credits when it comes to credit spreads.

Core vs. peripheral high yield bond spreads

5)      Probably the biggest sign of all, is that today Greece is re-entering the international bonds markets. The country is expected to issue €3bn 5 year notes with a yield to maturity of 4.95%.

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Equity multiple expansion to the rescue. A benefit to high yield ?

The high yield market rightly pays a good deal of attention to leverage trends (the relationship between debt and earnings). The larger the quantum of debt a business carries relative to its earnings, the greater the risk. Other metrics are arguably as important, though it is the leverage metric that consistently garners the lion’s share of attention. With spreads near the post Lehman tights, it is unquestionably concerning to see a trend of rising leverage as earnings plateau and companies generally take on more debt.

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The very same central bank policies that have kept bond yields low and encouraged high yield companies to take on more debt have also helped to support higher equity prices. As money has flooded into the asset class, the market has not surprisingly re-rated upwards. What this has meant for high yield investors is that one measure of the ‘margin of safety’, or an equity cushion has, at least temporarily, been increased. The chart below shows the implied equity cushion by subtracting the average level of US high yield leverage from the S&P Mid Cap trailing 12 month enterprise multiple. The higher the implied cushion the better. So for example with stock markets at the lows in early 2009, the implied equity cushion fell to a mere two turns, but has since recovered to a far more healthy and above average six.

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Many will no doubt point out that an implied cushion is exactly that- implied. And the argument is clearly a pro- cyclical one that relies on an imperfect comparison. We’d concur with that and emphasise the fact that there can be no substitute for thorough credit analysis. We will always prefer to invest in appropriate financial leverage, strong interest coverage and free cash flow generation over equity implied multiples. The former gives a business flexibility and exposes it less to market vagaries.

Yet there is no getting away from the fact that central bank policy has, and can still yet, come to the rescue of even some of most levered high yield companies. In hindsight, few of us would have predicted the surprisingly low level of defaults we’ve witnessed through this cycle. And whilst IPOs of high yield companies has been a fairly rare thing over the last few years, higher equity multiples, an on-going return of animal spirits and a desire/need to put money to work may yet alter that trend.

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20/20 hindsight – looking at three year government bond market returns

Investors in government bonds – historically seen as a low volatile and safe asset class – have had to get to grips with assessing credit risk as well as duration risk in their portfolios. It is simply no longer the case that investors can safely lend to a government without first assessing the government’s willingness and ability to pay back the borrowed sum. This has had a large impact on government bond market returns over the past three years, the results of which are shown below.

Given the fall in yields in developed bond markets, it is unsurprising to see long duration assets like UK index-linked gilts and government bonds performing very well. For example, a broad based measure of the UK index-linked market has generated a 40% total return for investors since the end of March 2010. This is despite the UK losing its prized AAA credit rating this year. Even more surprising is the fact that the big buyer in the gilt market – the Bank of England – has not spent a single penny on a UK index-linked gilt. To date, all £332bn of government bond purchases have been in the gilt market. One investor that did buy index-linked gilts was the Bank’s £3bn pension fund, which had a 95% allocation to index-linked gilts and corporates as at February 2012.

3 year total returns in government bond markets

Looking elsewhere, those that were willing to take some credit risk were handsomely rewarded in European government bond markets. For example, investors in Irish debt generated a return of 25% over the past three years. This compares favourably to Europe’s true “risk-free” asset, German government bunds, which generated a total return of 19%. That said, it was not all smooth sailing for peripheral bond investors. Just ask investors in Greek debt, who suffered a 40% loss. Investors in Cypriot government debt fared somewhat better, losing 6% over the three years. Unfortunately for investors seeking protection from Italian inflation, Italian index-linked government bonds generated a return of only 6%. This was below the increase in Italian inflation of 9% over the three year period and is the result of investors becoming more pessimistic about the Italian growth outlook.

Overall, the gold medal for government bond 3 year returns goes to the Philippines with equity-like performance of 64%. The bond market has benefited from purchases by foreign investors, largely due to its relatively strong fundamentals. The combination of a relatively high yield, strong growth and low inflation has been a magnet for government bond investors.

This analysis isn’t much of a guide for what is going to happen over the next three years. Going back to March 2010, I can’t remember many forecasting that Ireland would outperform Germany in government bond markets or that UK linkers would outperform their Italian equivalents by over 30% . So should we be worried about what the consensus is saying now? Isn’t 20/20 hindsight a wonderful thing.

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The Real Income Enigma

“The question isn’t at what age I want to retire, it’s at what income.”

George Foreman

The carry trade, the grab for yield – call it what you will, but this has been a persistent fact of life in today’s investment climate, especially as larger cohorts of the developed world join the ranks of the retired. As Mr Foreman points out above, the financial aspect of retirement isn’t really dominated by how much capital you might have, but how much income can be generated from your savings and various entitlements. Furthermore, safeguarding this income from the rapacious grasp of inflation is crucial. Real income is the goal.

While there is plenty of demand for real income, the supply of assets that can provide this is now dwindling. The chart below is a very simple one (and arguably too simplistic), but it paints a stark picture for income hungry investors. On the left hand side is the nominal income yield from various asset classes (dividend yield in the case of equities, yield to maturity for fixed income). The right hand side merely takes away the last inflation number to give you a snapshot of real income yields. This does not take into account the possibility of earnings and dividend growth from the equity markets (an important aspect) or indeed any changes in the inflation rate. For any income orientated investor, this essentially gives you the menu of options for generating inflation beating income in the here and now.

Comparing real yields across asset classes

One thing that should come as no surprise is that cash and government bonds offer negative real returns on a buy and hold basis, but what is less obvious perhaps is that the number of asset classes that offer a positive real return has shrunk dramatically. Indeed, only high yield bonds offer a significant pick up above and beyond the inflation rate. (This pick up is there in part to compensate investors for the risk of default, volatility and lack of liquidity). Whilst we do not expect dramatic capital gains from high yield in the near future, absent a major negative shock for risk appetite, this context provides very powerful structural and technical support for the asset class. Investors, particularly those seeking income, ignore this at their peril.

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Middle East research trip – a rare oasis of attractive bond valuations

My last research trip video to Asia was deemed by our marketing department to be so bad that we all had to be sat down and told what would be common sense to most people; apparently it’s not a great idea to speak to camera next to a busy airport runway, and you can’t see anything if you record yourself in your hotel room at night with the main lights off. So hopefully this effort is a slight improvement, although I still couldn’t resist a quick stint at Abu Dhabi International Airport, and the majority of it is filmed outside a shisha cafe in London.

You can view the video below.


The trip if anything strengthened my belief that parts of the Middle East debt market look very attractive relative to some of the massively overvalued emerging markets.

Abu Dhabi is said to be the Switzerland of the Middle East, and this appears to me to be largely justified. Abu Dhabi’s sovereign wealth fund is over US$600bn, which works out at almost US$100k per person. The big difference with Switzerland is in valuations. Many Swiss government bonds were until recently trading with a negative yield (meaning that investors were paying money to Switzerland for the privilege of parking their cash there), while the bonds of some AA rated Abu Dhabi state owned enterprises have higher yields than some junk rated EM sovereigns. The rating agencies’ assessment of the Abu Dhabi issuers looks broadly correct to us, so the valuations vis-à-vis EM sovereigns looks completely wrong.

Dubai remains a little worrying. It seems to see itself as Disneyland for adults; while I was out there reports surfaced of Dubai building its first underwater hotel, and yesterday plans were announced to build the world’s largest ferris wheel. Personally I don’t really get the attraction – it is a bit like going on holiday to Westfield Shopping Centre, not exactly my idea of a holiday – although there are many who disagree since apparently more people went to Dubai Mall last year than visited New York or Los Angeles.

Qatar perhaps sits somewhere in between. It is blessed with huge natural resources, but I’m still bothered on many levels why they bid for (and successfully won) the right to host the 2022 FIFA World Cup. The cost of hosting the FIFA World Cup is relatively trivial for Qatar; more concerning is that they are channelling quite a bit of money into economically and politically wobbly countries such as Egypt, and there are reports today that the Qatar sovereign wealth fund may invest $3.5bn in Russian bank VTB. Why?

I didn’t have a chance to visit Saudi Arabia or Bahrain, but some of the Emirati and Qatari banks provided interesting colour, suggesting they are concerned about investing or lending in Saudi Arabia given current valuations, and the ongoing unrest in Bahrain means that the country’s previous role as a regional hub has almost certainly been irreversibly ruined. In contrast to Bahrain, political unrest in Abu Dhabi, Dubai or Qatar is exceptionally unlikely given that the wealth effects of the economic boom have been widely distributed to the local population, and lower paid workers are on the whole migrant workers and are there voluntarily – if they don’t like it, they can leave.

PS I refer to avocado bathroom suites at the end of the video, but forgot to give Jim the credit for this point. See Jim’s blog from last year here.

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High yield – it’s pickin’ time

It’s fair to say that we have been toning down our view on the high yield market of late. We could well see returns in the high single digits for 2013, but the potential for more substantial capital gains is less apparent in today’s context.

This does, however, ignore quite a powerful feature of the current high yield environment – the scope for exploiting opportunities and pricing dislocations within the market itself. To use a more technical term, spread dispersion within the market is very elevated. What do we mean by this?

Here is a snapshot of the European high yield market back in 2007 with credit rating plotted against credit spread. As credit risk increased, you got paid incrementally more credit risk premium. This produced a gentle upward sloping curve. The market was fairly efficient and the level of spread dispersion within a credit rating category was fairly limited.

European high yield spreads June 2007

Compare this to a snapshot of today’s market below: not only is the average risk premium significantly higher than in 2007, but more importantly, there is a much higher range of spreads within each rating category.

European high yield spreads January 2013

How can this obvious dislocation be exploited? If you can correctly assess credit risk independent of the ratings agencies, then you can start to pick and chose the bonds that are mispriced. Furthermore the reward for getting this “stock selection” correct can be meaningful. If for example you purchase Bond X at a credit spread of 750bps and sell Bond Y at 250bps, this is a 500bps difference. Let’s say that this difference moves to zero over time with both Bond X and Bond Y converging to a credit spread of 500bps, with a duration of 5 years. This is a relative price performance of 25% (a capital gain of 12.5% for Bond X, and avoiding a 12.5% capital loss for Bond Y).

If an active manager can realise even a small element of these sorts of opportunities across a portfolio, then the additional returns can be meaningful. It’s (stock) pickin’ time.

It's Pickin' Time

 

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The chart annoying every Aussie consumer

In 2012, the Reserve Bank of Australia cut its cash rate five times and by a total of 1.25%. That is a big move in interest rates for an economy growing at 3.1%, an unemployment rate of 5.4% and inflation sitting bang-on target at 2.0%. The RBA cash rate is now equal to the 50-year low seen during the 2009 recession. So what has got the RBA so nervous?

One word: consumption. Around 54% of Australian GDP is household consumption. But the household saving rate, at 10.6%, is more than double the average of the past decade. Aussies are deleveraging. Consumption, for so long the driver of growth in the boom years, has stumbled.

And unfortunately for the RBA, the latest GDP statistics showed limited sign of investment outside the mining sector. Certainly the appreciation of the Australian Dollar – once known as the “Aussie Battler” or “Pacific Peso” – has not helped things. On a trade-weighted basis, the Australian Dollar has risen by 45% since January 2009, leading to calls from industry for the RBA to intervene in currency markets. The strong dollar is a huge headwind for the Australian manufacturing sector in an increasingly globalised world. The RBA is hoping that a reduction in interest rates will a) spur household consumption and b) have some impact on the strength of the currency.

On the currency front, the RBA rate cuts have had minimal impact. The trade weighted index rose over the course of 2012 by 1.7%. Ouch. On the consumption front, unfortunately for the RBA and the heavily indebted Aussie consumer, the banks haven’t been playing ball. The chart below highlights the spread differential between variable mortgages, variable term loans, and the standard credit card rate over the RBA’s cash rate.

The chart scaring every Aussie consumer

Despite a record low cash rate of only 3.0%, the spread between the rate charged on personal loans and credit cards is at a record highs. Banks aren’t passing on the full cuts in the official rate. In the variable home loan space, the spread has been steadily rising since October 2007. It is particularly important to have a look at the variable mortgage rate as around 80% of home loans in Australia are variable rate mortgages. Overall, the chart shows that the transmission mechanism of monetary policy in Australia is becoming increasingly muted, presenting greater challenges for the RBA.

Central banking isn’t the easiest job in the world at the best of times. Due to high rates of indebtedness and home ownership, the RBA has previously found that moving interest rates could quickly stimulate the economy if needed. The last thing that central bankers need is a further handicap on their ability to deliver their inflation targets. But that is exactly what is going on in Australia right now and the RBA should be concerned.

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Le cocktail économique explosif français : croissance en berne, manque de compétitivité et tour de vis budgétaire.

This post was originally published on 5.10.2012 in English and has been translated for our French readers.

Depuis le début de l’année 2011, la croissance économique de la France s’est révélée extrêmement décevante, en passant d’un rythme annuel de près de 2,5 % à tout juste 0,3 % au second trimestre 2012. Certes tous les pays de la zone euro ont été à la peine durant cette même période, mais la croissance française s’est néanmoins laissée distancée par celle des états du cœur de l’Europe. En Allemagne, la croissance du PIB est ressortie au minimum à 2 % pendant tous les trimestres (à l’exception des deux derniers) et s’établit aujourd’hui à 1 %. Les indices des directeurs d’achat pour le mois de septembre ont fait apparaître une divergence plus prononcée : les PMI des secteurs manufacturier et des services ont à nouveau reculé en France, tandis qu’ils ont progressé en Allemagne.


Evidemment, cela pourrait être pire – la Grèce, le Portugal, l’Espagne et l’Irlande ont enregistré une croissance économique bien plus faible et -élément peut-être le plus dommageable- des taux de chômage bien plus élevés. En Espagne, le taux de chômage s’est envolé de 8 % en 2007 à 25 % aujourd’hui, franchissan même la barre des  50 % chez les jeunes. En France, le taux de chômage global n’est  « que » de 10,3 %. Et l’autre grande différence est que les marchés obligataires pensent que la France fait partie du « noyau dur » de la zone euro, non de sa périphérie. A ce titre, examinons les CDS à 5 ans (le coût en points de base pour assurer une obligation souveraine contre le risque de défaut) ; celui de la France s’établit à 110 pb par an, contre 300 pb pour l’Irlande, 325 pb pour l’Italie et 370 pb pour l’Espagne. Pour autant, et même s’il reste toujours beaucoup plus important que le CDS de l’Allemagne (54 pb), l’écart entre les emprunts d’états allemands et français s’est toutefois sensiblement réduit depuis le mois de mai, de plus de 1,4 % à 0,75 %. Cette baisse témoigne en partie de l’atténuation perçue des risques de défaut/d’éclatement de la zone euro après l’annonce du président de la BCE, Mario Draghi, de son engagement à faire tout ce qui était nécessaire pour sauver l’euro et de son programme d’achat d’emprunts d’État à court terme émis par des pays en difficulté ; mais, cette amélioration relative coïncide également avec l’élection de François Hollande en mai qui est ainsi devenu le premier président français de gauche de ces 20 dernières années.


François Hollande a été élu sur un programme promettant d’augmenter la pression fiscale sur les riches. Il a également promis de limiter le déficit budgétaire de la France. Dans ce contexte, le projet de loi de finances pour 2013 présenté la semaine dernière n’a guère surpris les français en prévoyant des efforts de rigueur répartis comme suit : un tiers en impôts sur les ménages, un tiers en impôts sur les entreprises et un tiers de réduction des dépenses publiques. Selon les estimations de Goldman Sachs, le taux des prélèvements obligatoires en pourcentage du PIB augmentera de 44,9 % à 46,3 %. Mais, même ce tour de vis budgétaire relativement agressif (et les projections sont basées sur une croissance du PIB supérieure à un niveau jugé possible par beaucoup, surtout au regard de ce même durcissement budgétaire et du climat d’austérité) n’empêchera pas le ratio dette/PIB de franchir le seuil des 90 %. Pour rappel, ce seuil des 90 % est celui qui, selon Rogoff et Reinhart, compromet significativement la capacité d’une économie à croître. Toutefois, si la rigueur budgétaire « fonctionne », la France devrait alors renouer avec un budget équilibré d’ici 3 ou 4 ans.

Mais, revenons à la capacité de la France à combler son déficit budgétaire par la croissance. La compétitivité de l’économie française est un point qui continue de nous préoccuper. Le déficit de la balance des opérations courantes de la France est considérable, ressemblant ainsi plus à celui de l’Espagne ou de l’Italie qu’à celui de pays du coeur de l’Europe comme l’Allemagne ou les Pays-Bas (mais, il n’est pas aussi important que le déficit de 5,4 % du Royaume-Uni, la raison principale pour laquelle nous pensons que la livre sterling est extrêmement surévaluée).


Dans un modèle économique typique, un pays accusant un tel déficit de sa balance des opérations courantes dévaluerait sa devise afin d’aider ses sociétés exportatrices. Mais la monnaie unique de la zone euro ne le permettant pas, c’est donc une dévaluation interne qui doit plutôt se produire. Depuis la création de la monnaie unique, l’économie allemande a surperformé, principalement à la faveur de la vigueur de ses exportations. Ceci n’a pas été une coïncidence – après l’effondrement du mur de Berlin, les entreprises allemandes ont convenu avec les syndicats (une sorte de néo-corporatisme dans le cadre duquel le gouvernement, les sociétés et les salariés sont des partenaires sociaux au sein d’un système capitaliste) de limiter la croissance des salaires et ce faisant, d’empêcher la délocalisation de l’activité manufacturière en Orient où la main-d’œuvre est meilleur marché. Ainsi, au cours des 12 années écoulées depuis la création de la monnaie unique, le coût du travail en Allemagne a augmenté de moins de 25 %, contre 65 % en Grèce, 55 % en Espagne et 40 % en France. Par rapport à l’Allemagne, le coût du travail en France s’est donc renchéri de 15 % ou plus, une détérioration significative de la compétitivité du pays parmi les États du « noyau dur » de l’Europe.


Il est clair qu’une « dévaluation interne » intervient en Grèce et en Espagne où les coûts du travail connaissent une véritable chute (alors que le chômage s’envole). Je n’affirme pas qu’il s’agit là d’un élément positif – à moyen terme, cela va permettre de stimuler les exportations à mesure que les usines se délocalisent dans les régions où les coûts sont moins élevés ; mais, à plus court terme, le frein que cela aura sur la croissance espagnole et grecque pourrait bien s’avérer être le médicament qui tue le patient au lieu de le guérir. Mais si jamais il y a des capitaux à investir dans des usines, des équipements et des hommes en Europe, et si l’incertitude se fait moindre, prendront-ils le chemin de la France ou d’une Espagne restructurée et à plus bas coûts ?

Et une austérité budgétaire musclée et affirmée publiquement ne semble pas être une politique qui donne des résultats probants – à l’image du Royaume-Uni où moins de 10 % des réductions de dépenses projetées par la coalition sont effectifs à ce jour ; pour autant, l’impact psychologique sur l’économie a été sévère et depuis le début de la crise du crédit l’économie britannique a sous-performé non seulement les États-Unis (où de bonnes vieilles mesures de relance keynésiennes ont été mises en œuvre), mais également la zone euro considérée par beaucoup comme une région économiquement dévastée qui, néanmoins, a surperformé le Royaume-Uni de près de 2 % du PIB sur la période (et qui dans son ensemble présente aussi un ratio dette/PIB inférieur).

Les perspectives de la France s’annoncent des plus difficiles sur le front budgétaire – générer de la croissance (ou faire défaut) a toujours été la meilleure recette pour réduire l’endettement public, et même un taux de croissance réel optimiste de 2 % par an (provisoirement fixé par le gouvernement à partir de 2014) n’est pas synonyme d’une réduction notable du ratio dette/PIB – nul doute que le niveau de 40 % à 50 % que nous avons l’habitude d’associer à une économie notée AAA ne semble pas être pour demain. Il se pourrait que la sensible contraction de l’écart entre les rendements des emprunts d’État de la France et de l’Allemagne (pays noté AAA pour le moment encore) se soit révélée excessive. Les risques économiques et sociaux potentiels futurs sont pléthores pour la France – n’oublions pas que le Premier ministre espagnol Mariano Rajoy a été élu sur un programme de consolidation budgétaire et qu’il a fallu moins d’un an avant que les Espagnols ne changent d’avis sur la question.

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The toxic French economic cocktail: weak growth, poor competitiveness, fiscal tightening.

Since the start of 2011 French economic growth has been extremely disappointing, falling from an annual rate of nearly 2.5% to just 0.3% in the second quarter of this year.  Of course the whole Eurozone has seen weakness over the period, but French growth has lagged that of the “core” over the period.  German GDP growth was at or above 2% for all but the last two quarters, and now stands at 1%.  Purchasing Managers’ surveys for September show more divergence, with more falls in French manufacturing and services, whilst the German surveys strengthened.

German growth has tended to be stronger than French growth over recent years

Of course, it could be worse – Greece, Portugal, Spain, and Ireland have experienced much weaker economic growth and, perhaps most damaging, higher rates of unemployment.  Spanish unemployment has risen from 8% in 2007 to 25% today, with youth unemployment over 50%.  The French jobless total stands at “just” 10.3%.  And the other big difference is that the bond markets believe that France is part of the core, not part of the periphery.  Looking at 5 year CDS rates (the cost in basis points to insure a sovereign bond against the risk of default), France trades at 110 bps per year, compared with Ireland at 300 bps, Italy at 325 bps and Spain at 370 bps.  And whilst this is still much wider than German CDS at 54 bps, since May the spread between German and French government bonds has narrowed significantly, from over 1.4% to 0.75%.  Part of this reflects the perceived reduction in general Eurozone default/breakup risks following ECB president Draghi’s assertion that he will do whatever it takes to save the Euro and his plan to buy short dated government bonds of nations in distress, but this relative improvement also coincides with the election of Francois Hollande in May, when he became the first leftwing French president in two decades.

French government bonds have outperformed German government bonds so far in 2012

Hollande was elected on a platform of putting up taxes on the rich.  He also pledged to cap France’s budget deficit.  As such last week’s Draft Budget Law (PLF) for 2013 did not surprise the French population – there will be a fiscal tightening made up a third from household taxes, a third from corporate tax rises and a third from spending cuts.  Goldman Sachs estimates that the tax take as a percentage of GDP will rise from 44.9% to 46.3%.  But even this relatively aggressive tightening of fiscal policy (and the projections are based on GDP growth higher than many believe is possible, especially in light of that same fiscal tightening and a climate of austerity) doesn’t prevent debt/GDP from rising above 90% in 2013.  Remember that 90% is the level that Rogoff and Reinhart say delivers significant damage to an economy’s ability to grow.  But if the fiscal austerity “works”, France should be moving towards a balanced budget within 3 or 4 years.

But back to the ability of France to grow its way out of a fiscal hole.   Competitiveness is something that continues to worry us about the economy.  The French current account is sharply in deficit, looking more like Spain or Italy than the “core” of Germany or the Netherlands (but not looking as bad as the UK’s current account deficit of 5.4%, the most important reason we think that the pound is massively overvalued).

France looks more like periphery than core on its current account deficit

In a typical economic model, a country with a current account deficit like this would devalue its currency to help its exporters.  The single currency zone of the Eurozone doesn’t allow this to happen, so instead an internal devaluation has to occur instead.  Since the creation of the single currency, the German economy has outperformed, with strength in exported goods leading that strength.  This was no accident – post the collapse of the Iron Curtain, German companies had come to agreements with trade unions (a kind of neo-corporatism in which the government, companies and workers are social partners in a capitalist framework) to have wage restraint and thus keep German manufacturing from heading east to the cheaper labour supply.  It meant that in the 12 years since the creation of the single currency, German labour costs rose by less than 25%.  In Greece they rose by 65%, Spain 55% – and in France by 40%.  Relative to Germany then, French labour costs had risen by 15% more, a significant deterioration of relative competitiveness within the core of Europe.

Spanish and Greek labour costs are adjusting, but France looks uncompetitive

It’s clear that the “internal devaluation” is occurring in Greece and Spain, with labour costs falling sharply (as unemployment rockets).  I’m not arguing this is positive – in the medium term it will stimulate exports as factories relocate in lower cost regions, but in the nearer term the drag this will have on Spanish and Greek growth could be medicine that kills its patient.  But if there is capital to invest in plant, equipment and people in Europe once, and if, uncertainty fades, would it go to France, or to lower cost, restructured Spain?

And aggressive, publically stated austerity doesn’t appear to be a policy with great results – look at the UK where we’ve done less than 10% of the spending cuts that the coalition have planned, yet the psychological impact on the economy has been severe, and since the credit crisis began the UK economy has underperformed not just the US (where they did some good old Keynesian fiscal stimulus) but also the Eurozone, which is widely regarded as an economic disaster area here despite it having outperformed us by about 2% of GDP over the period (and having a lower debt/GDP level too, if you took the region together as a whole).

So the challenges to the French fiscal outlook are enormous – delivering growth (or defaulting) has always been the most successful method of reducing government indebtedness, and even an optimistic 2% per year real growth rate (pencilled in by the government from 2014) doesn’t deliver a significant reduction in the debt to GDP ratio – certainly the 40% to 50% level that we used to associate with a AAA rated economy seems a long way away.  It may be that the aggressive tightening in French government bond yields to those of AAA rated (for the time being) Germany has gone far enough.  There are plenty of economic and social buy-in risks to come for France – let us not forget that Spain’s Rajoy was also elected on a platform of fiscal consolidation, and it took less than a year for its population to change its mind about that.

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