Europe – It’s The Final Countdown

There were echoes of August 2008 for a few hours last week.  The yield spread on 10 year Spanish, Belgian and Italian government bonds over German government bonds spiked to a euro era record, while the cost of insuring Portuguese and Irish government bonds against default also hit a record high.  Greece has already become a zombie sovereign, and is being kept alive with a cash drip from the EU and IMF.  The Irish have been forced to bring out the begging bowl after markets decided its banks’ debts were too big for the sovereign to stand behind.  Portugal is wobbling.  It’s debatable whether a collapse in these countries is systemic (I believe it probably is) but there is little doubt that if Spain ends up in a position where it requires a bailout, then things could get very, very nasty for financial markets.  Spain’s economy is more than twice the size of Ireland, Greece and Portugal combined.  And if the evidence of the past few weeks is anything to go by, then Italy et al would be in the queue right behind Spain.  The prospect of Europe needing a bailout en masse doesn’t bear thinking about, which unfortunately seems to be the approach that the authorities are taking at the moment.

What are the solutions to this unfolding disaster?  Many have argued that the problem lies with the single currency, which I agree with – the UK had a severe banking crisis, yet thanks largely to sterling depreciating almost 15% on a real trade weighted basis since the end of June 2007, the UK had a nominal growth rate of 5.9% in Q3 this year.  The Euro has depreciated by only 5% over the same period, which has been insufficient for the weaker Eurozone countries.  Some have argued, therefore, that the solution is the breaking up of the Euro, which I disagree with.  If the non-core countries attempted to leave the euro, it would likely result in a collapse of the banking sector within those countries as depositors flee to stronger currencies.  Some have argued Germany could leave the euro, which would result in a much more competitive euro.  However, I suspect that this would bring about the collapse in the German banking sector, since the banks’ liabilities (customer deposits) would be in the new strong Deutschemark, while a significant chunk of German banks’ assets (which includes peripheral sovereign debt) would be in the weaker euro.

The temporary solution that the ECB has engaged in has been half-hearted buying of Irish, Portuguese and Greek government debt.  When the policy is implemented with force, as was the case in May when the ECB purchased over €30bn of sovereign debt, the policy can be effective.  The stepping up of peripheral sovereign purchases has also helped the markets rally in the past few days. But the main problem with such a policy is that it introduces huge moral hazard – why should Spain engage in painful austerity if it knows full well that the ECB will always be buyer of last resort and it will never face a funding crisis?  This seems to be the German fear – indeed just this morning, Juergen Stark was quoted saying that states are responsible for their own debts and the ECB’s job is not to finance EU member states.  This approach makes the likelihood of fiscal union and a single European debt agency exceptionally unlikely. Similarly, increasing the size of the stability fund is unlikely to prove popular with core countries given that if this sovereign debt crisis turns out to be anything other than a liquidity crisis, then it’s going to be paid for by taxpayers in the core countries.  (We’ve also got concerns about the stability fund’s viability anyway – more on this in the next link.)  I can’t see any solution other than debt restructuring for banks and very likely a number of sovereigns in the long term, and that’s not going to be pain free to put it mildly.

So it’s with these gloomy thoughts in my head that I recorded a short video a week and a half ago, discussing the problems facing the peripheral sovereigns in Europe over the short to medium term (you’ll notice my arm’s in a sling, let’s just say it was a sporting injury).  Some details are no longer bang up to date, such as Ireland has since been given longer to repay its borrowings, but you’ll get the gist.  And I haven’t even gone into one of one the biggest long term problems facing Europe’s solvency – demographics (see a blog I wrote on this subject last year here).  As Europe sang, “will things ever be the same again?  It’s the final countdown”…..

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. mark dampier says:

    I think we can see a possible train wreck but what should investors do! Sell all financial bonds, sell all bonds, wait it it out in cash and look for the opportunity after the wreck? 

    Posted on: 07/12/10 | 12:00 am
  2. longodds says:

    Mike,

    Good summary but would have been so much better if you could have embedded Europe's ” It's the Final Countown” music into the video and raised and lowered the volume of the track at appropriate moments as you spoke.

    Posted on: 09/12/10 | 12:00 am
  3. Mike Riddell says:

    In most cases, I'd argue that the likelihood of restructuring in financials or sovereigns does not currently appear to be reflected in the price of assets.  Looking at sovereigns specifically, the recovery value in the event of any sovereign default can vary widely, with recent examples ranging from 30% recovery in Argentina in 2001 to 95% recovery in Moldova in 2002 and the Dominican Republic in 2005.  In terms of peripheral European sovereigns, long dated Greek bonds appear to be almost fully pricing in restructuring given that they're currently priced in the mid 50s (we recently bought some despite our Eurozone fears), however most of the lowest price Irish and Portuguese sovereign debt is generally trading in the 80s and there's still a lot of downside.  The majority of Italy's government bond issues are still trading above par.

    In terms of bank bonds, there is a huge disparity in terms of prices and yields given the very different structure of each issue.  Subordinated bank debt will likely see a much greater haircut than senior bank debt in the event of restructuring.  As an example, Anglo Irish recently tendered a Lower Tier 2 bond issue at a price of 20 and the unfortunate few who didn't take up the offer received 1 cent per 1000 euros.   We certainly don't envisage all banks being in a position where they are forced to restructure debt, but we are only buying bonds in the stronger, better capitalised banks (which being lower risk will tend to have lower yields).

    As for asset classes generally, much depends on the policy reaction.  If restructuring is suddenly forced upon governments and banks, history suggests we'd see a sudden 'flight to quality', which would mean a rally in the best quality AAA rated government bonds and defensive currencies (US dollar, Swiss Franc, Japanese Yen etc).  This would likely be accompanied by a sell-off in the riskier assets, such as commodities, equities, and higher yielding bonds.  If restructuring is orderly (ie the authorities for once pre-empt markets), then I'd expect this effect to be much less pronounced.  If the authorities attempt to inflate their way out of any sovereign crisis then you may see a very different reaction in the markets.  So the short but unsatisfactory answer is that it depends (for what it's worth, I have 'derisked' the portfolios that I manage in the past few weeks).

    Longodds – yes, entirely agree and in fact I tried to do as you suggest, but unfortunately it's not very economical getting copyright for monster rock songs!

    Posted on: 14/12/10 | 12:00 am
  4. John Roberts says:

    On the face of it the overall outlook for Bonds in 2011 is bleak.

    Interest rates are likely to rise which will impact the capital value of Corporate Bonds.  The sovereign debt crisis in Europe is unlikely to disappear.  IMA Cautious fund managers are taking profits on Bonds and shifting to Equities.  The banking crisis roles on ….

    The question is; should I stick or twist and how are you positioning your remaining Fixed Interest holdings?

    Posted on: 17/12/10 | 12:00 am

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