2013 was a great year for the eurozone periphery. Irish government bonds returned +11.9%, Spain +11.1%, Portugal +9.7%, Italy +7.3%, and Greece delivered a whopping +57.1%. This was despite the financial crisis in Cyprus, uncertainty surrounding the stability of the Italian government as well as German government bonds returning -2.3% over which the periphery trades as a spread.
What a difference words make. Almost two years ago the Portuguese 10 year government benchmark bond closed at a yield of 16.4%. Last week it dipped briefly below 5%, trading at 4.93%, its lowest since August 2010. Five year Irish government paper now trades inside five year UK paper, touching a yield low of 1.62%, down from over 17% in 2011. Amongst the euphoria Spain managed to issue €10bn of bonds last Wednesday covering a fifth of its net funding requirement for 2014. The deal book was four times oversubscribed resulting in the largest ever eurozone syndicated government deal.
Holders of un-hedged peripheral debt could be in for a nasty sting.
The turning point for the periphery was the infamous “Bumblebee” speech given by ECB president Mario Draghi in July 2012, comparing the eurozone to a “Bumblebee” which is a mystery of nature because it shouldn’t fly but it does. Structural reforms would lead the “Bumblebee” to graduate into a real bee. After the lecture in apiculture he delivered the killer line – that the ECB will do ‘whatever it takes’ to preserve the Euro.This was followed up with the introduction of Outright Monetary Transactions (OMTs) which, combined with forward rate guidance, have added to the verbal commitments from the ECB and enabled eurozone countries to fund themselves at increasingly favourable rates.
Improvement
But the recovery is now based upon more than just words. The funding improvement has moved hand in hand with an improvement in underlying economic conditions. Since last July the periphery economies have continued to improve. The Eurozone Manufacturing Purchasing Manager Index (PMI) just came in at 54, back in expansionary territory, which is above 50, having been below 35 in 2009. The Services PMI lags at 51.9 but is still trending upward. Spanish GDP has turned a corner, returning to growth in Q3. Structural reforms have taken place freeing up labour markets & deficits are starting to come down.
Even the ratings agencies are turning more bullish. A new regulatory framework aimed at increasing transparency means that the ratings agencies now publish their sovereign reviews on Fridays as per a predefined calendar. 2014 highlights so far have included Moody’s upgrade of Ireland returning it to investment grade with all three major indices and Portugal being removed from Credit Watch negative by S&P.
So where does this all leave us?
Obviously the steady improvement in the eurozone has been positive for credit and the hunt for yield has pushed spreads for the region as a whole to the point where we feel much of the premium has been removed. However we believe that the opportunities now lie more in single name and sector selection as companies use the opportunity to improve their balance sheets. The improvement in the periphery has distracted many from the difficulties that the core still faces - notably France where PMIs are improving but still remain below 50. Additionally, as the peripheral spreads return to a normalised environment, so will their sensitivity to interest rates.
Last year’s sell-off in interest rates was mostly focussed on the UK and US where the economies have continued to show strong signs of recovery with EUR rates lagging the sell-off. This will not always be the case as EUR rates should normalise with those in the US and UK.
Holders of un-hedged peripheral debt could be in for a nasty sting.
