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Thursday, 14 December 2017

Peripheral vision

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There has been a palpable shift in the market mood as events in Europe have developed, with investors demonstrating a level of resilience and stoicism that implies they have become desensitised to negative news. This is reflected in the European sovereign bond market, where appetite for peripherals is on the rise.

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Market moves demonstrate a growing consensus that Europe is committed to solidarity. This logic is driving an increasing convergence between eurozone states in sovereign bond prices, as peripheral yields inch back towards the near risk-free rate implied by Bunds.

The logic of convergence is especially applicable at the short end of the curve, where political commitment to Europe appears to carry most weight, said Bill Northfield, head of SSA origination at Deutsche Bank. At the longer end of the curve there remains a more marked distinction between the credits of core versus peripheral Europe.

“Some of these valuations are understandable at the longer end of the curve,” he said.

For some, convergence is evidence of rationality returning to a market that has overreacted to concerns originating in Europe’s periphery. “Markets have placed an excessive price on risk,” said Zsolt Darvas, research fellow at Bruegel, a Brussels-based think-tank. “This has not been driven simply by fiscal fundamentals but by an irrational, speculative force.”

The interest of the investor community in peripheral paper has certainly been piqued. “The yield and roll-down characteristics in Italy and Spain remain very strong versus core European markets,” said Daniel Loughney, portfolio manager at AllianceBernstein – especially in longer-dated paper. “The long-term refinancing operation and Outright Monetary Transactions intervention has caused short-dated spreads to core markets to compress significantly.”

Recent years have seen – by European standards – a seismic shift in the architecture of Europe, giving structure to notions of solidarity.

Calming medicine

LTRO, designed to recapitalise banks, and OMT, the acquisition of sovereign bonds in the secondary markets, along with plans for a banking union, have all contributed to the current calm in the market. Assurances from ECB president Mario Draghi that the bank would do “whatever it takes” to support beleaguered European sovereigns have also soothed investor nerves.

Crucially, the global macroeconomic picture looks greatly improved in 2013, relative to 2012, notwithstanding fears from a bellicose North Korea. China’s economy looks healthier than some pessimistic predictions foretold, while the worst-case scenario from the US “fiscal cliff” was also mercifully avoided. These developments have provided the backdrop against which investors have felt encouraged to take more risk in the search for yield.

Meanwhile, some of the structural reforms already implemented in Europe, the reduction of current account imbalances and measures to increase competitiveness, are starting to bear fruit, said Cagdas Aksu, fixed-income strategist at Barclays.

“There is a major macroeconomic adjustment taking place in Europe right now,” said Peter Schaffrik, head of European rates strategy at RBC Capital Markets. Unit labour costs are falling across the eurozone periphery, while wages in Germany are rising. Current account deficits are falling, with Cyprus the only eurozone country with a large deficit, said Schaffrik. The current account deficit of France, one of the remaining big economies that still has one, is relatively small.

Healthy banks

The European banking sector is also looking considerably healthier. When Lehman Brothers collapsed it exposed frailties in banks not only in the peripheral countries but in Germany too. Now weak banks have been recapitalised and leverage ratios have started to come down, though they have further to fall, said Schaffrik. “The banking sector doesn’t look like it will contribute much to GDP, but at least it no longer looks like a liability,” he said.

The resulting confidence is fuelling convergence, said Schaffrik.

“What you are starting to see in Europe is the banking sector looking more like what existed in the US following TARP [Troubled Asset Relief Program],” he said. The majority of bank failures in the US came after TARP, when the major banks were healthy enough, and the system strong enough, for politicians to stand back and allow smaller institutions to fail.

Europe is now reaching a similar stage where confidence in the system is high enough to allow market failure, said Schaffrik, as evidenced by haircuts on deposits in Cyprus and the lesser reported bail-in for junior bondholders of Spanish banks.

“European governments are actively severing the ties between them and banks, indicating they will not be as deeply involved, which can be taken as a good sign that confidence in the strength of the system is returning,” said Schaffrik.

Ultimately, it should mean sovereign balance sheets start to improve and problems are contained within the banking institutions where they originated, and with their shareholders and creditors.

Increased market stability is also the result of the changing supply and demand dynamics of the market, said Cagdas Aksu, fixed-income strategist at Barclays. As the crisis goes on most of the flighty capital has been shaken out. The remainder is mainly domestic accounts which have to remain invested, and foreign investors with a high conviction, meaning less sensitivity to negative developments.

Conversely, some investors that were quick to shed their positions may now have re-entered the market. Markets have been trading in ranges, with intraday or intraweek volatility tending to be confined within them, encouraging investors to view those limits as opportunities to buy or sell.

This is especially true of international investors. Foreign investors held around 22% of Spanish bonds, for example. “In Spain and Italy in particular, if underweight investors miss the rally they underperform the index significantly, so there is an incentive to buy back in. The longer those countries remain stable the more people might be tempted to buy the paper for yield grab,” said Aksu.

Cautious mood

Yet these corridors themselves change over time, and the distinction between the periphery and the core is evolving. “Clearly the yield advantage of [Italian and Spanish] bonds has diminished relative to last summer, but the volatility has also diminished,” said Loughney. “With lower volatility, the ECB as a backstop and still high-yield differentials, it could be argued that the environment is more supportive of a less conservative stance on the part of institutional investors.”

However, investors are still in a cautious mood, even if their thirst for yield has seen them increase their appetite for risk. “Spain and Italy still have very challenging fundamentals,” said Loughney, particularly their growth potential vis-a-vis debt payments. “We believe that this, coupled with the political uncertainty, against the background of strong relative performance versus the core over the past half year or so, should still merit a cautious investing approach.”

Neither is this calculation confined to the peripherals. For some it is increasingly difficult to draw the line between those on the wrong side of the line – Spain, Italy and Greece for example – and the weaker core economies such as France. For some it may not make sense to shun the former while paying up for the latter. As with the peripherals, France faces a lack of growth and considerable structural challenges that a growing number of presidents have tried to tackle, so far in vain. As investors become more adept at distinguishing between peripherals like Spain and Italy, they also differentiate more between core countries.

“Clearly the yield advantage of [Italian and Spanish] bonds has diminished relative to last summer, but the volatility has also diminished”

Global markets are maturing. In the late 90s, the South-East Asian crisis saw investor contagion spread without regard for underlying country-specific economic realities, said Northfield. A few years later, the Argentine default had little direct impact on Brazil and Mexico as investors learnt to distinguish between individual countries in a region. This trend appears to be present in Europe as well, he said. Investors are looking through notions of a pan-European crisis and doing credit work on individual countries, and making investment decisions based on their analyses.

German yields are probably too low but strength is being maintained by demand triggered from global central bank liquidity, in particular, while investors with optimistic views on riskier assets are careful to hedge their positions with Bunds and other core bonds, said Aksu. “The situation is not great in Spain and Italy but people on the whole seem happy to buy long-term growth prospects in the expectation that things will improve at some stage in the future, as long as this is hedged with core paper,” he said.

“The first target is for peripheral yields to get to 4.5% but from there they should edge down further to around 4%. That could come by the end of the year as long as there are no external shocks to change the market dynamic,” said Aksu.

Cyprus heralds new chapter in eurozone crisis

Authorities are keen to stress the differences between the situation in Cyprus and events elsewhere in Europe. European intransigence in Cyprus is largely due to problems with money laundering, while the limited size of the problem, in the broader eurozone context, makes it possible to take a stand to reassert the principles of moral hazard.

But even in Cyprus there is a recognition that all actions set a precedent. While the language used in relation to Cyprus has been stronger than anything experienced in Rome or Madrid, it would be difficult to let Cyprus leave the union, which would surely exacerbate contagion in other weak peripherals. This presents a tightrope for the Germans and other austerity advocates, which must keep Cyprus engaged with Europe, while not being seen by their own electorates as over-generous in supporting not only feckless and extravagant peripheral governments, but in this instance tolerance of criminality as well.

“Cyprus is a game changer, Europe is rewriting the rules,” said one SSA banker. Ireland and Portugal have asked for extensions and have not had an answer yet, but events in Cyprus will have implications on other peripherals. And while core Europe demands ever greater levels of austerity, taxable revenue is falling. At some point this could lead to a fundamental rethink of the whole crisis strategy, with unknown consequences for the periphery.

“Cyprus is a game changer, Europe is rewriting the rules”

During the Cypriot crisis and during the bank closures there was a market reaction, with 10-year Bund yields at 1.35%. Moves in the equity markets contributed to the view that investors expected a solution, but were buying protection for themselves in the bond market.

“The market seems to be long equity and long Spanish and Italian debt, but with many hedging themselves with 10-year Bunds or long-dated swaps,” said Barclays’ Aksu. “The logic is you benefit from the upside from riskier assets but if something blows up along the way you have some protection, and the correction is not likely to be huge anyway.”

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