Thursday, 24 January 2019

Watching, waiting, worrying

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  • Watching, waiting, worrying

Yet another year of volatility and uncertainty is facing the eurozone’s embattled periphery. Sovereign debt issuance started with a bang this year, but concerns about contagion spreading from the Syriza political victory in Greece, and infecting the minds of voters in Spain come December’s general elections in Madrid, could spook global investors.

Every man has a breaking point, Captain Willard is told in the film Apocalypse Now. Every country too, it seems. When Greece’s populace turned out in force on January 25 to usher in a radical leftist party, Syriza, it was in direct if belated response to years of relentless, grinding austerity – and the threat of many more to come.

At first, the elections – the biggest political earthquake in Athens since the dismantling of the military junta in 1974 – did little to impact on the wider region. Markets were still focused on a €1.1trn (US$1.25trn) quantitative easing programme rolled out three days before by European Central Bank president Mario Draghi. Investors overwhelmingly endorsed the decision to install a €60bn per month bond-buying programme that will run at least until September 2016.

QE’s effect was instantaneous. Borrowing costs for peripheral eurozone states tumbled, with yields on 10-year Spanish bonds falling to 1.25%, and the single currency slipping to an 11-year low against the US dollar. Investors praised Draghi’s decision, and tipped bond issuance by eurozone states to remain robust.

Indeed, in the days following the roll-out of financial stimulus across the 19-nation bloc, it was hard to find any dissenting voices, and for good reason. Issuance by peripheral eurozone sovereigns had after all started the year with a crackle and a bang.

“We started 2015 firing on all cylinders,” said Philip Brown, head of public sector origination at Citigroup. “January is always a great month for SSA debt, but the first two weeks of the year were better than ever.”

Ireland printed €4bn worth of seven-year paper on January 7, returning in early February to raise a further €4bn from its maiden 30-year bond issue. Portugal tested demand for longer tenor debt in January, issuing a €5.5bn dual-tranche print of 10-year and 30-year bonds.

“We are experiencing a renewed grab for yield,” said Brown, who describes as “remarkable” the enthusiasm for the super-long Portuguese print. “A year ago we could not have anticipated such diversified demand for sub-investment grade 30-year peripheral eurozone paper.”

Demand for peripheral government debt held up well in the days before and after the Greek elections, but Syriza’s victory also had investors nervously consulting their diaries to identify new sources of risk.

In the poll’s aftermath, the immediate concern was that Syriza would use its leverage over a range of European issues, from Russian sanctions to the planned Transatlantic Trade and Investment Partnership, to secure a new haircut on the country’s debt, 80% of which is held by public-sector institutions. In early February premier Alexis Tsipras, who pledged to renegotiate the terms of the country’s bailout, met European leaders to gauge the interest in helping ease Greece’s debt burden.

When this report went to press, there was still no clarity over Greece’s future. Tsipras was still on his European tour, refusing to allow Athens to continue to labour under what he described as a “policy of subjection”, in hock to international creditors. German chancellor Angela Merkel was still stubbornly refusing to grant any new relief to the heavily indebted nation.

Investors sweated the uncertainties. In a flash note issued the day after the January 25 poll, Deutsche Bank highlighted the risk of a “quick and brutal” run on Greek lenders, and the lingering challenge of the national debt mountain, standing at 174% of GDP.

“Decisions made in Athens, rather than inflation or growth figures, or the actions of the US Federal Reserve, were the single biggest factor weighing on issuance plans by peripheral sovereigns”

For investors, the main stress factor affecting peripheral eurozone states going forward appears to involve the risk of regional financial and political contagion. In the days following the Greek elections, it took little to rattle their cages. Tsipras’s vow to wind back austerity by blocking plans to privatise state assets and taking control of domestic lenders pushed short-term Greek bond yields to 17%, and 10-year benchmark bond yields north of the psychologically important 10% mark.

Hopes that any broader regional contagion would be avoided proved wide of the mark. On January 28, 10-year Spanish bond yields inched up 5bp to 1.45%, with Italian yields rising 7%, while stocks in peripheral eurozone states took their biggest beating in months.

Jerome Legras, head of research at Paris-based Axiom Alternative Investments, said decisions made in Athens, rather than inflation or growth figures, or the actions of the US Federal Reserve, were the single biggest factor weighing on issuance plans by peripheral sovereigns.

“It’s all about Greece: Will they reach a deal with the Troika, and can Syriza strike a deal with Germany and the EU that accommodates everyone’s needs,” he said. “You still cannot rule out the likelihood of everything blowing up in Greece, followed by a Grexit. It’s now in our base scenario but equally we cannot completely exclude it.”

In a research note published on January 28, Rabobank said tensions between Greece and the Troika – the trio of institutions, led by the IMF and the ECB, that assembled the original Greek bailout – would remain elevated, at least in the near term, “rais[ing] the question of how much of a knock-on effect this might have elsewhere and, in particular, within the remainder of the periphery”.

Political contagion is harder to quantify but easier to pinpoint. Pierre Blandin, head of DCM, SSA, at Credit Agricole said politics was “the biggest uncertainty” facing Europe this year. With neither of the major political parties expected to gain an outright majority in May, Britain may well face two general elections in a year for the first time since 1974. Of greater concern is Spain, where the populist Podemos party, established in 2014 and with the same socialist leanings as Syriza, may pull off a stunning upset in December.

Experts are split over the likely impact of Podemos at the polls. Many political analysts expect national support for the party, which jumped from virtually nothing to 25% in just nine months, to wane as the year progresses. Indeed, support for the freshman party dipped sharply in the week after the Greek polls.

“I have the feeling that the Spanish voters are more conservative than Greek voters,” said Zeina Bignier, head of public sector at Societe Generale. “In Spain, reforms have been better received – in fact, the state achieved exactly what it set out to do.”

All eyes on Syriza

All eyes over the coming weeks and months will be firmly fixed on Syriza’s actions. Will it prove willing to compromise with its European partners? Or will it pursue a Pyrrhic victory involving, say, a wholesale reduction in its debt burden but only in exchange for a messy divorce from Brussels?

Spanish voters may well be provided with a salutary lesson as to how far eurozone leaders are willing to be pushed. Most likely, said SG’s Bignier, “Spain will not want to go down that road. It’s perilous and I think Spanish voters will look long and hard at Greece and weigh up the impact of their decision.”

Perhaps the biggest unanswered question is how decisions made by voters in peripheral eurozone countries – buffeted by economic torpor, bowed by unemployment – may impact on investor appetite for sovereign debt issued by those very states. Again, much may depend first on Syriza’s state of mind in the months ahead, and then on Spain’s relative appetite for change. Axiom’s Legras said the mere threat of a win in December by Podemos may “lead to a fall in sovereign debt demand” among regional and global investors.

Others aren’t so sure. Risk remains everywhere, in ways that the market has not and cannot price in, merely because it’s impossible to predict random events.

“We as an investor community missed all the big ones last year,” said Marcus Svedberg, chief economist at emerging market investment manager East Capital. “We failed to predict Ebola, the rise of ISIS, Russian sanctions, lower oil prices.”

This year will be filled with unforeseeable events, not least in the eurozone. Some may emanate from peripheral states now deemed to be on the mend; others from core eurozone countries sweating over growth and inflation.

Yet even these unknowns may fail to deter investors aware of the threat posed by rising uncertainty across the eurozone’s periphery – yet equally aware that debt issued by the region’s fringe sovereigns is likely to offer marginally better returns. This, said Credit Agricole’s Blandin, was likely to continue to drive investor demand for paper printed by the likes of Madrid, Lisbon, and Dublin.

“Spain and Ireland remain the success stories of the eurozone,” said Bignier. “They have overcome crises, and their yields are in positive territory, trading below US yields. So they will capture part of the liquidity as investors are looking for higher yield offered by countries that have undergone reforms. Their economies will also be further supported by quantitative easing.”

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