Tints and hues

IFR IMF/World Bank Report 2014
10 min read

The eurozone today is far more nuanced as the view from and of Lisbon, Dublin, and Madrid is, if not golden, then at least a lot less bleak, but France gives rise to concern.

As it turned out, rumours of the financial death of the eurozone’s periphery were greatly exaggerated. A year ago, it was easier for the countries girding the single currency’s southern and western reaches to walk to the moon than to sell tranches of sovereign debt. Ireland, Portugal and Greece remained locked into their international bailout programmes; Spain’s banks were still being artificially bolstered by €41bn (US$54bn) of EU funds.

How things change. Tick forward to the closing business months of 2014, and views from pweripheral eurozone countries, look, if not golden, then at least a lot less bleak. Over the past year, Ireland has plundered the sovereign debt market, its once equally unfashionable lenders following suit. Spain issued its inaugural inflation-linked bonds, with orders for the €5bn 10-year print topping €20bn.

Everyone, it seems, has their favourite deal from the past 12 months. For some, it’s the return of Greece, not so long ago a sovereign about as popular as measles, to the markets. Others highlight Cyprus’s benchmark bond issuance, 15 months after its fumbled March 2013 bailout.

Michael Krautzberger, head of the euro fixed income at BlackRock, said the turning point came with Portugalmaking a clean exit from the stimulus programme without even requiring a standby credit line. That was one of clearest signs of how the market has improved.”

For others, it was Italy’s €22.3bn November 2013 issuance, the largest single bond sale ever by a European government, which set in motion demand for inflation-linked prints. That “particularly impressive” sale, said Yves Kuhn, group chief investment officer at the Bank of Luxembourg, also underlined at the time “how many investors were suspicious about inflation”.

Even bad news has failed to dampen sentiment towards the eurozone’s outer reaches. When data showed a limp eurozone recovery petering out in the three months to end-June, attention focused on Germany’s economy, which contracted, and France’s, which posted zero growth for the second consecutive quarter. Few turned to Portugal and Spain in exasperation, preferring to blame Berlin’s adherence to its austerity orthodoxy.

Even the enforced €4.9bn rescue of Banco Espirito Santo in early August, which split Portugal’s largest listed bank by assets into “good” and “bad” lenders, failed to drag on sentiment, despite having some of the harshest bailout terms ever imposed on a failing EU bank.

“Twelve months ago, the troubles at BES would have caused a wide-spread sell-off in Portugal, and probably other peripheral eurozone states,” said Christian Schulz, senior economist at Berenberg Bank.

To many, this underlines the continued shifting of tectonic plates across the region. Post-crisis, eurozone economies were broadly shunted by global institutional investors into two categories. On the one hand there were strong, “core” states, typically Germany and the Nordic region. On the other lay the weaker periphery, comprising a crescent-shaped sweep of cash-strapped nations stretching from Ireland to Greece.

“A few years back in the crisis, there was no middle ground: you were either a ‘core’ eurozone economy, ranked Double or Triple A, or you were outside in the periphery, ranked BBB or lower. Now, with, say, Ireland rated A, there is a middle ground again. You aren’t one thing or the other”

Today’s eurozone is far more nuanced. Germany clearly remains the single market’s de facto safe haven, despite sluggish growth. On August 28, yields on 10-year German bonds fell to a record low of 0.89% on fears of further escalation of the crisis in Ukraine.

But look south and west and you find yields on Spanish and Italian sovereign bonds underlying US yields. Ireland enjoyed another moment in the sun in late August, when Fitch raised its sovereign rating to A– from BBB+, citing fiscal probity and a positive reform agenda.

“A few years back in the crisis, there was no middle ground: you were either a ‘core’ eurozone economy, ranked Double or Triple A, or you were outside in the periphery, ranked BBB or lower,” said BlackRock’s Krautzberger. “Now, with, say, Ireland rated A, there is a middle ground again. You aren’t one thing or the other.”

French worries

Perhaps the greatest concern as 2014 rolls toward its conclusion lies in Europe’s old Francophone core, where a country that co-founded modern Europe strives for growth and relevance.

“If current positive trends continue for Spain and take shape with Italy, the only ‘sick man’ major economy of Europe may remain France,” said Sam Theodore, managing director of financial institutions at Berlin-based Scope Ratings, Europe’s largest credit ratings agency. “That would be a shame, but it’s the way things are displaying right now.”

Yet despite the shift in perception among many, the eurozone’s outer reaches are likely to face a brace of stiff challenges in the year ahead. The first remains more of a “what if”, as investors pore over Mario Draghi’s late August speech in Jackson Hole, Wyoming, to find evidence of a desire to launch a full-blown quantitative easing programme, or to push ahead with large-scale asset purchases.

Lower long-term eurozone inflation

The European Central Bank president faces a daunting challenge, with markets starting, as the European summer rolled to an end, to price in the likelihood of lower long-term eurozone inflation, and even the prospect of deflation. In July 2014, inflation tumbled to a 4-1/2-year low across the region. Mario Draghi’s speech implicitly included a more tolerant approach to stimulus, and an admission that inflation expectations had become “unanchored”.

Few doubt that QE now appears more of a probability (if not yet a certainty) than a possibility.

“The likelihood for the ECB doing more” to inject stimulus into the eurozone market through a QE programme before the year is out “has increased”, said Krautzberger.

Bank of Luxembourg’s Kuhn said the signs pointed to a two-step programme, starting with a smaller, private sector easing programme focusing on private, corporate debt instruments such as asset-backed securities, totalling €70bn–€90bn.

“If that’s not enough to relaunch the eurozone’s economic engine,” he said, “then we could even see a straight-out public QE, involving the ECB directly buying sovereign bonds.”

To many, the question becomes: will QE re-inject broad-based momentum into the region’s economy, or will it merely drive a new wedge between the region’s core and peripheral states?

At end-August, after all, peripheral sovereign 10-year yield spreads were trading higher than June levels against Bunds, implying a rising credit risk premium for buyers of eurozone sovereign debt.

Challenge number two, equally nebulous in terms of investors’ ability to divine its likely impact, involves how and when the Federal Reserve will finally move on a tighter monetary policy.

The mass mid-2013 sell-off in emerging market stocks and bonds, which followed former Fed chairman Ben Bernanke’s tapering speech, underlined “how quickly money can flow out of markets and back to the US, causing volatility”, said Berenberg Bank’s Schulz.

For many in Brussels and Frankfurt, the imminent night-sweats are likely to stem from the danger of launching an aggressive easing programme, only to see yields tumble further in the eurozone’s outer reaches.

“There is room for spreads to go lower if the ECB pushes ahead with a huge QE programme,” said Schulz. If that happens, he adds, “there is the risk that some credit could flow back [to the US]”.

Tying up loose ends

And there are a few loose odds and ends to tie up. Economically speaking, the eurozone is far from out of the woods. Growth remains elusive, and sometimes illusive, in Europe’s edgelands, and in countries being sucked closer to the periphery.

Nominal growth has returned at times to Italy, which has done a solid job balancing its primary budget. But this alone is not enough: it needs, said Krautzberger, “to be followed up with positive nominal growth including healthy levels of inflation”.

Finally there is the long-awaited Comprehensive Assessment, an ECB-led health-check of eurozone lenders, incorporating an asset quality review and stress tests. Investors will be eyeing the results on their release in late 2014. Most observers expect a few stinging slaps on the wrist, but the market’s sanguine reaction to the struggles at BES has convinced many that the upcoming tests will beget few major shocks.

Indeed, many hope that the CA will be a major and crucial step towards the return of the eurozone, including its once-hobbled peripheral portions, to full economic and financial recovery.

“Going forward, the successful conclusion of the AQR should be a positive trigger point,” said Scope Ratings’ Theodore. “We won’t see huge surprises at Europe’s big banks, I believe, so once the AQR and its aftermath are over at the end of the fourth quarter, confidence in the region’s banks may in fact return. Next year could be a good year for credit losses, but less good perhaps for top-line revenue growth.”

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Tints and hues