Europe At A Crossroads: Invesco

Date: Thursday, June 7, 2012
Author: Brian Bollen's Blog

Mark Nash, senior portfolio manager at Invesco Fixed Income, shares his views on Greece, the eurozone and the European government bond market

Greek politics remains the precedent and has opened up the possibility of Euro break up. The muted market reaction to the Greek bailout package unveiled on 20 February suggested that investors retained scepticism about the solvency of Greece looking forward. And for good reason, as the implementation risk of the package is tremendous given the EU stipulates that Greece makes debt repayment a priority over basic public services.

This package, and the deteriorating economy, led to inconclusive Greek elections in May and, more importantly, a clear rise in the popularity of the leftist anti-bailout parties. The second round of elections in June could possibly lead to a Greek exit – we place the odds at 50/50 at least. The risks to the European project are very real and the contagion effect of a Greek exit would be very large as investors feared other nations following Greece’s departure. The impact on asset markets would be both big and unpredictable. There would be central bank measures and EU policy responses to contain the fallout, but at this stage it’s very difficult to gauge their effectiveness.

Our long run investment approach to European government bond markets remains guided by our contention that the European authorities have made an incorrect diagnosis of the crisis. This remains a solvency crisis, not just a liquidity crisis. The key to solving it is economic growth, improving tax receipts and thus, solvency.

The current method employed by the authorities to tackle the European crisis is primarily through fiscal austerity. Coming at a time when the global recovery is weak and when these sovereigns’ private sectors are retrenching, this seriously limits sources of growth. While this has morphed into a fiscal crisis, its roots are in a balance of payments crisis. Economies that are dependent on foreign funding are struggling just as global growth stutters. Uncompetitive economies stuck within the fixed currency block of the Euro will continue to be shunned by markets as growth prospects diminish.

Without strong GDP growth (also see in Finance Reference), there are three realistic solutions to the crisis - bondholder losses within the Euro, Euro exit and German socialisation of the debts. At this juncture, the market will continue to see private bondholders as candidates to take losses and Euro breakup a possibility. Official sector (the European Central Bank (ECB)) seniority in the debt chain also adds risk premium for private bondholders.

The outcome of the private sector involvement (PSI) process in Greece underlined the pecking order of creditors with the ECB refusing to take part in loss-sharing with the private sector. Germany is unlikely to assume the ‘joint and several guaranteed uncapped’ debts of the problem sovereigns due to obvious domestic political hurdles. Deposit outflows have begun to spread from Greece to Spain as contagion spreads and break-up fears broaden. The ECB has provided EUR1 trillion in liquidity but this only proved a stopgap measure as private sector financing continues to leave southern European states.

Given recent policy-making experiences in Europe, what is likely is we get a ‘fudge’ solution. This is likely to be very slow steps towards fiscal union and Eurobonds, perhaps combined with a weak investment plan. So called ‘Redemption’ bonds are a strong possibility – being Eurobonds-lite, this would involve sovereigns’ debt over 60% of GDP being pooled and sold off together. Without fiscal transfer this would not solve European imbalances but because budgets would need to be signed off in Brussels, this would limit moral hazard implications.

The ECB can also certainly provide support with further liquidity, and most likely eventually with full blown quantitative easing on the back of the deteriorating growth and inflation outlook in Europe. ECB action would only buy time, as borrowing costs within Europe need to be brought down permanently and this can only be done with the support of a German balance sheet.

The authorities continue to fail to address the root cause of the crisis, weak growth and the deteriorating solvency of the EU periphery. Weaker global GDP growth and Spanish bank losses have sparked the latest panic and more recently, political change in Greece has made the break-up of the Euro a real possibility. As private bondholders continue to sell, deposit outflows have also begun across Europe, precipitating the next, very dangerous, phase of the crisis.

The market is now at a crossroads of a Euro break-up or a common Eurobond/fiscal union. The timescale for what road is chosen is now measured in weeks, not months. Given the clear binary risk, we are positioned defensively and have been since mid-March, before markets focused once again on Greece. We will re-evaluate this strategy as and when we get responses from European politicians and policy-makers.