European Sovereign Outlook: Eight Themes to Consider
At the start of this year, we identified eight themes we wanted to watch in Europe during 2013. As expected, we have avoided the extreme levels of market stress that were experienced in 2011 and 2012. The European Central Bank’s (ECB) decisive action to restore market confidence in mid-2012 reduced tail risk and has established the ECB as a credible backstop. Still, the underlying structural challenges remain of achieving fiscal consolidation, encouraging competitiveness and seeking a more integrated financial and political European Union.
So what has been achieved in Europe in 2013? Framed around our eight themes, we reflect on whether developments in Europe so far this year have met our expectations, and also provide an outlook for the second half of the year.1. Economy
Growth has disappointed our expectations of a gradual and shallow recovery. Gross domestic product (GDP) in the eurozone contracted 0.2% in the first quarter year-on-year (YoY), marking the sixth consecutive quarter of decline for the region. Germany reported meager growth at 0.1% YoY, while the eurozone’s second- and third largest economies, France and Italy, are entrenched in recession. The ECB will likely revise down its 2013 GDP forecasts later this year (current estimates suggest average annual real GDP growth at -0.6%).
What has been surprising is how the improvement in the financial markets in the second half of 2012 (including the reduction in sovereign spreads and improvement in bank and corporate funding conditions) has not flowed through into the real economy as of yet. We maintain our view that the fourth quarter in 2012 marked the bottom (or worst point) of the recession and the economy should gradually recover, albeit one that is slow, bumpy and uneven.
The longer-term indicators we monitor (including Purchasing Managers’ Indexes – PMI) data and their correlation to money supply—see Figure 1) show that the eurozone economy in aggregate should return to modest growth in the second half of 2013. That said, we expect growth to be within a concentrated core of countries, namely Germany, Austria, Belgium, Finland, Slovakia and Ireland with the rest remaining in recession until 2014 at least.Figure 1
In terms of the broader macroeconomic adjustment, probably the greatest untold eurozone story over the past year is the improvement in current account balances. Ireland holds a surplus of 4.5%. Spain and Italy’s current account deficits have declined from 3% to 4% of GDP 12 months ago to almost zero today. Portugal and Greece’s declines have been greater (see Figure 2). These developments will reduce external debt liabilities and improve competitiveness.
Indeed, labor costs have been declining across most periphery countries vis-à-vis Germany, mainly resulting from productivity gains. The extent of competitive adjustment varies across countries, with Ireland’s adjustment mostly complete. Spain and Portugal have also made significant progress but, due to their worse starting position, still have a way to go.Figure 2 Source: Eurostat. Figure 3
While the periphery countries’ external adjustment exceeded expectations in 2012, their fiscal adjustments have generally lagged expectations. For example, Spain’s 2012 budget deficit was 7.0% of GDP against an initial target of 4.3% of GDP 3. Ireland was the only periphery country to outperform its fiscal target in 2012.
With the potential exception of Ireland, it is likely that periphery governments will miss their deficit targets again in 2013. Worse-than-expected economic performance in the year to date has already caused slippages behind plan. For example, as of April 30, 2013, Italy’s budget deficit was tracking at an annual rate of 4.5% of GDP versus a target of 3.0%. 4 The Spanish central government’s deficit at the end of March was tracking at an annual rate around 4% of GDP, slightly above the government’s target. The macroeconomic assumptions embedded in the regional and social security budgets are too optimistic, so those aspects of the government deficit will also probably be above targets.
2. The doctrine of fiscal austerity
We correctly assessed that the doctrine of fiscal austerity would weaken through 2013. Spurred on by the Italian election results and later the Reinhart & Rogoff revelations, the French, Spanish and Italian governments have led a revolt against additional austerity this year.
There is growing political consensus around the view that measures should be taken to boost growth if austerity is to be successful over the long term. Indeed, as we forecast, the German leadership has been willing to slow the pace of fiscal consolidation to support the broader eurozone economy ahead of the national elections in September, as well as avoid potential diplomatic spats distracting from other key issues. We do not expect the German election outcome to have a significant impact from an investment perspective. All of the major German political parties have similar policies on Europe, even if they sometimes choose to emphasise their differences.The fiscal austerity debate: immaterial in the short run…
Much of the public debate on austerity is about political point scoring. It is largely immaterial in the short run. The French, Spanish and Italian politicians are not arguing for traditional fiscal stimulus, which is difficult to implement since the EU Fiscal Compact was signed last year. Their immediate objective is to avoid an additional round of fiscal tightening in mid-2013.
This is not a particularly controversial position, given the ongoing recession. The European Commission’s recent announcement revising up 2013-14 budget deficit targets merely formalises what was agreed to several months ago. The hope is that a mild economic recovery will not be extinguished in the fourth quarter (as happened last year).…hugely important in the long run
Nevertheless, the austerity debate is hugely important in the long run. The eurozone is clearly dividing into two camps, characterised as the “soft” adjusters (France, Spain, Italy and Portugal) and the “hard” adjusters (Germany, Netherlands, Austria and Finland). The visions espoused by the two camps will lead to very different looking eurozones in 10 years’ time.
The soft camp puts growth ahead of austerity, wants a more interventionist ECB, and shies away from tough structural reforms. This implies a politically and socially easier adjustment, no sovereign defaults and no eurozone breakup. However, over the long term, this is likely to lead to the “Italianisation” of the eurozone, with high sovereign debt, negligible GDP growth and significant income disparities between countries.
The hard camp wants fiscal austerity, tough structural reforms, tight monetary policy and a centralisation of economic powers at the European level. Although this should lead to a leaner, more efficient and competitive eurozone over the long run, it is also the more difficult and riskier path. It is uncertain whether the soft countries’ political and social fabric could withstand the pressures that such a regime would entail. Political and social upheaval would be required. For those countries unable to adapt, sovereign defaults would be possible, as would Euro exits.
On balance, the soft camp is winning right now. Although the hard camp has had some recent success, notably on Cyprus, the general trend has been toward easier monetary and fiscal policy and a slowdown of structural reforms.
3. Sovereign downgrades
As we anticipated, there have been very few sovereign downgrades so far compared with 2011 and 2012. Based on the (unweighted) average of the three major credit ratings agencies, the eurozone sovereign rating remains unchanged at A.
Moody’s has taken only one rating action on a eurozone sovereign in 2013, downgrading Slovenia to Ba1 from Baa2. S&P also downgraded Slovenia (to A- from A) in February 2013, but they also moved the outlooks on Ireland, Portugal and Austria to stable from negative. Italy and Slovenia were downgraded by Fitch to BBB+ in March and May 2013, respectively. Most recently in May 2013, Fitch upgraded Greece’s credit rating to B- from CCC, citing improvements to its budget and current account deficits and economic stabilisation.
In the second half of this year, Slovenia could be downgraded by S&P, but we expect the country to remain investment grade. Moody’s could move its outlook on Ireland from negative to stable. Moody’s is the only agency to rate Ireland as sub-investment grade. Eventually, Moody’s should upgrade Ireland to investment grade, but this is more likely to happen in late 2014.
4. Social unrest
Job creation was one of the most significant challenges that we cited in our January outlook. It continues to mire the eurozone’s growth prospects (see Figure 4), especially in periphery countries. The eurozone average unemployment rate has reached an all-time high of 12.1% and appears to be on a rising trend. Most concerning, youth unemployment sits at extreme levels: 56% in Spain, 62.5% in Greece and 38.4% in Italy.
The lack of protest so far has been surprising. We continue to believe that the risks posed by social unrest should not be underestimated. Italy’s election result in February demonstrated the growing popularity of antiestablishment parties (such as the 5-Star Movement) across Europe and the rejection of the economic reform agenda as well as wider European integration. High and rising unemployment brings significant risk of protest, but other factors play a role too: fiscal cutbacks, structural reforms to weaken job protection of existing workers, allegations of high level corruption in many countries, from France to Spain to Greece. Determining the specific trigger of unrest is difficult—if it occurs at all—but the conditions are in situ for such a scenario, and investors need to be cognisant of the risks.
Greece’s fiscal and economic crisis is not solved yet, but there has been incremental progress. First-quarter data, albeit preliminary, suggest that the Greek government may be finally getting its budget under control (see Figure 5). The current pace may be sustainable since there is no election planned this year to derail progress, unlike last year. Moreover, the pace of contraction in the economy is moderating (according to survey data such as the European Commission’s Economic Sentiment Indicator and the Manufacturing PMI).
While Greece has made progress on fiscal adjustment, the coalition government still has to address structural economic reform. The unemployment rate continues to escalate, which is a major social risk. And government debt levels are still too high. Greece will require additional sovereign debt restructuring in the future, although it is uncertain whether this will only be done for European Union loans or if private sector bonds will be included. Greece’s financing requirements for the next couple of years are low, so it is more of a longer-term risk.
6. IMF-EU rescue program
In our January 2013 outlook, we stated: “The most obvious candidate for an IMF-EU rescue program is Cyprus.” Cyprus was indeed rescued. The banking system collapsed and two of the country’s largest banks were restructured. Initially, we were very surprised that all depositors were to be bailed in. This decision was quickly reversed and, in the end, only non-guaranteed depositors (with €100,000) were included.
In addition, the government secured €10 billion of loans from the European Stability Mechanism to cover deficit financing and some debt repayments. Capital controls were put in place to prevent capital flight. They are officially prohibited by the EU Treaty, but there is sufficient flexibility in the treaty to allow capital controls in extreme circumstances.
The issue of capital controls raises concerns. As of today, there are still restrictions on cash withdrawals and international payments out of Cyprus. Although there has been little reaction in other countries, and we do not expect this to be repeated in other countries’ rescue programmes (for example, if Spain entered a rescue programme), it sets a dangerous precedent. It makes other periphery countries more fragile, as depositors could rush to withdraw funds from banks if they feared such controls being enacted in their country.
Is Cyprus a template for other eurozone countries? Yes and no. No, because Cypriot banks were unique in that they were very large compared with the size of the economy, and most of their liabilities were in the form of deposits. Yes, because there is increasing reluctance to spend taxpayers’ money to bail out banks. Bank creditors, including sub-and senior debt holders, will have to start taking some losses.
The risk of Spain entering a rescue program has declined this year, but over the long run, we believe that additional support will be required from the IMF and European Union.
7. ECB monetary policy
We stated in our original outlook that the ECB was likely to ease monetary conditions, and the first step would probably be a cut in the repo rate. The ECB acted in May and cut the repo rate to 50 basis points. It will probably cut again (to 25 basis points) within the next few months. The actual cut has a limited impact on the real economy—bank overnight funding costs (EONIA) are only 0.07%—but it has an important signaling effect.
To some extent, the ECB has to continue easing as it needs to counteract the gradual repayment of long-term refinancing operations (LTRO) money (see Figure 6) and avoid a tightening of credit conditions. Excess liquidity is still about €100 billion above the level the ECB has signalled that it would start to impact the money markets (i.e., push up EONIA). The ECB will want to act before that level is reached.Figure 6
Of the other ECB options listed in January:
- The activation of OMT (outright monetary transactions) is unlikely as we do not expect Spain or Italy to request a macroeconomic rescue program this year.
- Buying financial sector assets. The ECB has signalled that it wants the European Investment Bank (EIB) and European Commission to spearhead an initiative to jumpstart the asset-backed securities (ABS) market in the eurozone. We think that the EIB may offer some form of partial guarantee on eligible assets packaged into ABS (which would include mortgages and small and medium enterprises loans, for example). The ECB could then offer lower haircuts (a percentage reduction in the par value of the asset to account for its credit risk) when financing those assets via repurchase agreements. Therefore, banks that hold those ABS could finance them cheaply through the ECB’s main financing operation and LTRO repo operations.
- A negative deposit rate to encourage bank lending and investment. While we stated in January that this option would likely be used only as a last resort, recently, the ECB indicated that its concerns about unintended consequences have lessened, and it considered that action could be taken to mitigate those consequences. We believe there is a reasonable expectation of a negative deposit rate in the second half of this year. The investment implications would be negative for the euro, positive for core long-term bonds and positive for short-and medium-term periphery bonds.
8. The cycle of hope, disappointment and crisis
Using the characterization of the euro crisis of hope, disappointment and crisis, we remain in the “hope” phase of the cycle. Although there are no obvious catalysts for a return of disappointment and crisis, the markets have become even more complacent about eurozone risks.
The lack of stress in the financial markets means that politicians have also become more complacent. At the national level, structural reforms are being put off and fiscal reforms are being watered down. For example, the new Italian government is planning to dilute the reform agenda championed by Monti in 2012. It will probably take a resurgence of stress to rejuvenate the reform process amongst the politicians and governments.
Progress towards eurozone integration has slowed significantly. A single European supervisor for banks will be established next year, but efforts to create true banking union (including supervision, resolution, fiscal backstops and rules for deposit insurance) could be years away. A significant hurdle is the reluctance of politicians and citizens to transfer important powers to a supranational regime. A new monetary and economic order would be required to replace and renew institutions that were founded upon a 19th century model of nation states. That probably requires a crisis— but one should remember that the European Union itself was founded out of a crisis.
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1 European Commission.
2 Excluding the cost of bank recapitalizations.
3 Later revised up to 6.3% in September 2012.
4 Although we expect Italy’s final 2013 deficit to be around 3% of GDP.