In this week’s bulletin:
- Italy took centre stage in the markets as the issue of their rising sovereign debt yields came to the fore. French bond yields also came under fire following a mistaken downgrade by Standard & Poor’s rating agency. However, a new government for both Greece and Italy and ECB intervention in the bond markets pushed the FTSE 100 up 0.3% in the week to close at 5545.38.
- The yield on Italy’s 2-year and 10-year bonds crossed the psychologically important 7% mark last week which was the point at which Portugal, Ireland and Greece had to be bailed-out. Thankfully ECB intervention caused the yields to fall back and Italy managed to raise €5 billion in an auction of one-year securities paying an average rate of 6.09%.
- Data from China showed that inflation is falling and growth is strong so where is the eurozone aid that was suggested some weeks ago? According to independent sources in the Chinese government it is tied up in a political deadlock after Europe spurned all of Beijing’s demands.
- EU leaders have many routes to take, none of which are easy but the sudden change in Italy’s fortunes, considering just how big it is, may just force EU leaders to take decisive action and implement policy that could bring Europe out of its debt crisis.
- Finally, with European sovereign debt in the press we take a look at the UK Gilt market, exploring why yields are so low compared to Europe and Ian McVeigh, UK Equities Team Director at Jupiter Asset Management, gives his view.
Markets last week were again hit for six by the eurozone crisis but this time it was Italy that took centre stage as the issue of its rising sovereign debt yields came to the fore. Troubles in the markets were then compounded by the widening spread between the sovereign debt of France and Germany. Despite this, risk appetite improved as the week progressed, following the European Central Bank’s (ECB) intervention in the Italian bond market, and signs that Italy’s politicians were grasping the nettle of reform. The Italian senate approved the financial stability bill on Friday, making way for final approval in the lower house. It was also a busy weekend for Italy’s president Giorgio Napolitano as he rushed to appoint former EU commissioner Mario Monti as the new prime minister after Silvio Berlusconi formally stepped down on Saturday. This was enough to push the key indices into positive ground within the week: the FTSE 100 gained 0.3% to close at 5545.38 and the S&P 500 gained 0.8% to close at 1263.85.
The Bailout Club
Groucho Marx famously said: “I don’t want to belong to any club that will accept people like me as a member.” Unfortunately for Italy, the bailout club is scarily welcoming. Amid scepticism over Italy’s ability to tackle its debt mountain, its bond yields rose sharply, with the 2-year and 10-year yields crossing the psychologically important 7% mark; the point breached by Portugal, Ireland and Greece before they were forced to seek bailout funds.
Source: Bloomberg 2011
With a borrowing rate three and a half times that of Germany’s, Italy’s debt re-financing looks unsustainable. On Thursday, Italy raised €5 billion in an auction of 1-year securities paying an average rate of 6.09%; far above the 3.57% it paid for a similar offering on 3 October this year. Of course, despite hitting this historically high mark, Italy will only pay these high rates on its new debt issues; and if EU leaders can bring them down, the picture may become rosier for the circa €300 billion that they have to raise by the end of next year. The reason why everyone is worried boils down to the sheer size of Italy’s debt. It is not only too big to fail: it is too big to save. Unlike Greece, which is essentially a peripheral eurozone economy, Italy is the world’s 8th largest economy. As The Telegraph pointed out, the size of Argentina’s default in 2002 was $95 billion, Lehman Brothers’ was $613 billion, Greece has $480 billion of debt outstanding and Italy has debts just shy of $2.5 trillion. That means that an Italian default would be 20 times the size of Argentina’s!
It was not only Italian yields that suffered – the spread between Germany’s 10-year bund and France’s 10-year note widened to their highest level since 1995 (before the euro was introduced). This was helped by the rating agency Standard & Poor’s, which accidentally posted on its website that France had lost its coveted AAA status. Despite being an error it would suggest that Standard & Poor’s are at least planning for it and merely pressed the button too early. Perhaps this, and the constant fear of contagion across the eurozone, could be the reason why the yield spread has still not fallen back.
Source: Bloomberg 2011
With the overriding focus on the eurozone, some positive news from China had less impact than might normally have been expected. Data showed that the country experienced its biggest fall in inflation since early 2009. This looked enough to allow authorities to ease both monetary and fiscal policy – a good move for encouraging growth, which currently stands at 9.1%. So, with China doing well in relative terms to the eurozone, where is the aid that was suggested some weeks ago? According to independent sources in the Chinese government, it is tied up in a political deadlock after Europe spurned all of Beijing’s demands. According to the sources, Beijing wanted either more influence in the International Monetary Fund, market economy status in the World Trade Organisation, or the lifting of a European arms embargo. With this political impasse, a circa $100 billion cash injection for the eurozone looks unlikely. Of course, China will have to weigh up the fact that without a stable eurozone it may lose its biggest trading partner.
Decisions, Decisions, Decisions
Italy is on the cusp of needing a bailout, but it is worth remembering that a bailout is just adding to the country’s debt pile. As Greece is finding out, the extra debt and enforced austerity measures that accompany the bailout do not help when a country is experiencing solvency problems. So to prevent Italy going the way of Greece, what could be done? First is a complete fiscal union within the eurozone, but this needs both northern Europe to take responsibility for southern Europe’s debt and southern Europe to give up sovereignty, both of which look unlikely, certainly in the short term, although increased fiscal union is inevitable as the eurozone moves to avoid similar crises in the future. Another option could be for the ECB to start printing money to purchase the sovereign bonds of indebted euro nations. This would be good for the debtors (southern Europe) as debt levels will be eroded away, but northern Europeans are understandably reluctant; not least of all Germany for which this may bring back memories of Weimar-style hyper-inflationary chaos. As German Vice-Chancellor Philipp Rösler also pointed out, “if the ECB launched large-scale quantitative easing to clean up the debt of Italy et al, the impetus to create lasting stability and make reforms would disappear”. Perhaps the biggest barrier to this idea is that there is no method of actually doing it. As Jens Weidmann, head of Germany’s Bundesbank and a pivotal ECB governor said “We have a mandate, and we have to stick to our mandate – the euro system must not be the lender of last resort for sovereigns because this would violate Article 123 of the EU treaty”. With the ECB constrained, the €440 billion European Financial Stability Fund (EFSF) is supposed to step in but it is itself struggling to raise money at a viable cost. Finally, Greece could be ejected from the eurozone… but who would follow – Portugal, Italy, Spain, Ireland, perhaps Austria and Hungary too?
This week will see Italy’s new prime minster face some tough decisions as he is expected to take decisive action. This responsibility will also lie with the new prime minister of Greece who will be hosting members from the ECB who are expected to authorise the release of another €8 billion in bailout funds if they find that Greece has met the conditions of their loan. Meanwhile, leaders outside of Europe will be applying increased pressure. Our own Mr Cameron will hold private talks with Angela Merkel on Friday where he is expected to urge Germany to do more. Mr Cameron’s thoughts were backed by Vince Cable who said, “It is very clear that, in addition to the disciplines that the southern Europeans are going to have to adopt, the Germans are going to have to play their role in supporting the eurozone.” Avid market watchers should also keep a close eye on Spain. Notwithstanding the fact that their 10-year sovereign debt yield is uncomfortably close to the 7% line (as seen in the first chart), data has just been released showing that their economy registered zero growth in the third quarter of the year.
We have had many reasons for EU authorities to act; but the sudden change in Italy’s fortunes, given its size, may force EU leaders to take some serious decisions and implement policy that could start to bring Europe out of its debt crisis.
With the sovereign debt yields of Italy and France rising as their security as a lender is called into question, investors have been flocking to the relative safety of the UK. Since the year’s high in February, where a 10-year gilt yield hit 3.88% amid fears of inflation and higher interest rates, they have been falling and now stand at just 2.29%. You would have to go back to the 1950s to see similar lows. The yield curve below, which plots the yield of gilts with varying maturities from 2 to 30 years, shows the extent to which yields have fallen compared to the same yield curve 6 months ago. This is the risk-off side of the risk-on/risk-off trade that many investors will have been made aware of over recent months.
Source: Bloomberg 2011
So why are they so low? In addition to demand from safety-seeking investors willing to pay nearly any price for the short-term security of holding bonds backed by the government, the coalition government has earned this ability to borrow money cheaply through the early adoption of austerity measures currently being forced on the more reluctant members of the EU by the markets. Falling yields may not seem like good news for investors but since the capital value has an inverse relationship to the yield, those investors lucky enough to own them have seen a good return. Over the past six months the FTSE Gilts Total Return index has seen a rise of 11.02%. The downside now is that new investors into, say, a 10-year gilt are accepting a rather unexciting 2.89% interest per annum which, with CPI running at 5.2%, produces a current real return of –2.31% per annum.
The biggest advantage of investing in gilts is the security of the income. Not only are you getting a fixed return per annum, you are getting it from the UK government which, as lenders go, is very secure. They are also going to be less volatile than other, riskier asset classes, such as equities or high-yield corporate bonds. On the downside, their underlying capital value is susceptible to inflation and interest rate rises. Like any asset class, they should not be relied upon in isolation and should instead be combined with well-chosen equities and other asset classes to construct a low-medium risk conservative portfolio. Despite seeing recent falls, equities have always been seen as a good hedge against inflation and have on the whole remained relatively robust, perhaps reflecting the underlying strength of companies as proven by their Q3 earnings.
Jupiter Asset Management’s UK Equities Team Director, Ian McVeigh said, “To us this flight to safety is highly reminiscent of the panic we saw in the aftermath of the Lehman’s collapse. The world could slide into recession, but we note that a lot of the emerging world has an issue with too much rather than too little growth. Even with the downgrades we have seen, the consensus for global GDP growth is around 3–3.5%. It could get worse, but we are still talking of a global economy that is growing rather than contracting.” He added, “We think the current backdrop is reflecting an extreme pessimism that could, but is in our view unlikely to, prove correct – such extreme pessimism often represents outstanding buying opportunities. We think we are at or close to one such opportunity now.”