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Andrew Bosomworth, John Henning Fock
With developments in the eurozone continuing to escalate, a lack of clear political decisions has driven government bond yields of various eurozone members, notably in Southern Europe, to extreme levels, signaling that the status quo in place since the introduction of the euro in January 1999 is no longer tenable. In the absence of a credible destination and roadmap to point the way, we believe the European Central Bank’s (ECB) current policies and its acceptance as a lender of last resort can only serve as a bridge to a more sustainable and lasting solution that ultimately restores investor confidence in the eurozone.
At the same time, while ECB policy actions have helped stem capital flight and buy time for the eurozone, its policies have increasingly blurred the line between its core objective of setting monetary policy and the fiscal policy objectives of others. In essence, the ECB has filled the void left by the absence of political resolve to address the eurozone’s deeper structural issues. European governments, not the ECB, must provide more decisive leadership if the eurozone is to achieve a lasting solution. As the ECB and European policy makers struggle with the ever widening contagion, institutionalising the muddled middle status quo as the accepted norm is not a viable option for the eurozone, regardless of time horizon. Essentially, we see only two realistic and sustainable alternatives for the eurozone: 1) Either a full or perhaps partial break-up and reintroduction of domestic currencies or 2) a political and fiscal union to complement monetary union.
Without clarity of destination and guidance, given the fragility of the eurozone’s capital markets and rising political risks, few investors are likely to enter into long-term capital allocation decisions without a reasonable degree of confidence and certainty about the future parameters of their debtor. The greater the uncertainty faced by investors, the higher the risk premium they require to discount potentially volatile and uncertain future cash flows.
Unstable long-term equilibrium in Europe Such an unstable equilibrium is depriving some eurozone states of private capital at reasonable interest rates as they seek to adjust internal and external balances. Evidence of this can be found in the broken transmission mechanism of monetary policy where companies’ borrowing costs depend more on their geographic location than their credit quality, as shown in Figure 1. In the current environment, “BBB” rated firms in Spain and Italy pay more than twice as much for their debt as “BBB” rated companies in Germany and junk-rated companies – “BB” and lower – in Germany are paying less over swaps on average than investment grade-rated companies in Southern Europe.
Taking a specific example, the cost of insuring against default as measured by credit default swap (CDS) rates on German cement producer Heidelberg Cement (rated high yield - Moody's Ba2, Fitch BB+) today remain below those on the Spanish telecom company Telefonica (rated investment grade - Moody's Baa2, S&P BBB, Fitch BBB+; see Figures 1 and 2).
The apparent market distortion results not from a shift in each company’s idiosyncratic default probabilities, rather from each firm’s underlying reference yield curves. For Heidelberg Cement, the underlying yield curve is the German government bond yield curve, which had a 5-year yield of 0.36%. For Telefonica, the yield curve is priced off Spanish government bonds with a 5-year yield of 3.6%. In short, Telefonica has to pay more to refinance its activities than Heidelberg Cement as borrowing costs for companies located in Spain and elsewhere do not reflect their company-specific business risk. (Bloomberg as of 26 March 2013)
Are lower-rated companies in Germany better quality businesses than higher-rated companies in Spain or Italy? Not likely. Instead, the fragmented market for credit in the eurozone continues to reflect uncertainty about the irreversibility of its monetary union, i.e., the euro. Fragmentation of the credit market reflects a market failure aided by the configuration of decentralised fiscal policy with centralised monetary policy.
What future does the eurozone want and need? Ultimately, we believe that the eurozone will have to endure the pain of having to choose between a full or partial break-up that includes the reintroduction of domestic currencies or a political and fiscal union to complement the monetary union.
The consensus among Europe’s political leaders appears to indicate that “more Europe”, not less, is wanted. Indeed, Germany's Chancellor Angela Merkel stated in 2012: “(W)e don’t just need a monetary union, we also need a fiscal union, meaning more common budgetary policies, and, in particular, a political union; i.e., we will need to transfer competencies to Europe, step-by-step, going forward, and give Brussels intervention rights.” We concur and this is also the lesson to be drawn from the history of monetary unions. Those that endured developed federal fiscal policies, those that failed did not.
Hurdles along the way Economic and cultural differences continue to represent significant, yet we believe surmountable, hurdles facing the 17-member eurozone. A prominent example of economic differences, and likely the most crucial, is the current account positions of different countries (see Figure 3). Notably, deficit countries ran large and persistent current account deficits up until 2008 when fiscal policy induced internal devaluation and higher borrowing costs led to a sharp correction in external positions. While Ireland and Spain moved into current account surpluses during the latter half of 2012, the key challenge for these countries is whether they can maintain external surpluses and grow given the continued contraction in the region. Without growth, today’s liquidity crisis, which the ECB is financing, risks morphing into the same sort of solvency crisis faced by Latin America in the early 1990s.
Europe’s current governance structure and fiscal capacity are inadequate to address these challenges. Institutions and policies are divided between 27 nations in the EU and subset of 17 eurozone countries, while the primacy of politics resides at the national level instead of the European Parliament (Pisani-Ferry, Sapir and Wolff, “The Messy Rebuilding of Europe,” 2012). The EU’s budget – of which 1% of its GDP is transferred across borders – is insignificant relative to other economic and monetary federations. The eurozone’s challenge is to balance conditionality, mutualization and democracy, which will require national legislatures to hand over more responsibilities to a centralised chamber of governance and enable its citizens to participate in choosing who to represent them in it. Without democratic representation, the eurozone cannot consider a common fiscal capacity.
A successful example of a common fiscal capacity is Germany’s solidarity surcharge. Adopted after Germany’s reunification and levied on taxes paid by all citizens, its proceeds are still being transferred to rebuild Germany’s new states and bridge the economic gap between east and west. Over the past 20 years, the solidarity surcharge has helped raise GDP per capita in Germany’s eastern states to levels on par with Spain and higher than those in some other eurozone countries. Introducing a 5% euro solidarity surcharge modeled on Germany’s tax and levied on general government revenue in the eurozone would create an annual fiscal capacity of approximately €115 billion, equivalent to 1.25 % of GDP (Eurostat as of 15 November 2012). This common fiscal resource would go a long way to cushioning the eurozone against asymmetric shocks and, in our opinion, would represent a very low price to pay to ensure the euro’s irreversibility.
Final destination Without individual member states implementing needed structural reforms and without political agents specifying and committing to a feasible destination for the eurozone’s governance structure, we believe the region will remain mired in stagnation reminiscent of Latin America’s lost decade in the1980s.
Looking ahead, we expect regional growth to be in a range of -0.75% to -1.25% over the next year, with the risk of high unemployment and bail-out fatigue disenfranchising its citizens from the benefits that a monetary union was supposed to achieve. The ECB can buy time, engineer lower interest rates and fix the fragmented market for credit. But without its political partners committing to a common destination for the euro that completes its fiscal architecture, we believe the ECB’s actions alone will not suffice.
Past performance is not a guarantee or a reliable indicator of future results . Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Outlook and strategies are subject to change without notice.
The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The Quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively. The Option Adjusted Spread (OAS) measures the spread over a variety of possible interest rate paths. A security's OAS is the average return an investor will earn over Treasury returns, taking all possible future interest rate scenarios into account.
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The BofA Merrill Lynch Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the Eurobond or Euro member domestic markets. The index is made up of securities with investment grade ratings (BBB-, Baa3 or better) that have at least one year remaining term to final maturity, coupon schedule and a minimum outstanding debt of EUR 250 million. The BofA Merrill Lynch European Currency High Yield Constrained Index is designed to track the performance of euro- and British pound sterling-denominated below investment grade corporate debt publicly issued in the eurobond, sterling domestic or euro domestic markets by issuers around the world. It is not possible to invest directly in an unmanaged index.
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