The sick men of Europe
During the eurozone sovereign debt crisis, the currency bloc was sometimes compared to a patient on the verge of a heart attack.
As 2015 approaches, it seems fair to say the patient has survived – the eurozone remains intact, and only one country (Greece) defaulted on its debts. During and after the crisis, many ways were suggested to help the eurozone become fitter and reduce the risk of a future financial heart attack. However, parts of the eurozone now resemble patients who say they wants to become healthier but actually remain obese and won’t give up smoking. Government debt levels are high and keep rising, economic growth rates hover around zero, and despite talk of structural reforms, some countries still suffer from inflexible markets and high levels of corruption.
The crisis saw spreads of eurozone periphery government bonds widen dramatically over equivalent German bonds, reflecting perceived default risk. Since 2012, spreads have tightened significantly as investors have regained a measure of confidence in the periphery. One of the goals of official responses to the crisis has been to seek to break the link between banks and sovereigns – a link that caused difficulties for Spain and Ireland in particular. However, while there have been moves toward banking union in the eurozone, it appears the union will not extend to pooling sovereign liability for banks – Germany, for example, is not expected to bail out periphery banks if they are in distress.
In 2015, we expect eurozone investors to focus more on economic growth and corporate earnings than on the risk of sovereign defaults. Here, too, banking is crucial. The eurozone’s corporate bond markets are proportionately smaller than those of the US and the UK, which leaves eurozone companies more reliant on funding from bank loans. The European Central Bank’s survey of bank lending showed that eurozone banks tightened their lending standards in every quarter from the first quarter of 2008 to the second quarter of 2014. Over the same period, demand for bank loans plunged. However, the latest data show tentative signs of recovery in demand and a slight easing in lending standards. If these fragile shoots turn into more robust growth in lending, the prospects for economic recovery would be greatly increased. Investors will also want to see how the ECB’s plans to buy asset-backed securities (ABS) work out in practice.
The ECB has a strict policy mandate to keep eurozone inflation close to, but below, 2%. Since late 2013, inflation has been below 1%, and heading toward zero. The ECB has tried to stimulate the economy by loosening monetary policy. It is hard to imagine the ECB going much further with cuts to its main interest rates, one of which is already below zero. If inflation stays well below target, there could be pressure for quantitative easing on a larger scale than the ABS program, but purchases of government bonds could face legal and political obstacles.
The biggest political controversies, however, surround government deficits and structural reforms. Periphery government debt levels remain high and continue to rise – spending cuts and tax rises are unpopular with voters. Meanwhile, some voters in core eurozone countries such as Germany have complained about the perceived transfer of wealth from the northern half of the eurozone to the southern parts. Against that backdrop, the eurozone crisis saw a big drop in the popularity of the European Union among its own citizens, shown in Figure 1. The latest results available at the time of writing suggest the EU may be past its lowest point in terms of citizen dissatisfaction. Nevertheless, politics could remain polarized in 2015 and beyond.
(Source: European Commission)
Note: The percentages represent responses to the question “In general, does the EU conjure up for you a very positive, fairly positive, neutral, fairly negative or very negative image?”
The periphery countries also have highly regulated product and labour markets, and low rankings in the World Bank’s ease of doing business survey, relative to other developed markets such as the US and the UK. Deregulation may boost an overall economy, but it can be unpopular with special interest groups. In some ways, loose monetary policy may have made debt reduction and structural reform harder by removing pressure on governments. Eurozone sovereign bond yields, and therefore governments’ borrowing costs, are near record lows, reducing the incentive for governments to reduce debt levels or to enact the structural reforms that could improve long-term creditworthiness.
Another structural reform that could benefit some periphery countries is reducing levels of corruption, which is associated with many harmful effects including loss of public resources, lower economic efficiency and higher government borrowing costs. A widely used metric is the Corruption Perceptions Index published annually by Transparency International. A high score represents less corruption. In the eurozone, countries with scores closer to the developed markets average generally did not experience difficulties in government debt markets during the eurozone financial crisis that began in 2010 – Ireland being a notable exception. However, countries with scores closer to the emerging markets average were much more likely to show signs of market stress, such as high and rapidly rising government bond spreads, at some point in the crisis.
Figure 2: Corruption Perceptions Index scores
(Source: Transparency International, UBS Global Asset Management. Note: The data refer to the 2013 Corruption Perceptions Index. Developed markets countries and emerging markets countries are based on MSCI definitions.)
What to watch in 2015
- Ongoing debate over quantitative easing by the ECB – the central bank’s officials may be uncomfortable using the term “QE”, but if inflation and growth remain close to zero, they should expect increasing pressure to increase the size of asset purchases and widen their scope.
- The ECB’s quarterly bank lending survey is a key barometer of financing conditions in the Eurozone – after a long period of deterioration, investors are hoping that recent signs of recovery will turn into a substantial improvement in lending conditions and activity levels.
- The UK general election in May 2015 could unsettle European Union politics if the result is victory for the Conservative Party, which has promised to renegotiate membership conditions ahead of a 2017 referendum on UK exit from the EU.
How are asset classes affected?
- The euro could be weakened if the ECB adopts aggressive QE-type measures, but could strengthen if the ECB is more conservative than expected – a weaker euro would help exporters and may reduce the risk of deflation.
- With less focus on tail risks such as Eurozone break-up, European equity markets could return to a focus on fundamentals such as earnings and economic growth.
- Periphery government bonds tend to behave as risk assets with country-specific risks, but with less scope for big gains compared with recent years because yields have already fallen so far.
Matthew Richards is strategist, Global Investment Solution, at UBS Global Asset Management