Global Investing

In a week in which euro zone debt fears returned in earnest for the first time in 2012, a positive investment tip about one of the three bailed out peripheral euro economies was eye-catching in its timing. RBS on Thursday issued a recommendation to its clients to buy the bonds of one of Ireland’s main commercial banks Bank of Ireland.

Now, financial markets have for some time priced Irish government debt more positively that either Greece or Portugal, in large part due to the country’s superior private sector growth prospects and the government’s seeming acceptance of and adherence to the austerity targets demanded in return for European bailout funds.  That said, there is little end in sight to problem of banks bad debts and mounting mortgage arrears and few signs of recovery in a housing market where prices are down some 50 percent from pre-crisis peaks. Moreover, Ireland has scheduled a referendum on the new euro fiscal pact for May 31 and, if it’s rejected, the country could lose access to future euro emergency funds.

But, in a note entitled “The Celtic Tiger is coming back on track”, RBS credit strategists  Alberto Gallo and Phoenix Kalen took a positive tilt on developments and recommended investors snap up the 8.45% yield available on the senior unsecured bonds of  ailing, government-backed Bank of Ireland — the country’s “main viable bank”. The bonds mature in 2013 and had an original coupon of 4.625%.

The broad RBS argument is that Irish banks are tackling their problems, deleveraging more than banks elsewhere on the euro periphery, using less ECB liquidity and doing fewer sovereign carry trades. But the main reason for the trade is that they do not expect government support for the banks to be removed before the maturity of these bonds next year and therefore feel the 8.45% yield now available is a pretty good compensation for interim risks of deposit flight and those emanating from exposure to the still-dire local housing market.  What’s more, this yield is a premium to the 10-year Irish government bond yield of some 6.9 percent even though the banks continue to be effectively gauranteed by the sovereign. The reason for the premium is the risk the government backs away from that pledge, something very much at the centre of the debate about rescheduling promissory note payments to the shell of failed real estate lending behemoth Anglo Irish Bank.

These risk premia reflect fears that the Irish government could reverse its support for bank debt, in our view. The IMF and EU are showing more flexibility for Ireland and have agreed last week to the exchange of the next promissory note payment for government debt. That said, we think concerns on senior bank debt haircuts are overdone, and particularly so for Bank of Ireland. First, haircuts are not necessary, as Ireland is currently on track with its fiscal targets. Second, a voluntary bank haircut would have negative systemic consequences for funding, potentially shutting both banks and the sovereign out of primary markets. Compared to the little amount of outstanding senior debt, this is unlikely to happen. Third, our economists expect the Irish referendum will centre on the fiscal compact, not on EMU membership.

Fear of many years of stagnation in the major western economies has everyone fretting about a repeat of  the “lost decades” that Japan suffered after its banking and real estate bubble burst in the early 1990s. Indeed HSBC economists were recently keen to point out that U.S. per capita growth over the noughties was already actually weaker than either of Japan’s lost decades.

But in a detailed presentation on the impact of two years of soveriegn debt crisis on euro zone government bond holdings, Barclays  economist Laurent Fransolet asks whether that market too is turning into the Japanese government bond market — where years of slow growth, zero interest rates, current account surpluses and captive local buyers have depressed borrowing rates for years and turned JGBs into an increasingly domestic market dominated by local banks, pension funds and insurers. Non-residents hold less than 10 percent of JGBs, compared to more than 50 percent for the EGB as a whole, and Japanese banks hold up to 35 percent of their own government bond market.

But is the euro government market heading in that direction after successive crises have seen foreign investors flee many of the peripheral markets of Greece, Portugal, Ireland and even Italy and Spain? Fransolet argues that the seniority of substantial European Central Bank holdings built up in the interim (now about 15 percent of each of the five peripheral markets) may be one reason why these foreign investors will be wary of returning. Meantime, euro zone banks, who have traditionally held a high 20-25 percentage point share of euro government markets, withdrew sharply late last year amid balance sheet repair pressures but have  rebuilt holdings again sharply in early 2012 after the ECB’s liquidity injections — particularly in Italy and Spain.

Until this week at least, one of the big puzzles of the year for many investors was squaring a 10-15% surge in equity indices with little or no movement in rock-bottom U.S., German and UK government bond yields. To the extent that both markets reflect expectations for future economic activity, then one of them looks wrong. The pessimists, emboldened by the superior predictive powers of the bond market over recent decades, claim the persistence of super low U.S. Treasury, German bund and British gilt yields reveals a deep and pervasive pessimism about global growth for many years to come. Those preferring the sunny side up reckon super-low yields are merely a function of central bank bond buying and money printing — and if those policies are indeed successful in reflating economies, then equity bulls will be proved correct in time. A market rethink on the chances for another bout of U.S. Federal Reserve bond-buying after upbeat Fed statements and buoyant U.S. economic numbers over the past week also nods to the latter argument.

But as we approach the final fortnight of the first quarter,  more seems to be going on. Much of the whoosh of Q1 so far has merely been a reversal of the renewed systemic fears that emerged in the second half of last year. In fact, gains in world equity indices of circa 13% are an exact reversal of the net losses suffered between last June and the end of 2011.  And if those gains are justified, then much of the extreme “tail risks” that scared the horses back then must have been put to rest too, no? Well, the two mains tail risks — a euro zone breakup or collapse and a lapse of the U.S. economy into another recesssion or depression — do look to have been been put to bed for now at least. The ECB’s mega 3-year cash floods in December and February and the “orderly” Greek debt default and restructuring last week have certainly eased the euro strain. The remarkable stabilisation of U.S. labour markets, factory activity, household credit and even retail sales has also silenced the double-dippers there for now too.

The net result seems to have been this week’s synchronised retreat in three of the main “catastrophe hedges” — gold, AAA-government bonds and equity volatility indices — and this move could well mark a critical juncture. Gold is down 8% since its 2012 peak on Leap Day,  10-year U.S., UK and German government bond yields are up 25/30 basis points since Monday alone, and equity volatility gauges such as Wall St’s ViX have dropped to levels not seen since before the whole credit crisis exploded in the summer of 2007.  If extreme systemic fears are genuinely abating and the prevalence of even marginal positioning like this in investment portfolios is being unwound, then there may well be some seismic flows ahead that could add another leg to the equity rally.  The U.S. bias in all this is obvious with the rise of the dollar exchange rate index to its highest since January. That has its own investment ramifications — not least in emerging markets. But the questions for many will remain. Is the coast really clear? Are elections over the coming weeks in France and Greece and an Irish referendum on the euro fiscal pact just sideshows? Is the global economy sufficiently repaired to bet on renewed growth from here and will corporate earnings follow suit? Has bank and household deleveraging across the western world halted? Are the oil price surge and geopolitical risks in the Middle East no longer a concern? And if you’ve made 10-15% already this year, are you going to go double or quits?  The chances are there will not be 10-15% equity gains in every quarter this year.

With the ECB’s second cheap money flood in three months coursing through European banks and financial markets and the possibility at least of a further interest rate cut in offing, the relief in Europe’s austerity-wracked periphery is palpable. But what of the impact on the relatively buoyant “core” in Germany, the bloc’s largest economy and super-competitive export engine? Darren Williams at money managers Alliance Bernstein reckons  German inflation is being cooked up by this super-easy ECB money, coming as it does against a backdrop of  relatively brisk German credit growth and house price inflation there of some 5.5% last year which is “positively explosive by German standards”.

This is the flipside of pre-crisis euro zone problem with “one-size-fits-all” monetary policy. Before 2007,  sluggish  German growth meant ECB policy was kept far too loose for the faster-growing  peripheral economies who then generated credit and inflation-fueled booms that boosted real-estate prices, private and public sector debts and eroded competitiveness.  Now, monetary policy appropriate to a euro-wide slowdown fueled by the hobbled periphery looks far too too loose for Germany.

However, Williams posits that if Germany can tolerate an effront to its anti-inflation psyche then this move could help rebalance skewed intra-euro current accounts by boosting German domestic demand for the exports of its troubled euro neighbours while curbing the super-competiveness of German exports flooding other euro economies and undermining producers there. That’s not the way many in Germany want the rebalancing to happen clearly. But even the most ardent hawks in Berlin probably now acknowledge that endless austerity and economic contraction in its nearest neighbours or the sort of financial implosion likely from a euro collapse would not be in Germany’s best interests either. So, a little compromise perhaps.

Euro breakup risks, although subsiding, are still high on investor minds.

Almost one in two fund managers surveyed by Bank of America Merrill Lynch last month said they expect a euro zone country to leave the monetary union.

Technology services company SunGard, which has modelled different euro breakup scenarios, says the departure of Greece and Portugal will lead to a 15 percent rise in the euro against the dollar, a 20 percent fall in euro zone yields, a 15 percent fall in euro zone equities and a 20 percent increase in credit spreads.

Below are other findings:

If all PIIGS left the euro, the single currency would rise 25% and regional equities would fall 20%. U.S. stocks would drop 15 percent. European banking stocks would fall by 25% and ITRAXX Financials credit spreads would increase by 100%, which would imply losses of up to 20% in high-grade corporate debt. VIX would be over 50. A total collapse scenario would see European equities down 40%, U.S. and global equities down 30%, euro yields down 75% and ITRAXX Europe and ITRAXX Financials credit spreads up 150% and 200%respectively. Oil would fall across the scenarios, ranging from 5% from a Greece departure through to a 50% decline from a complete breakup. Sterling would strengthen against the Euro by between 5-25% across the scenarios.

The results seek to model the impact of each scenario over three months, looking eight weeks before and six weeks after the shock to form a balanced picture.

Just one look at the whoosh higher in global markets in January and you’d be forgiven smug faith in the hoary old market adage of “Don’t fight the Fed” — or to update the phrase less pithily for the modern, globalised marketplace: “Don’t fight the world’s central banks”. (or “Don’t Battle the Banks”, maybe?)

In tandem with this month’s Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that’s a lot of additional central bank support behind the market rebound.  So is betting against this firepower a mug’s game? Well, some investors caution against the chance that the Banks are firing duds.

According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What’s more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.

Currency speculators boosted bets against the euro to a record high in the latest week of data (to end December 27) and built up the biggest long dollar position since mid-2010, according to the Commodity Futures Trading Commission. Here -- courtesy of Reuters' graphics whiz Scott Barber, is what happens to the euro when shorts build up:



This week’s evaporation of confidence in the euro zone’s biggest government debt market — Italy’s 1.6 trillion euros of bonds and bills and the world’s third biggest — has opened a Pandora’s Box that may now force  investors to consider the possibility of a mega sovereign debt default or writedown and, or maybe as a result of,  a euro zone collapse.

Given the dynamics and politics of the euro zone, this is a chicken-or-egg situation where it’s not clear which would necessarily come first. Greece has already shown it’s possible for a “voluntary” creditor writedown of  the country’s debts to the tune of 50 percent without — immediately at least — a euro exit. On the other hand, leaving the euro and absorbing a maxi devaluation of a newly-minted domestic currency would instantly render most country’s euro-denominated debts unpayable in full.

But if a mega government default is now a realistic risk, the numbers on the “ifs” and “buts” are being being crunched.

One of the more bizarre aspects of the euro zone crisis is that the currency in question -- the euro -- has actually not had that bad a year, certainly against the dollar. Even with Greece on the brink and Italy sending ripples of fear across financial markets, the single currency is still up  1.4 percent against the greenback for the year to date.

There are lots of reasons for this. The dollar is subject to its country's own debt crisis, negligible interest rates and various forms of quantitative easing money printing -- all of which weaken FX demand. There is also some evidence that euro investors are bring their money home, as the super-low yields on 10-year German bonds attest.

Finally -- and this is a bit of a stretch -- some investors reckon that if a hard core euro emerges from the current debacle, it could be a buy. Thanos Papasavvas, head of currency management at Investec Asset Management, says:

No longer an idle “what if” game, investors are actively debating the chance of a breakup of the euro as a creditor strike  in the zone’s largest government bond market sends  Italian debt yields into the stratosphere — or at least beyond the circa 7% levels where government funding is seen as sustainable over time.  Emergency funding for Italy, along the lines of bailouts for Greece, Ireland and Portugal over the past two years, may now be needed but no one’s sure there’s enough money available — in large part due to Germany’s refusal to contemplate either a bigger bailout fund or open-ended debt purchases from the European Central Bank as a lender of last resort.

So, if Germany doesn’t move significantly on any of those issues (or at least not without protracted, soul-searching domestic debates and/or tortuous EU Treaty changes), creditor strikes can reasonably be expected to spread elsewhere in the zone until some clarity is restored. The fog surrounding the functioning and makeup of the EFSF rescue fund and now Italian and Greek elections early next year  — not to mention the precise role of the ECB in all this going forward — just thickens. Why invest/lend to these countries now with all those imponderables.

Where it all pans out is now anyone’s guess, but an eventual collapse of the single currency can’t be ruled out now as at least one possible if not likely outcome. The global consequences, according to many economists, are almost incalculable. HSBC, for example, said in September that a euro break-up would lead to a shocking global depression.