01 July 2018
Recent events in Italy have highlighted again that while the government bonds of Portugal, Italy, Greece, and Spain, (the ‘European periphery’) have historically provided a source of opportunity for global bond investors in the form of higher yields compared to their European counterparts, France and Germany, the trade-off has been higher volatility.
This note looks back on the journeys of these bond markets since 1999, and provides insight into the current environment for global bond investors looking at the European periphery for opportunities.
A history lesson in bond spreads
As Europe’s economy harmonised with the introduction of the single currency framework, the yields between these periphery bonds and those of Germany began to converge. The yield differential is known as the ‘spread’, and its history can be seen in Chart 1.
This spread essentially gauges the tension or prosperity in the eyes of investors of the periphery over time. It took about 10 years after the 2007/2008 global financial crisis for the spread to meaningfully widen. This widening accelerated as the European debt crisis of 2011/2012 unfolded, causing panic amongst investors over the sustainability of Greek debt and the European Monetary Union in its current form should Greece leave.
Chart 1: 10 year periphery bond spreads to German bonds
In an attempt to alleviate these fears, the European Central Bank (ECB) cut policy rates and told investors it would do whatever it took to preserve the stability of the European Monetary Union. In 2015 the central bank embarked on a Quantitative Easing (QE) program, purchasing European bonds in significant amounts to provide liquidity to the economy via the banking system. This saw the ECB’s balance sheet increase by 130 per cent to EUR4.6 trillion - and it continues to grow today under this program, forecast out to the end of 2018.
Chart 2: ECB Monetary policy
Key themes to consider
There are a number of key themes we monitor when looking at periphery bond markets for investment opportunities.
Monetary policy - We would like to see the ECB maintain accommodative monetary policy, and continue to foster growth in the Euro area. While QE is likely to come to an end, the ECB should continue to purchase a large amount of bonds from the cash it receives from the maturity of existing purchases. It would also be unwise for the ECB to tighten policy further via raising interest rates too soon.
Economic health - The health of the European economy is of primary importance. The European debt crisis caused a recession in Europe over 2012, hitting periphery economies quite hard as shown in Chart 3, and causing spreads to widen. These economies spent two and half years in recession before extremely loose monetary policy fostered a period of economic recovery. Positive growth is considered vital for these government efforts to improve their fiscal situations, as the stronger the growth the greater the revenue and their ability to service their debt. It is important as the strength and breadth of economic growth across Europe continues.
Chart 3: European GDP
Fiscal positions - Fiscal recklessness was also behind the volatility of 2011/2012, and governments must continue to improve their fiscal positions in order to maintain the trust of investors. For the most part, these countries have, in response to investor pressure, undergone economic rebalancing and fiscal reform in attempt to better balance budgets with the aim of reducing their debt burden. Chart 4 shows the improvements to budget deficits these countries have made over the past few years; deficits have more than halved in most countries since 2015 and are projected to be below two per cent by the end of next year. The improvements have come predominantly via spending cuts and through business and labour market reform which are beginning to see workers return to employment, boosting tax revenues. Declining interest costs as a result of lower yields have also contributed to much improved government balance sheets.
Ratings agencies are also keenly focused on government fiscal plans with periphery countries enjoying ratings upgrades over the past few years. While upgrades can lead to a lowering of government borrowing costs, deviations and missed targets leading to downgrades can create volatility and increased borrowing costs.
Italy and contagion risk – Deviations and missed targets of lower government borrowing is largely where the recent concerns over Italy are centered. The new Italian coalition government composed of populist leaders may introduce changes to taxation and spending which could materially move their budget deficit away from estimates for 2019 and beyond. This may lead to ratings downgrades and lower investor confidence that Italy are serious about reducing their debt levels.
While contagion fears may have short term implications for periphery bonds as a sector, over the medium-term investors are likely to differentiate between those that are attempting to reduce debt, and those that are not. For example, Spain and to a lesser extent Portugal have showed their commitment at attempting to reduce their debt.
Chart 4: European periphery budget balance as percentage of GDP
The European periphery bond markets generally perform better when:
- the European economic environment is growing, and is fundamentally stable, and
- governments are attempting to improve their fiscal positions through reform.
The above is currently apparent but uncertainties around ECB policy and the contagion fears from the Italian situation mean risks are real and should not be underestimated.