Download Market Eye • Fears over the eurozone resurface as Spanish bond

Monday 1 October 2012
Market Eye
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Fears over the eurozone resurface as Spanish bond yields hit 6%
Investors switch from ‘risk-on’ to ‘risk-off’ mode in response
After basking in the afterglow of more QE from the US Federal Reserve and the European Central Bank’s
(ECB) Outright Monetary Transactions, the world’s financial markets’ respite from worries over the
eurozone and global growth proved, once again, to be short-lived. Last week became a turning point, with
investors once again fretting over the euro, China’s slowdown and frustratingly snail-like growth from the
US, exacerbated by the fast-approaching ‘fiscal cliff’. In what has now become a familiar pattern, investors
switched from ‘risk-on’ to ‘risk-off’ mode, which means selling risky assets such as equities and buying
quality bonds, together with the yen. Unsurprisingly, global equity markets mostly went into reverse, led by
Paris which endured its worst week for some time, falling almost 5%. Wall Street, London and Tokyo
followed, with their respective lead indices retreating 2–3% as investors became more cautious. In contrast,
Shanghai led the way up for the emerging markets as investors stepped in to pick up some bargains following
the recent sell-off. The change of investors’ mood has been swift and it’s worth reflecting on why this may
have happened.
Yet more pain in Spain
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Spain’s austerity budget fails to reassure the markets
Markets expect Spain’s prime minister to formally ask the EU for a bailout package
Attention turned to Spain with a vengeance last week: firstly because it was hard to ignore the violent antiausterity protests that erupted in Madrid on the eve of the unveiling of the country’s 2013 budget. Second
was the warning from the eurozone’s northern states – Germany, Netherlands and Finland – that they were
not prepared to carry on paying for their more profligate members’ bad ways. Specifically, they stated that
plans to move bad bank assets (such as our own Northern Rock’s lending portfolio) off government books
would not apply to any “legacy assets”. This effectively dashed Spain and Ireland’s hopes of being freed of
billions of euros of debt incurred in bailing out their banks. Both euro members have seen their economies
devastated by the effects of the bursting of speculative property bubbles. As a direct consequence, the yields
on Spain’s government bonds started rising once more as investors’ aversion to risk increased. Spain’s 10year benchmark bond briefly rose above the 6% level for the first time since the ECB announced its bondbuying plan last month. Higher borrowing costs increase the pressure on any government’s finances and
Spain is already struggling to cut costs.
The honeymoon period for Spain is clearly nearing an end, and this makes it almost certain that the
country’s prime minister, Mariano Rajoy, will formally ask the ECB to intervene and unleash its unlimited
bond-buying programme, thus driving down Spanish bond yields and reducing the cost of borrowing. But
Mr Rajoy finds himself in a difficult predicament because any request for help would be seen as a humiliation
and, with regional elections due later this month, his party would potentially feel the full wrath of voters.
Pressure is also building internally with Catalonia, Spain’s largest region, calling for greater autonomy or
possibly outright independence; none of which creates any reassurance for investors. There is also a growing
view that Mr Rajoy – for these obvious reasons – has been playing ‘a game of chicken’ with the markets; on
the basis that, with the ECB’s announcement calming investors’ concerns, Spanish bond yields fell, lessening
the need for him to ask for help.
Not that Spain hasn’t demonstrated a willingness to endure some pain. Its austerity budget promised €13
billion of spending cuts and higher taxes; an independent review of its weakened banking sector concluded
they needed €59 billion of new capital. And on the economic front, figures showed that it recorded a
current account surplus in July. Unfortunately, a closer look showed that Mr Rajoy was perhaps a little
optimistic with a forecast of a mild recession – just a 0.5% contraction – next year, as an independent
survey by Bloomberg reckons the economy will shrink by 1.25%. So where does this leave Spain? The
markets are convinced that however unpalatable it may be for Mr Rajoy to officially ask for help and accept
any EU terms and conditions imposed on his country, there is no alternative. This week ratings agency
Moody’s is due to announce a review of its sovereign credit rating that could possibly see it reduce Spain’s
status to ‘junk’; which would put its bond market under enormous strain. The risk of moral hazard is
undeniably high; and based on past experience, it is likely that if Mr Rajoy does not cry for help then the
markets will deal with the matter itself, which is likely to hurt a lot more.
Decision time for America
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Impending ‘fiscal cliff’ dampens investors’ mood on Wall Street
“The US fiscal cliff is looming as the biggest ‘known unknown’ facing the markets.”
Gustavo Reis, Bank of America Merrill Lynch
It is not just the decision about the new president that Americans need to make but also the impending one
about how to deal with a swathe of tax cuts that are due to expire together with government cutbacks that
are due to kick in at the turn of the year. This is the so-called ‘fiscal cliff’ that potentially threatens the US
economy. Of course, the outcome of the presidential elections will have an impact, but it is unlikely that
whoever wins will also have control of both the House of Representatives and Congress. To date neither
Republicans nor Democrats have, for clear reasons, been willing to discuss policies to avert the preprogrammed changes which would result in an estimated $800 billion fiscal contraction, equivalent to the
economy shrinking by 3.8%. The US economy is the world’s largest and currently struggling to maintain
growth of 2% this year so any shrinkage of this magnitude would cause recession.
So the pressure for Congress to agree a deal is mounting but, fortunately, the permutations of a deal are
extensive as the cuts range across all government spending plus the tax changes impact on payrolls,
dividends, income and capital gains taxes. It is the view of many economists that Congress has no choice but
to act: certainly the financial markets seem to be taking a sanguine view, with Wall Street registering
double-digit gains so far this year coupled with record dividend increases. Not that all is well: last week, US
August durable goods orders dropped 13.2%, the largest fall since 2009, while the Chicago purchasing
managers’ index contracted for the first time in three years. But many investors believe that the US Federal
Reserve’s recent decision to pump an extra $40 billion per month into the economy via its QE programme
will continue to help the economy both avoid recession and continue growing.
More growth, please
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Global economy slows as austerity cuts bite
Global policymakers including the US Federal Reserve, ECB, Bank of Japan and China announce
stimulus measures
New era of lower growth does not necessarily mean lower investment returns
After three years of reasonable growth in the global economy, albeit unevenly distributed, there are growing
signs that the world may be suffering a relapse, or that growth is not as robust as it should be. Despite the
problems of the eurozone weighing on confidence the global economy is still, according to recent
International Monetary Fund forecasts, likely to grow around 3%. The problem is, as mentioned, that we
are not all benefiting equally. The US is growing but below trend rate; the UK economy is flat but
improving; China is slowing but by Western standards still racing along at around 7.5%; and even parts of
the eurozone have been remarkably robust. However, some economists still have doubts about the ability of
global policymakers to hit the accelerator. Last week there were signs that even powerhouses like Germany
may be slowing. The Ifo Institute’s closely watched index of German business confidence declined for a fifth
successive month in September to its lowest level since early 2010, reflecting scepticism amongst German
companies that EU leaders have the ability to resolve the debt crisis. The fragility of the global economy has
certainly been the catalyst amongst policymakers and central banks, in the words of ECB president Mario
Draghi, to “do whatever it takes” to restore economic growth. The ECB’s response was to announce its
Outright Monetary Transactions programme to buy bonds, whilst the US Fed and Bank of Japan both
announced further rounds of QE.
There is no doubt that many countries are feeling the draught from the eurozone’s problems; the world’s
second-largest trading region is so important to the likes of China whose own economy is flagging.
However, as previously discussed, China has taken significant steps to boost its economy and it is inevitable
that there will be a trail of data showing slowing growth – such as today – before the numbers start to
improve once more. It is true to say that many feel that austerity in Europe is backfiring with budget cuts
harming the economy, thus reducing tax revenues and causing businesses to put expansion and investment
plans on hold. The view that the apparent ‘low-growth, high-debt’ trap can only be avoided if more growth
is generated has obvious attractions; and, here in the UK, we have seen numerous policies designed to
encourage borrowing and increase investment, and hopefully stimulate job growth.
The reality is that the global economy is adjusting to a slower pace of growth than that experienced in recent
decades but it should not be interpreted that low growth means low investment returns. As said, this year
many equity indices are registering double-digit returns. For example, the S&P 500 is up around 15%; here,
the index of our top 250 companies is up a similar amount; and in Europe, its broad-based index is up over
20%. So, whilst recognising the increased volatility of recent times, even in a low-growth environment it is
possible to still find very attractive high-quality stocks with good valuations and these, as part of a diversified
investment portfolio, can help boost income and capital growth prospects for those investors prepared to be
patient.
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