and Fixed Income Outlook
December 11, 2012
The European Central Bank (ECB) has seemingly thrown the kitchen sink at the problems it has encountered. Do you think the downside “fat tail” risk has largely been taken off the table?
There were two key announcements in Europe that have taken the fat tail risk out of play. The first was the Long-Term Refinancing Operation (LTRO), which took the systemic banking crisis off the table. The second was the ECB saying that it would not tolerate too high of a convertibility premium in the periphery. It didn’t want the monetary transmission to be blocked to the periphery. That’s how the ECB came up with the Outright Monetary Transactions (OMT). It has removed, to a certain degree, the risk of convertibility, such as Portugal and others leaving.
Now, you look at Portugal-type names, and let’s say maybe the embedded convertibility risk gets taken out and they start trading more in terms of a spread to core names – then Spain, Italy, and Portugal start to look attractive, and that’s what has happened from where we were in July. Spreads have ratcheted down enormously. We’ve been long Spain and Portugal plus the investment-grade corporates. So, we captured all of that, and there’s more to come.
The next thing that could come is a triggering of the OMT, but our underlying premise is that the eurozone will stick together. It’s more of a range trade. We think the convergence trade theme will continue with peripheral yields coming down and the core names selling off as the flight-to-quality bid fades.
Michael Pettis’ commentaries are among my favorite to read. He recently remarked that, “For now, Spain has implicitly chosen the option of unemployment, in the hopes that it will be able to adjust in one or two years and eventually resume normalcy. No country, after all, can bear the pain that Spain is bearing today without a serious deterioration in the social and political fabric. If Spain wants to continue along its current path, it must be prepared to suffer at least another five years of extraordinarily high unemployment, an erosion of the productive capabilities of its economy, and rising political chaos. Or it can leave the euro. Given how rapidly the political environment is deteriorating, I have little doubt it will leave the euro. Unfortunately we will have to wait a few more years for Madrid to drive the economy into the ground and to rip apart the country’s social fabric before they choose to devalue. But I fully expect they eventually will.” Do you agree with his assessment of the options?
I agree with what he’s saying. The policy decision of austerity is the wrong one for Spain, or anyone else in the periphery for that matter. Spain is facing a balance sheet crisis, and the last thing you need when the private sector is deleveraging is for the public sector to deleverage too. That is a policy mistake, and that’s becoming well understood now. The complexity comes from the political situation, where the core doesn’t want to throw good money after bad.
Germany has kept the pressure on these countries, not austerity for austerity’s sake but, rather, to make big structural changes and fiscal reform, moving toward fiscal centralization. They are trying to get countries to give up their sovereignty over their fiscal policy, which is a big leap for them to make, and broad labor-market reforms. That’s what Germany is really after; they are keeping pressure on these countries so they are forced to make the hard decisions.
It feels like some progress is being made, but, in my opinion, it will get worse politically and socially before it gets better.
Slowly but surely these policies are being enacted. They are playing a delicate game, and they need to be careful what they say politically. Pettis is right that it’s a dangerous game to play, as there’s a certain amount of hubris in saying you can do this without causing a crisis. But the lynchpin is the ECB.
The ECB, through its OMT, can keep the market from getting too unhinged to the downside and setting off a crisis. The funny thing about the OMT program is that it has worked well. Looking at Spain’s yields, they’ve come down without ever having to trigger the OMT, and the OMT has reduced borrowing costs. It has allowed Spain to not ask for the OMT. It’s a bizarre situation, but if push comes to shove, Spain will come back to the ECB and agree to the core government requirements. There may be some tests along the way, and it’ll go on for years, but eventually, the north will have some control over the budgets of the south.
Eventually, the current-account-deficit situation in the south will need to be repaired for true healing to occur.
We are already starting to see big changes in current account deficits. I think Portugal has a current account surplus at this point. That’s not because it is becoming competitive on its exports, like Ireland is, which is the poster child for positive reform. Portugal has a current account surplus, a knowledgeable workforce, and low tax rates. The other countries don’t have that; the way Portugal’s surplus happened was a collapse in its imports, and that’s not necessarily a good thing. But that does build the adjustment in. It will be painful, and the risk is that it can lead to social unrest.
You’ve said that your base case is for the eurozone to stick together, but how, if at all, should investors go about hedging tail risk?
A lot of it is trying to figure out how many of these macro risks are priced into the market. You don’t want to be hedged paying for insurance when the risk is already out there in the market. This time last year, the risks seemed high, but you were already being paid for it.
We are in a transition market right now. The global economies are deleveraging. The private sector debt has ended up on the balance sheets of the public sector. The public sector’s fiscal budgets are tapped out, and they are being forced, in the best case, to be non-stimulative and, in the worst case, to undergo some austerity. A weak private sector and a public sector with handcuffs on it mean that the underpinning impulse of the economy is very disinflationary. In Europe, you have the possibility of deflation in some places. The only reflation game in town is through the central banks, and they are doing their best to keep it going.
The way out is through reflation and debt monetization. Historically, they get solved through inflation down the road, as debt as a percentage of nominal GDP gets eroded or monetized away.
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