Harbour commentary: Deja Vu: Europe on the Brink Again
· The European sovereign crisis has moved into a new phase, with a sharp economic deterioration, heightened political uncertainty, and policy paralysis.
Wednesday, June 6th 2012, 12:19PM
· Concerns about Spain are on a different scale to Greece. Spain is too big to let fail, but it could also be too big to be saved.
· Fixed interest markets are left coping with two very strongly opposing forces: extremely negative news flow out of Europe versus market prices that are already factoring in extremely bad European scenarios.
· The strong flight to safety has driven US and German government bonds to all-time expensive levels.
· We can understand the appeal of NZ government bonds in this environment. Despite yields being at all-time lows, to global investors New Zealand government bonds provide stability and comparatively high yield.
· We do not expect the Reserve Bank of New Zealand to cut its Official Cash Rate (OCR) unless there is a major accident in Europe that seizes up funding markets. Market pricing reflects the small chance of a large cut in 2012.
· Corporate bond markets have been surprisingly resilient throughout, and we see this as a reason to remain cautious in this market until Europe settles.
The global backdrop deteriorates
Through October and November 2011, market commentaries were littered with titles like "Europe on the Brink" or "Holes in the Lifeboat". The problems were well understood: high government debts levels, under capitalised banks, low productivity, nervous investors, public unrest, and a monetary and fiscal system not well designed to address the deep-seated problems of the region. Europe was faced with a choice of breaking apart or binding each other closer together.
The actions of the European Central Bank (ECB) at the end of the year provided some well needed breathing space. With politicians finally taking the situation seriously, the ECB provided support by injecting unlimited 3 year liquidity to the European banking system through its long-term repurchase operation (LTROs). This enabled markets to settle and gave the politicians some time to implement reforms. And, it was a strategy that was working while there was a reasonably positive backdrop outside Europe, with US economic data pointing to a long awaited recovery and China still looking robust.
Even the most skeptical commentators have been surprised at how fast the situation has unraveled. The relative calm of January and February was a distant memory, even before the ink was dry on the agreement to restructure Greek government debt in March. First, the global backdrop deteriorated, with economic data in US, Europe, China and Australia all starting to surprise on the downside through March, April and May (Chart 1). Then the political backdrop become more uncertain, with a new socialist president in France, and the rapid rise of radical politicians on both sides of the political spectrum in Greece. But worst of all, Spain became a focal point for the market, given its languishing economy, weak domestic banking system, and clumsy attempt to rescue one of its largest banks, Bankia. Spain is in a completely different league to Greece: is too big to let fail, but possibly too big to save.
There are very few pieces of good news to take out of developments in Europe. One of the few comforting things is that bank funding markets remain open so far, unlike the end of last year when they were closed for months. The other is that the agenda of politicians has shifted from a blind focus on "austerity" as the solution to Europe's problem (the German line), to an increasing focus on "jobs and growth" (the French and US line). That said, it is ultimately Germany that has the financial strength and resources in Europe, and there is currently little sign of a willingness for them to compromise.
Our central view is that Greece will remain in the euro, and that politicians and policymakers in Europe will eventually be resourceful enough take policy measures that restore the confidence of markets - regardless of the economic reasons for them to cut their losses, they have invested too much into the European project over the past 60 years to give in without a fight. But for now, the politicians haven't felt the electoral support and sense of urgency needed to grip the situation and take a decisive step. And, as markets learnt from the collapse of Lehman Brothers, there is always the chance of an accident - despite their best intensions, there is always that outside chance that politicians and policymakers just run out of time and cut it too fine.
In the meantime, in our view markets are left coping with two very strongly opposing forces: extremely negative news flow out of Europe versus market prices that are already extremely stretched and factoring in extremely bad scenarios for Europe.
The table below illustrates this by setting out market prices at the height of concern during 2011 Q4, against their most buoyant of Q1 2012, and now at the end of May 201. US 10 year bonds yields at 1.6% are the most expensive of all-time according to US Federal Reserve models. The record low yields in the US and Germany can only be justified on a valuation basis if investors believe we are facing a decade of low growth and deflation. Rather, the real driver has been a strong preference for ‘safe assets' - investors have been willing to hold expensive bonds, given the fear they will become even more expensive as the European crisis unfolds.
Table 1: Key market indicators - stress versus calm
|
|
Market price |
Q4 2011 Most stressed |
Q1 2012 Calmest |
End May 2012 Now |
|
Core bonds |
10 year German Bunds |
1.65% |
2.05% |
1.25% |
|
|
10 year US Treasuries |
1.75% |
2.40% |
1.60% |
|
Periphery bonds |
10 year Italian |
7.50% |
4.80% |
5.90% |
|
|
10 year Spanish |
6.70% |
4.80% |
6.60% |
|
Downunder bonds |
10 year Australian |
3.75% |
4.35% |
2.90% |
|
|
10 year New Zealand |
3.75% |
4.30% |
3.40% |
|
Equities |
US S&P 500 Index |
1075 |
1420 |
1315 |
|
Foreign exchange |
NZ dollar |
0.7395 |
0.8470 |
0.7550 |
|
Credit |
Australian iTraxx Index |
240 bps |
130 bps |
200 bps |
NZ fixed interest and monetary policy
With this backdrop there has been unrelenting global demand for NZ and Australian government bonds.
We can understand the appeal of NZ government bonds, in a world of increasingly fewer safe havens. To global investors scanning the world for attractive countries providing stability and comparative yield, Australian and New Zealand stand out for their strong rule of law, sound policy frameworks, low levels of government debt, and government committed to budget surpluses. Investors have rushed into the Australian government bonds market first, given its deeper liquidity and even better fiscal position. In our view, 10 year NZ government bonds look increasingly attractive versus Australian equivalents, given the extra 50 basis points yield and prospect that the NZ cash rate at 2.50% is still significantly below the Australian cash rate at 3.75%.
As the situation in Europe has deteriorated, the market has moved from expecting the RBNZ to hike the Official Cash Rate (OCR) in early 2013, to pricing in the chance that interest rates are cut during 2012. This contrasts with the view of economists, who almost unanimously expect the OCR to remain unchanged through 2012.
Indeed, during May, the Overnight Index Swaps (OIS) market was pricing the OCR to fall as low at 2.00% by September. Global investors in particular have seen the scope for the RBA to cut interest rates from 3.75% and have drawn the conclusion (rational or otherwise) that the RBNZ will flow suit. Rather than a central estimate of the market's expectation, we interpret this market rate as a product of three factors:
i. a large probability that the OCR remains unchanged
ii. a small probability that the RBNZ needs to cut aggressively
iii. a risk premium (reflecting that given the uncertainties investors were unwilling to stand in the way of the OIS market pricing cuts).
In our view, the RBNZ would be need to see a major accident in Europe and banking funding markets seizing up to elicit an emergency response. Since their last OCR review, the RBNZ will be very comfortable that the currency has fallen sharply and fixed mortgage rates have been cut, both effectively loosening overall monetary policy and supporting the economy. They will be watching developments in Europe extremely closely, as well as the prospects for commodity prices given their sharp correction from recent highs. But without a strong reason to cut the OCR, the RBNZ will be hesitant to take that approach, knowing that there is very strong domestic demand somewhere down the pipeline from the Christchurch rebuild and the Auckland housing shortage. Indeed, looking at the domestic consideration alone, the argument would be for a tightening bias.
NZ and Australian credit markets
Corporate bond markets, both in New Zealand and overseas, have been surprisingly resilient during the heightened concern about Europe and volatility in other markets. If anything, there has been a disconnect between the rates market expecting the worst (with cash rates and bond yields at record lows) and the corporate bond market suggesting that things will be okay (with credit spreads little changed).
A common explanation put forward is that there is so much cash in the system that fixed interest investors feel they need to put it to work somewhere, and this has created strong demand for corporate bonds, especially for short-dated corporate bonds (with shorter exposure to the issuer) from non-financial issuers (many of which are looking stronger than sovereigns).
An alternative explanation is that corporate bond markets have just been slow to catch up with developments in other markets, and if Europe remains under stress then credit spreads will inevitably move wider in coming months, particularly when financial issuers return to the primary market in large volume. One of the fastest credit markets in this part of the world to respond to news is the Australian iTraxx index, which is an index of the 25 most liquid Australian credits.
Over 2011, the Australian iTraxx index has responded quickly to developments in Europe, and the NZD corporate credit market finally adjusted in late 2011. The Australian iTraxx has approached stressed levels once again in May 2012, and this is one factor that is encouraging us to take a cautious approach to our holdings of corporate bonds. While our central view is that the Europeans are resourceful and muddle through yet again, there is a risk that slow moving credit markets will catch up with the worst-case scenario being priced in the rates market, or that events will catch up with both markets.
In our view, the truth is probably somewhere in between, with the iTraxx and corporate bond market likely to meet somewhere in the middle. The iTraxx is at high levels in part because it overreacts to news, as it is the only liquid credit hedging instrument for investors to use. By contrast, corporate bond spreads may drift wider to meet the iTraxx, but are still partly isolated from sovereign risks, especially those non-financial corporate with strong balance sheets.
Market outlook
While European issues remain unresolved, investor concerns, political uncertainties, and weaker economic growth all reinforce the demand for safe haven asset, despite their unattractive long-term return prospects. While flight-to-safety is alive and well, we are mindful that markets can be fickle and that the pressure on markets and politicians could force a full-scale policy response that triggers a reversal of the recent market trend. The ‘risk-on, risk-off' cliché is likely to be with us for some time yet.
Christian Hawkesby,
Director, Head of Fixed Income
Harbour Asset Management
IMPORTANT NOTICE AND DISCLAIMER
The New Zealand Fixed Income Commentary is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that any such contents constitute advice, they do not take into account any person's particular financial situation or goals, and accordingly, do not constitute personalised financial advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any person.. The bond market is volatile. The price, value and income derived from investments may fluctuate in that values can go down as well as up and investors may get back less than originally invested. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. Actual performance of investments managed by Harbour Asset Management Limited will be affected by management charges. No person guarantees the performance of f
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