Harbour commentary: Europe: A Step Back from the Brink

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Harbour Asset Management looks at the fixed interest market and recent events which investors need to focus on.

Tuesday, July 10th 2012, 2:35PM

Key points

• Europe took a step back from the brink, with a market-friendly Greek election result, a rescue package for the Spanish banking sector, and an EU Summit that exceeded market expectations.

• Closer to home, stronger than expected NZ Q1 GDP was a welcome surprise, supporting our view that the NZ economy has reasonable momentum.

• However, global fixed interest markets remain rightly fixated on the economic and political challenges in Europe, and in this environment, local measures of consumers and business confidence have become more cautious.
• While a near-term European disaster has been averted for now, it remains an environment where the RBNZ is in no hurry to raise interest rates.

At the end of May, Europe felt like it was on the brink of collapse yet again.   Equity markets and commodity prices were falling sharply.  Global bond yields in core countries were at record lows, with the German 10 year bond yield touching 1.25%.   The market was pricing in a 50 basis point interest rate cut from the RBNZ in response to an anticipated disaster in Europe.  And credit and funding markets looked very vulnerable to freezing up as they had done in late 2011.

From this very precarious state, during June Europe moved half a step back from the brink.    First policymakers showed an effort to be pre-emptive by surprising the market with a $100bn rescue package for Spanish banks.  Then the much-feared Greek elections passed without major incident - New Democracy gained enough seats to lead a coalition that would not reject outright the existing Greek bailout package or threaten an immediate messy euro exit.  Finally, at the end of the month, European policymakers surprised a skeptical market with a wide ranging package of measures.  These measures were collectively aimed at breaking the link between weak banks and weak sovereigns, and flavored policies for growth over policies for more austerity.

Closer to home, Q1 GDP in both New Zealand and Australia were much stronger than expected, proving there is still reasonable economic momentum in this part of the world.  The NZ GDP number in particular was a welcome surprise, and supported our view that the New Zealand economy does have reasonable momentum.   However, looking forward, businesses and consumers still look relatively cautious, with confidence indicators softening in response to risks from Europe and moderating commodity prices.   

A challenging landscape in Europe

It is certainly true that Europe still faces enormous challenges going forward. 

While European leaders surprised markets with a more comprehensive set of policies than expected from the EU Summit, this will need to be quickly followed up with policy details and concrete timetables.   The latest round of negotiations has also strained political relationships, with Germany increasingly isolated from the main European countries, and their disagreements becoming increasingly public.

Despite the market positive election result, Greece itself still looks fragile.   Both the new Prime Minister and Minister of Finance were hospitalised soon after the election result.  While the coalition partners of New Democracy and Pasok are both moderate parties on the political spectrum, they are unusual partners, raising the chance that the alliance is short lived.  And all the while, the radical Syriza party waits in the wings, buoyed by a stellar rise in electoral support and ongoing social discontent.

An extension of ‘Twist' by the Federal Reserve

While the situation isn't nearly so dramatic and theatrical on the other side of the Atlantic, the US still face its own challenges.   Economic data in the US continued to surprise on the downside in June, following a now familiar pattern from 2010 and 2011 of the economy showing signs of recovery in the first quarter only to run out of steam mid-year (Chart 1). 

But the slowdown in the US hasn't been sharp enough to prompt the US Federal Reserve to announce a further round of quantitative easing (so-called QE3) to pump out more cash to kickstart the economy.   Instead, the US Federal Reserve announced an extension to the end of the year of its so-called Operation Twist (buying long-dated US Treasuries funded by sales of short-dated US Treasuries).   With markets hoping for an injection of stimulus, this half-way measure was greeted with some disappointment.  In our view, if the Federal Reserve did see the need for further dramatic action to support the economy, they are more likely to return to policies first launched in 2008 to directly support credit markets and the mortgage-backed securities market.   

Global factors remain the key drivers for the RBNZ

Just days before the Greek election, the RBNZ released its June Monetary Policy Statement.    Over the past 18 months, these statements have covered distinct themes through time, from the Canterbury earthquake in early 2011 to worries about the high levels of the dollar in early 2012.  While they kept the Official Cash Rate (OCR) unchanged at 2.50% and their central forecast was for the OCR to rise over time, it was clear that risks from Europe consumed their thoughts (Chart 2).  

Although the RBNZ did not set out an alternative set of forecasts where everything turned sour in Europe, they make it plan that they understood that in fragile market conditions it made sense for the market to place some probability on the need for an emergency cut. 

While in May we considered the market pricing a 100% probability of a 50 basis point cut excessive, in the current environment we think it remains fair for the market to continue pricing a very small chance of a cut (Chart 3). 

Resilient credit markets

Corporate bond markets, both in New Zealand and overseas, have continued to be surprisingly resilient.   If anything, there has remained a disconnect between the rates market and the credit market, although not as dramatic as in May.

Indeed, in New Zealand credit spreads narrowed for many bonds over the course of June, with the NZ Local Government Funding Authority (LGFA) being the strongest performer.  We continue to favour a relatively cautious approach to corporate bonds in the current environment, with a preference for non-financials for their safety and short-dated financials for the relatively attractive risk reward compared to long-dated exposures.

Market outlook

Last month we highlighted that 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.   

In June, both of those forces eased a touch.   The news from Europe became more balanced as they took a step back from the brink, and there was a release of tension in markets that saw interest rates in safe havens like New Zealand rise from their record lows. 

In our view, the medium-to-long-term outlook for interest rates remains asymmetric, with more chance that they will eventually rise from these low levels.  However, we think that while Europe faces such significant economic and political challenges any marked rise in interest rates is likely to remain capped for now.  In the meantime, the market is likely to ebb and flow with news from Europe and the associated bouts of optimism and pessimism.  

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 funds managed by Harbour Asset Management Limited.

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