As Greek default widens to Spanish and Italian contagion, many investors are wondering what will happen now for European Union sovereign debt. A key question is whether the issue can be kicked further down the road.
I would say, no. With the EU debt crisis now incorporating Spain, Italy and Belgium, the proverbial ‘can’ has now got too big to kick any further, so expectations must now rise that a series of new policies will be adopted in the coming week, otherwise the future of the euro and the EU may well be in jeopardy.
Over Friday’s Finance Ministers’ meeting we must see moves to let Greece default as its debt burden is unsustainable. This will likely lead to solvency issues for Greek banks, where refinancing would be required, and for Greek bond owners, including the European Central Bank (ECB), all of whom might now need to participate in the restructuring or re-profiling of the debt.
Also the European Financial Stability Facility’s (EFSF) terms and conditions need to be changed to allow the purchase of existing debt. The EFSF needs to be substantially increased so that there is the clear firepower to ring fence the contagion now at work in markets. This ring fencing must allow for the ongoing refinancing of EU sovereigns to continue, Italy alone needs to borrow circa €70 billion in the next two months.
Future funding requirements need to be clarified and governments held to account by the EU. Many peripheral countries will likely have to run budget surpluses in the future so that their debt levels remain sustainable. The sustainability of this will be both a political, and an economic challenge. Politically the challenge will be that some degree of sovereignty has been lost and economically because, as the UK may reveal today in its ‘Whole of Government Accounts’, the true amount of sovereign debt may be two or three times understated through pension and healthcare obligations.
An EU bond looks inevitable as another step towards unity so the funding risk and market volatility can be removed progressively over time. However, this process may have some interesting investment side effects. Germany’s 10 year bond yields 2.5% as a safe haven, the EFSF issued bonds at circa 4% and the peripherals anywhere from 5.5% to 17%. Thus investors would be complacent in assuming that the new rate post crisis will revert to German levels experienced before the debt crises emerged. Moreover, the EFSF has issued very few bonds so far, so a huge additional supply should lift yields, but by how much?
RCM research estimates that EFSF and EU bond funding should clear at 4.5 % to 5.5% blending all current yields and supply requirements. This might suggest that peripheral bonds are now much better value than German bunds whose yields may rise from 2.5% to 4.5% at worst. Additionally, even Germany would need to run a primary surplus of over 1.5% of gross domestic product (GDP) which would entail yet more austerity across the eurozone.
Bank stress tests will be announced on Friday evening and markets will be unable to react until Monday morning. It seems likely that there will not be a sufficient risk ration for EU sovereigns which, may default and market estimates of capital required to be raised may still be too low. As ever the ‘extend and pretend’ policies of banks globally has failed to give bank managers the incentive to raise enough capital. Indeed after falls of nearly 30%, the cost of raising equity has soared and the ability to raise debt has collapsed.
The Euro has again started to weaken, but remains well above last year’s Greek lows indicating that international investors may see the US and its own political paralysis over its own financing and debt ceiling an even greater concern. It may indeed be possible that a pre-emptive sovereign downgrade occurs next week if the debt ceiling impasse continues as seems likely at the moment.
Further weakness in the Euro should not be discounted. A weaker Euro could allow Portugal, Italy, Greece, Ireland and Spain’s economies to become more competitive and for Germany to gain a greater global market share. Indeed, given the clear trend of world central banks to diversify US dollar investment into the Euro and Gold, the emergence of a United States of Europe may well be the answer and lead to further rapid investment into Europe at America’s expense. Looking to the future, the ECB would then be able to return to its roots of sound money, in the German tradition, which would differentiate itself greatly from the UK and USA where inflation will be the only solution.
What will Monday morning bring? If there is no clear political and financial fix which covers all of the economies, then markets may return to contagion trades and indeed start to strike at the core of the EU. Sovereign debt would be sold off, credit widen and banks and other economic proxies may see shares collapse. Any threat to the EU core should lead to a rapid and huge response or else a collapsing euro, as EU citizens seek the safety of non euro currencies this would exacerbate the funding requirements of the EU banking system and hence the ability to fund their governments.
Many investors and banks own bonds which are now a poor investment. It is time to mark to market and accept that the can has got too big to be kicked any further. The bond bull market and ultra low yields may be over.