Wed, 14 Nov 2012
The European Central Bank has helped soothe short-term sovereign debt worries in Europe, but long-term competiveness must be improved for the crisis to fully fade away, says Morningstar's Dave Sekera.
Jeremy Glaser: For Morningstar, I am Jeremy Glaser. We've had a bit of a quiet period in the European sovereign debt crisis, but is this just the lull before the storm? I'm here with Dave Sekera, Morningstar's corporate bond strategist, to take a look at the crisis.
Dave, thanks for talking with me today.
Dave Sekera: Happy to be here, Jeremy.
Glaser: So, let's talk a little bit about why the headlines seem to have moderated a lot over the last couple months. Is it just because we've been focused so much on the presidential election, or on the so-called U.S. fiscal cliff, or has there been a real softening in the crisis in Europe?
Sekera: Well, I think it's twofold. I think you did get it right that the news media here has definitely been concentrating its time on the elections, and now that the elections are over, looking at the fiscal cliff. And actually in addition to the fiscal cliff, we also have to realize we're going to be coming up on the debt ceiling again pretty soon, and I think that's going to have to get wrapped up into the fiscal cliff negotiations which you haven't seen too much news, so that's something that's going to be on the horizon coming up as well.
Secondly, Mario Draghi, the president of the European Central Bank, had come out a number of months ago, and he had talked about doing whatever the ECB had to do in order to be able to preserve and save the euro, and essentially they created what they called OMT, the Outright Monetary Transaction program. Essentially what that is, is that any country within the EU that needs a bailout essentially, that requests one, if that gets approved by the troika, then he would be willing to go out and buy the sovereign credit or the sovereign bonds of that individual nation in order to support the bond prices and keep yields relatively low.
So, with that out there, we saw Spanish bonds, the yields drop pretty dramatically. I think they are still below 6% right now on the 10-year bonds, and the two-year bonds are well under control as well. So, they've really kind of papered over the problems that we'd seen for the past couple of months. There has definitely been a lot more rumblings as far as what's going on with Greece. As you know, last week Greece did pass some more austerity measures, some more structural reforms, and they needed to get that done as a precondition for the next tranche of bailout financing from the troika; the troika being the European Union, the International Monetary Fund, and the ECB. So now they're just negotiating among themselves.
Do we still keep Greece on track that they have to get their debt/GDP levels down to 120% by 2020? I think some of the EU members are trying to loosen that up that that they don't have to hit that target until 2022. However, the IMF is still out there pushing for the 2020 date. We know that Greece has a couple of different bond issues that mature before the end of this month. They need to get the cash in the door to be able pay for those. However, even if they don't get the cash in the door, there still enough mechanisms out there that the ECB can essentially finance that until Greece gets the next tranche in.
Glaser: Let's look a little bit more at Greece though. As their GDP continues to fall, it gets that much harder to get under that limit. Are they going to have to go through another debt restructuring, and is there an appetite in Europe to actually restructure the debt to take some losses?
Sekera: Well, there is certainly no appetite for anybody that's willing to take losses. And in fact, we've already seen the three different members of the troika already out there publicly start to disavow any willingness to take losses. So, first out there Mario Draghi was out saying that, well, the ECB wouldn't be willing to take any losses on the funding that they've already put into the country, essentially saying that everything that they've done has been for monetary purposes, and so, therefore, they should be more senior to other lenders.
The IMF; certainly not used to taking losses on their positions, have also stated that they don't anticipate having to take any losses on their positions. So then that leaves us the individual member states of the EU, which, of course, none of those politicians are going to be willing to take losses because if they do that's going to be a detriment for them when they run for re-election.
So, it's going to be unclear as far as the timing and certainly who is going to take how much of those losses. It's not guaranteed yet, but it certainly looks like with debt to GDP continuing to get worse, and, in fact, it rises up to 190% by 2014 according to Greece's own budget, and even that is probably optimistic. We haven't seen Greece hit one of their numbers yet, so it could even be worse than that.
So, I do think that people are starting to realize that we do need to take more losses, and you have to remember, this is on top of the PSI, the public sector involvement, in which the private bondholders did have to take 50% haircuts on their bonds, as well. And at this point there's not even enough of those bonds left that even if you haircut them that there would be enough to really bring down that debt to GDP to more meaningful levels.
Glaser: So, looking at Spain then, they have been reluctant to formally apply for that bailout, and that has kept the ECB from being able to buy those bonds. Is that sustainable? I mean, is Spain eventually going to have to ask for this money, and why are they waiting so long?
Sekera: So, with Spain, there's a couple things going on, but yes, you're right, they have definitely been able to have their cake and eat it too. So, they have not gone and formally requested any kind of bailout program because, of course, now that the bond yields have come down very substantially, they don't need to go and request that bailout program. But we are still waiting for a couple of different things to occur. First, we have seen the stress test results for their banking system, and they need, I believe, about EUR 60 billion in order to recapitalize their banking system. A lot of people are looking at those numbers and thinking even those numbers are still low, but we haven't even gotten the cash in the door for that yet, as well.
Now we are looking in Spain. Their economy is still continuing to deteriorate. Their unemployment is going up. Their GDP is coming down. We're seeing general strikes go on which will bring down their GDP and make their credit metrics look even worse here in the near term. But essentially, while the headlines have been quiet, none of the underlying structural issues in Europe have really been resolved, and until we see a lot of labor market reforms and we see the productivity of the peripheral nations really start to increase and match that of these core countries, we're still going to have this always in the background.
How long can we continue to paper this over, kick the can down the road? That's anybody's guess, but I do think that over the course of 2013, we will see a lot more volatility just like we saw in 2012 where there'll be individual catalysts that bring up the volatility. The different policymakers and the politicians will figure out something to do which will alleviate that in the near term, but we definitely need to see kind of the inefficiencies between the different countries get resolved. And I don't know if that's just a matter of having to have some more inflation in some of the core countries, or if it's going to be within the peripheral countries that they're just going to have to see their standard of living decrease over time until they get to the point where they can compete efficiently.
Glaser: You've talked a little bit about how the market is giving Spain the benefit of the doubt right now, and the country's yields have come down quite a bit. But when you look across the bond market, both the corporate and sovereign, what kind of systemic risk is the market pricing right now?
Sekera: Well, that's the interesting thing, is really since Mario Draghi came out at the beginning of August saying he was going to do whatever he needed to do to defend the euro, is that systemic risk that's getting priced in--and we evaluate that in a couple of different ways--has really substantially dropped.
So, one of the things that we look at is that, historically, European corporate credit used to trade significantly tighter than equivalently-rated U.S. corporate credit. Then once the crisis started to come about, we saw that spread tighten until the U.S. and the European bonds were essentially trading on top of one another. And then middle of 2011, when the European sovereign crisis really started up in earnest and people were worried about some sort of financial collapse and the collapse of the banking system, those European bonds really widened out significantly further.
Well, that's actually come in over the past couple weeks which is telling me that the market is pricing in substantially less systemic risk, less risk that the banking system there really will end up imploding upon itself that if we do have sovereigns having to take haircuts that those banks would be in financial trouble.
In fact, one of the best-performing sectors has been the banking sector. As you would expect, when the market had been widening out, they got hit hardest the fastest, and so now that this systemic risk is being priced in to a much lesser probability, those bonds have rallied very substantially.
Glaser: Dave, I certainly appreciate your update today.
Sekera: Anytime. Glad to be here.
Glaser: For Morningstar, I am Jeremy Glaser.