Changing perspective on the ‘periphery’

Rebecca Braeu, Standish and Alexis Renault, Meriten Investment Management

Changing perspectives on the periphery

Market participants are already factoring in lower credit risk, especially amid improving fundamentals according to Rebecca Braeu, director of sovereign research at Standish. Portugal, for instance, posted its first current account surplus for a full year in two decades in 2013, as reported earlier in 2014. The upgrading of outlooks by the rating agencies has also contributed to a more upbeat stance on the part of market participants.

On top of lower credit risk, domestic flows into the asset class have been striking since the start of 2014. A contributing factor could be the preparations for the Asset Quality Review of the European Central Bank (ECB) and the light shed on bank balance sheets at the end of 2013, marking a return to normal bank buying since the commencement of 2014, commented Braeu. (Supervision of the eurozone’s banks is passing to the ECB, which is conducting a warts-and-all review of the balance sheets of the banks it will take change of in 2014.)

One or more Asian central banks is reported to have invested in Italian government bonds, while domestic pension funds are returning to investing in the ‘periphery’, said Braeu.

Supportive of the ‘periphery’ is the willingness of the ECB to countenance quantitative easing (QE), while other central banks move in the opposite direction, such as the US Federal Reserve, which is ‘tapering’ its QE programme.

According to Braeu, current spreads are such that investors are being sufficiently compensated for the risk of holding the European ‘periphery,’ at least for the next six months. Braeu believes the risk is more likely for positive economic surprises, thereby improving the ability of the sovereign to pay. As long as the economy is growing at a modest pace, default risk, in Braeu’s opinion, is negligible. The threat to this view is an external shock that disrupts the pace of the recovery, commented Braeu.

Mario Draghi’s 2012 promise to do “whatever it takes” to save the euro proved to be a turning point for the European Union and specifically for the ‘periphery’, according to Alexis Renault, head of high yield at Meriten Investment Management. The rise of the ‘periphery stems from that utterance of ‘Super Mario’, the president of the ECB; the risk of investing in the ‘periphery’ began to be perceived as having diminished and the economy improved.

Moreover, spread and yield volatility for peripheral countries has receded over recent months, bringing it even below the level for US Treasuries. This has rekindled interest from ‘carry’ investors and funds that had been restrained by risk-budget considerations. As a result the investor base is broadening and improving, said Gunther Westen, head of asset allocation and fund management at Meriten.

Indeed, the eurozone ‘periphery’ has become viewed as a relative ‘safe haven’ as investors look to reduce exposure to the emerging markets, observed Renault. Competitiveness has improved in the ‘periphery’ as labour costs have fallen, enhancing its attractiveness vis-à-vis the emerging markets. Some countries within the periphery, such as Portugal and Spain, have grown their economies, with rises in GDP.

Spain, Portugal and Ireland have undergone structural reform – this is less the case in Italy, which has a debt to GDP ratio of more than 130%1. Italian bond yields, however, have gone to their lowest level since 1945, noted Renault. Greece’s successful €3bn auction of bonds is an illustration of the change in perceptions, with the demand for its bonds seen as a vote of confidence.

Rating agencies have issued upgrades or outlook improvements, with Italy, Spain, Ireland and Portugal beneficiaries and their progress acknowledged to date. More upbeat statements could encourage further inflows into the region’s bond markets, said Renault.

As long as the economy continues to improve, the ‘periphery’ should not be a concern, believes Renault. The European economy has improved, as highlighted by the trend of improvements to the European Commission Economic Sentiment Indicator EU27.

However, should the periphery undergo a deep recession, that would constitute a risk, according to Renault. The economies of the periphery need three to five years in order to ‘deleverage’ or reduce debt, and this which would be threatened by severe recessionary conditions.

The electoral cycle could intrude and provide potential upsets, with the political environment turning less positive, noted Braeu. Spain, for instance, is due to hold a general election in 2015.

Slowing economies could also impede the ability of governments to pay down debts, added Braeu.

1. Bloomberg as of 7 May 2014