Surging oil prices, meteorological disasters and a special anniversary for the Queen, the summer of 2022 is shaping up to be a lot like the summer of 2012. And there is another headline that is set to make an (unwelcome) comeback: a sovereign debt crisis in the eurozone.
Spreads on 10-year Italian and German bonds have hit more than 200-basis points, the highest level since 2018. The sharp rise in borrowing costs is fuelled by the threat of stagflation in the eurozone. In the first quarter of 2021, eurozone GDP grew 0.3% while inflation exceeded 8%.
But these figures mask a divergence between countries. Austria, Poland and Portugal, for example, report moderately positive GDP growth of 2.5%, 2.4% and 2.6%, respectively. But some of the biggest economies in the region, including Germany and France, are close to reporting negative growth figures of 0.2% and 0%, respectively. Italy may be on the brink of a recession with its economy shrinking 0.2% during the first quarter.
Similarly, inflation varies from country to country. The sharpest increases in prices were in Central and Eastern European countries, such as Estonia (20.1%) and Lithuania (18.5%), while inflation in France was at 5.8% and 8.7% in Germany.
High debt levels, aggravated by higher borrowing to tackle the pandemic, have the potential to be a much bigger headache in Italy, where debt-to-GDP sits at 150%, compared to 58% in Germany, while Spain and France also owe more than their economies are worth. This fragmentation of macro-economic data presents a major headache for European policymakers.
Whatever it takes
Ten years ago, several eurozone countries were brought to the brink of default by a sharp rise in bond yields. A brief look at bond markets today suggests that history might be repeating itself. Rising borrowing costs were accelerated by the countries in question not having the option to devalue their currencies
due to being part of the currency union.
A turning point at the time was a pledge by the then president of the European Central Bank (ECB), Mario Draghi, to “do whatever it takes”. This was combined with the introduction of the Outright Monetary Transfer (OMT) mechanism, which permits the ECB to buy unlimited bonds issued by eurozone countries. Ten years on, the OMT mechanism has still never been used.
Fast forward to 2022 and the cast remains remarkably unchanged, aside from former IMF president Christine Lagarde replacing Draghi at the helm of the ECB. But will she be able to replicate Draghi’s success in reassuring the markets with the promise of unlimited bond purchases?
The intention is certainly there. The government bond sell off in June prompted an emergency meeting of the ECB’s governing council, followed by a pledge to launch an “antifragmentation” tool to intervene in markets and tackle widening bond spreads.
By late July, the ECB announced an aggressive rate hike of 50 basis points, in an attempt to control inflation and the introduction of its planned anti fragmentation tool, now labelled Transmission Protection Instrument (TPI), reinforcing the trend that every eurozone crisis has to be tackled by a new acronym.
But unlike the OMT mechanism introduced in, this time the ECB did not hold back in firing its guns, as the latest asset purchase data released in early August reveal. The data shows that the ECB has significantly cranked up its purchases of Italian debt and reduced debt holdings of countries with lower debt to GDP ratios. Within it’s Public Sector Purchase Programme (PSPP) the ECB reduced its holdings of German debt by €3.6bn, and of French debt by €1.1bn and Dutch debt of €3.6bn whilst buying more than €2bn in Italian debt .
The implications for UK institutional investors are difficult to gauge, in part because few disclose their allocation to European bonds. But they are likely to hold a considerable allocation, due to the limited scope of the gilt market. The UK’s largest private pension scheme, the £83bn Universities Superannuation
Scheme (USS), for example, has opted for a combination of UK, US and European index-linked debt as part of its liabilitydriven investing strategy.
Another indication is that a significant proportion of eurozone debt is owned by international investors. This is the case for some 35% of Italian and more than 40% of French debt.
Moreover, almost half of fixed income assets owned by UK defined benefit schemes are held passively, according to Mercer’s Asset Allocation survey. And passive investors are likely to hold significant positions in Italian debt.
For example, Italy is the second largest issuer in the MSCI Eurozone Government Bond index, at 22.7%, behind France, which has a debt-to-GDP ratio of more than 100% and accounts for a quarter of the index.
Is this good or bad news? For investors, rising bond yields might offer an opportunity to lock in more favourable rates. But much will depend on the ECB’s ability to contain market fears and this in turn will depend on whether inflation will come down.
A fall in inflation could give the ECB more power to intervene in markets. At the same time, higher inflation also effectively reduces the debt burden of eurozone nations. All eyes will now be on the ECB governing council’s meeting in July where details of the anti-fragmentation tool are likely to be announced.
The summer of 2022 might still have some surprises in store for investors holding European sovereign debt.