By Michael Siviter, portfolio manager, Invesco Fixed Income
Over the last three years eurozone government bonds have experienced unprecedented levels of volatility, manifested in sharply diverging returns for “core” and “peripheral” markets. Many clients have chosen to exclude peripherals from government mandates, both because they have started to exhibit positive correlation with risk assets and as a hedge against perceived convertibility risk in the event of a eurozone break-up.
Many investors have been left with portfolios concentrated in relatively low-yielding core government bonds. Given the announcements by eurozone policy-makers over the last two months, it’s worth considering the macro scenarios necessary for lasting stability in the eurozone and the implications for core government bond holders. On entering the monetary union, peripheral countries were faced with historically very low real interest rates. These fuelled a private and public sector credit boom. High levels of growth led to inflation rates that were substantially higher than those of the core. Higher inflation led to rising wages relative to productivity (Unit Labour Cost) and a resulting loss of competitiveness reflected in widening current account deficits, particularly with Germany.
The financial crisis has resulted in the peripheral credit boom going into reverse. The public and private sectors in the periphery have been forced to deleverage as foreign investors have withdrawn. Collapsing credit growth is deeply deflationary, as shown by the decline in nominal growth in the periphery. Unfortunately, falling nominal growth worsens the solvency of peripheral countries, making the necessary fiscal adjustment close to impossible. The question is therefore, how do peripheral economies maintain nominal growth while also continuing private and public sector deleveraging? Domestic demand in the periphery is likely to remain very weak. The only avenue for growth is therefore external demand. Exports can be either to the eurozone core or to outside the eurozone. Hence the periphery can benefit from both an intra-eurozone real exchange rate devaluation and an extra-eurozone real exchange rate devaluation. An intra-eurozone real exchange rate devaluation will require peripheral economies to run inflation rates well below those of the core.
Relative wage levels will have to decline. But just cutting wages will be very damaging for growth and lead to deflation, which will make achieving debt sustainability near to impossible, as nominal growth will be less than the nominal interest rate charged on peripheral debt. To achieve this adjustment without exacerbating the debt crisis, we therefore need to see higher inflation in the core. As some peripheral countries will need a price adjustment of between 20% and 50%, it’s possible that core inflation will have to be substantially above the ECB target of 2%. Opportunities for substantial growth in exports to the eurozone’s core may be limited. Many core countries are undertaking substantial austerity programmes, limiting domestic demand. Furthermore, the Bundesbank appears ready to use its new macro-prudential tools to constrain credit growth, limiting the scope for an inflationary boom. Peripheral countries might therefore have more export success outside the eurozone.
To regain competitiveness with major noneurozone trading partners the periphery may need a large devaluation of the external exchange rate. Many major developed economies are experiencing public and private deleveraging; consequently, exports to faster growing emerging markets, particularly in Asia, have more potential. Both a solution to the eurozone crisis and a eurozone break-up are likely to involve a weakening of the euro’s trade weighted exchange rate. This prospect could lead investors in eurozone government bonds to look at diversifying currency exposure, which can be achieved through investment in global, pan-european and/or local currency emerging market bonds rather than just eurozone bonds. An intra-eurozone real exchange rate adjustment will involve higher than average inflation in the northern core. In this scenario investors may look at inflation hedges, such as inflation linked government bonds, property and commodities.
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