This month’s Off The Record poll reveals that, while some of the fear has been taken out of the euro-zone situation over recent months, no-one feels certain we are past the worst. Asked to identify the biggest risk to the integrity of the zone, a few cited threats such as unemployment, social unrest and the fragile banking system, but most focused on unsustainable debt levels and political divergence.
“[The biggest risk is the] persistent failure to reduce sovereign borrowing levels,” said a UK fund. [It is] likely to be a combination of factors, such as lower growth and non-delivery of austerity measures.”
A Dutch fund identified the risk as “fatigue with austerity measures, and a lack of leadership from politicians who continue to kick the can down the road”.
A French fund commented: “We are inconsistent in that we want a common currency, but without being sure we really want what that means – a significant EU budget and harmonised tax systems and, worse, the ultimate result of that project, which would be a federal state.”
Tellingly, it was an Italian fund that offered the bluntest assessment of the biggest political risk: “German government behaviour”.
Just over half of respondents (53%) felt the Cyprus ‘bail-in’ of large depositors and senior bondholders was a template for banks across the euro-zone, while 47% thought it was a special case with limited relevance for banks elsewhere.
“The EU has made it clear that in future it is more likely to be bail-ins, rather than bail-outs, that will be the solution for countries needing support,” said an Irish fund.
However, a Spanish fund said: “Banks in Cyprus did not have senior or subordinated debt, nor equity, so deposits had to be bailed-in. In other parts of the euro-zone, there is enough equity, plus debt (senior or subordinated), which should be enough not to need to bail in depositors.”
Just two respondents said the Cyprus resolution had caused their fund to review its investment in bank capital structures.
Turning to sovereign bond allocations, the survey revealed that half the respondents had made no change to their benchmarks over the past five years, while one that had removed some issuers has since re-introduced them.
Nine had removed some sovereigns from their benchmark and still did not hold them in their portfolio, and six had removed some sovereigns from their benchmark, but have been investing in them tactically. Of those 15, 13 thought their fund would one day re-introduce these sovereigns into its benchmark,.
“We reduced some sovereign German bonds (very low yields), and increased Italian bonds with a short duration (high yields),” said an Italian fund.
A French fund said: “Our regulation makes it mandatory for us to invest a minimum of 65% of our assets in bonds.” But the manager was not happy at this: “With a duration of 30 years and net positive cash flows at €2bn per year for the next 10 years, it is not ‘optimum’. Where is the upside to buying a fixed interest bond at overinflated prices (the central bank liquidity contributes to that inflation of assets prices)?”
On that subject of relative valuations, respondents considered French and German-issued bonds to be the most overvalued.
“Can the Bund go any further down?” asked one French fund. “Maybe, but I don’t think there is 50% on each side for a 100bp decrease or increase in its rate. At some point Germany will have to accept some sort of mutalisation of European debts or the euro-zone will split [….] Either way that should lead to a rise in German interest rates and, as a fallout, French rates.”
A Spanish fund stated: “Most of the fixed income market is very overvalued, no matter where. Excess liquidity by central banks is misguiding the fixed income market.” Or, as one German fund succinctly put it: “Draghi put!”