Euro-zone sovereign bonds: State of the nations
Since the European Central Bank (ECB) confirmed at the start of 2015 that it would introduce quantitative easing (QE), it has been tempting to regard its pledge to inject massive additional liquidity into financial markets as a turning point, perhaps one as significant as ECB president Mario Draghi’s famous “whatever it takes” pledge in 2012.
With QE now under way in the euro-zone, we examine its potential effect on Italy and Spain, whose sovereign bonds, in our view, represent the most attractive investment opportunities among the larger euro-zone members. We also look at what it means for two smaller countries whose sovereign debt we think has investment potential – Poland and Lithuania. Finally, we examine the potential longer-term implications of QE for the euro-zone.
The prolonged build-up to the start of QE sustained the momentum of the fall in Italy’s borrowing costs since the height of the euro-zone crisis, when 10-year Italian yields peaked at about 7%. Those yields fell close to 1% as QE commenced in March but Italy’s debt dynamics remain challenging, weighed down by a combination of the euro-zone’s second-highest debt levels and an economy that has been in mild recession for several years.
Italy’s prime minister Matteo Renzi promised sweeping reforms on taking office in 2014. Among his plans to reduce debt was an expanded privatisation programme, worth about 0.7% of GDP between 2015 and 2018. A labour market reform bill passed at the end of 2014 marked an important step to improve the economy’s growth potential, although restrictions on hiring and firing workers remain daunting. The government is also looking to reform the troubled banking sector, in which outdated governance structures and high levels of bad loans have inhibited the economy’s ability to pull out of recession.
In essence, QE has extended the timeframe for Renzi to move ahead with these and other structural reforms that could improve Italy’s debt dynamics. Indeed, with a lower euro and cheaper energy helping to sustain demand in the coming year, the improved sentiment sparked by QE might provide the best window of opportunity since the financial crisis. It is this potential for an improvement in fundamentals that leads us to believe that, at current levels, yields on Italian debt remain relatively attractive compared with those on French or German bonds.
QE has helped drive down yields on Spanish government bonds in a similar way. But, in contrast to Italy, growth in Spain’s economy has accelerated since late 2013, reaching an annual pace of 2% in the final quarter of 2014. Much of the turnaround can be attributed to labour market reforms, which have given Spanish firms more flexibility in hiring and firing, as well as greater leeway in setting wages. The decline in the euro – partially driven by the ECB’s introduction of QE – has also increased the competitiveness of Spanish exports, while the other important element boosting confidence has been the stabilisation of the Spanish banking system, brought about by restructuring in the sector since mid-2012.
While Spanish unemployment has fallen – nearly 500,000 workers have found jobs in the past 12 months, according to Eurostat – it remains at an extremely high level. With a general election due before the end of the year, the question is whether the economy’s return to growth will stem the rise of populist anti-austerity parties like Podemos. The overriding risk is that the country’s political fragmentation might slow the pace of reforms recorded in recent years.
Arguably, many of the preconditions for the recovery in the Spanish economy were in place even before QE was first discussed for the euro-zone. The severity of the country’s crisis in 2012 forced Spanish policymakers to push through significant reforms in the face of domestic opposition. Although there are political risks, we believe that the progress so far on removing structural rigidities, and the momentum that it has provided for the Spanish economy, make Spanish sovereign bonds, at current yields, attractive compared with most core euro-zone government debt.
At first glance, the effect of QE on Poland would appear to be limited. Polish policymakers are probably hoping that it will alleviate the deflation that has spread to their country from their euro-zone neighbours, which has pushed interest rates down to record lows. The economy slowed as the euro-zone’s debt crisis unfolded, but a rebound in 2014 brought expansion of 3.3% – a level that, in the euro-zone, only Ireland approached.
“Arguably, many of the preconditions for the recovery in the Spanish economy were in place even before QE was first discussed for the euro-zone”
Poland’s structural reforms have been implemented more or less continuously since its transition to a market economy, allowing it to enjoy unbroken growth since 1992. Crucially, few of the successive waves of modernising reforms brought in by Polish governments have been reversed, underlining the consensus among policymakers about the general reform path. With a fiscal framework that includes a rule written into the constitution limiting the level of public borrowing, Poland’s fundamentals remain strong compared with most euro-zone members.
But one area where QE has had an effect is exchange rates. The euro has weakened sharply against the Polish zloty since the start of 2015, underlining the reason why Polish policymakers are committed to becoming part of the single-currency bloc. While this exchange-rate volatility may continue, and would therefore minimise exposure to the zloty, Polish sovereign debt remains attractive to us in comparison with the debt of some of the lower-growth, more indebted euro-zone countries.
A country of only 3m inhabitants that joined the euro-zone at the start of 2015, Lithuania is another EU member that enjoys elevated levels of growth, having undergone deep reforms. In Lithuania’s case, reforms were a response to a severe recession in 2009 when GDP fell by 15% and unemployment reached 18%. However, the country’s public debt had historically been manageable, and rather than seeking a bailout, Lithuania decided to finance its budget deficit by issuing US dollar-denominated bonds worth over $7bn (€6.2bn). Since then, with the help of structural adjustments, the government has reduced its deficit to around 2.5% of GDP, stabilising the debt-to-GDP ratio at just over 40% in 2014 – among the lowest levels in the EU.
As a euro-zone member, Lithuania’s government finances have benefited from the fall in borrowing costs that has been triggered by QE, although some benefit would have accrued anyway from joining the single currency. These tailwinds should help the economy to continue to perform strongly, and we believe that Lithuanian government bonds offer a decent risk/reward trade-off for investors.
• To summarise, QE has undoubtedly helped to improve sentiment in the euro-zone, which continues to grapple with its structural problems, lack of growth and deflation. Coming at the same time as a fall in global energy prices and a weakening of the euro, the lower borrowing costs resulting from QE should temporarily boost growth. Of course, such an improvement also increases the risk that euro-zone politicians might hold off on reining in budget deficits and improving labour-market and business conditions, mindful of challenges from populist parties.
But the euro-zone’s structural impediments will have to be addressed if there is to be a more meaningful and sustained upturn. The sheer magnitude of reforms that remain to be tackled in many member countries, and the extended timescale which they may require, underscores the necessity for QE as an accommodative backdrop to help policymakers, although it is unlikely to prove a game-changer in its own right.
David Zahn is head of European fixed income at Franklin Templeton Investments