November 2010
Irish question
/// The point of view of Natixis Asset Management
Deciphering the macroeconomics by Philippe Waechter, Chief Economist of Natixis Asset Management The strains in the Irish bond market over the past few weeks reflect investor concerns as to the ability of the Irish economy to contend with some significant economic and financial challenges. Rather than deal with this situation alone, Ireland has accepted help from Europe, the ECB and the IMF. This mutualization of the risk could head off an adverse scenario for the Irish economy and maintain the credibility of the Euro zone. This wariness on the part of investors recently increased with the difficulties encountered by the Irish banking system. The support given to its banking system by the Irish government in the form of guarantees has resulted in an unprecedented ballooning in the public deficit, which could approach 32% of GDP in 2010. The bail-out, which should amount to some €80-90 billion, should be divided between help for the public finances and support for the banking sector, based on a coefficient to be defined. The negotiations that are beginning between Ireland and the representatives of the troika (Europe, ECB, IMF) should define the relevant rules whereby the Irish public finances should return to a sustainable trend over the medium term. To this end, the discussions on the Irish economic situation and the resulting growth profile will be key.
•
Irish economic situation
Profile of economic activity and inflation The Irish economy had seen a prolonged period of very strong growth, with GDP rising by an annual average of 5.3% between 2000 and the end of 2007. This growth was propelled by a robust performance from the real estate market, more abundant banking credit and the renewal of its offer. This last point reflected the increased diversity of the industrial fabric and services in the Irish economy resulting from a non-negligible fiscal incentive.
Ireland 60000 Annualized trend growth rate for the period between Q1 2000 and Q1 2008: 5.3% . Growth since the low (Q1-09) – ns 55000
50000 45000 40000 35000 30000 2000
2001
2002
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2003
2004
2005
2006
2007
2008
2009
2010
Datastream – Natixis AM
Markets Flash / November 2010
This growth came to an halt in 2008 when the bullish trend for the Irish economy went into reverse. The real estate market turned down, triggering a first negative shock for activity and employment. Then came the widespread downturn in the global economy which compounded this slowdown. Since the diversity of its offer had enabled Ireland to benefit from a very positive export GDP deflator - Annual change 10.00 dynamic, the country was directly impacted 8.00 by the sudden fall-off in global trade. 6.00 The trend in economic activity very rapidly 4.00 turned down as seen in the first chart. At the 2.00 end of the 2010 second quarter, Irish GDP 0.00 was 13.5% lower than its high during the -2.00 final quarter of 2007. This collapse was -4.00 accompanied by a very rapid increase in -6.00 unemployment. The ensuing fall in demand -8.00 1998 2000 2002 2004 2006 2008 2010 was reflected in a long period of declining prices as seen in the chart opposite. CSO – Natixis AM Growth drivers The virtuous dynamic from which the Irish economy benefited is shown in the chart opposite, showing the different contributions to Ireland’s annual GDP growth. Internal demand played a predominant role in Irish economic growth since its contribution was close to 5% on average, with household consumption and investment both making a significant contribution. External trade made a positive contribution on average with exports showing robust growth.
Contributions to annual GDP growth 15.00
10.00
5.00
0.00
-5.00
External demand
-10.00
Internal demand Change in inventories
GDP
-15.00 1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Datastream – Natixis AM
The domestic market was a key driver for Irish growth with significant job creation and a very low unemployment rate. The chart shows that, in 2008 and 2009, domestic growth reached an inflexion point with consumer spending turning down and investment collapsing. At the same time, external trade made a positive contribution, with Ireland benefiting from the recovery in global economic activity while imports slowed due to a depressed internal market. Government forecasts In a document on the economic and fiscal outlook dated 4 November 2010, the Irish government published its road map and the expected profile for the public finances. As of 2011, the Irish government expects a rapid rebound in economic activity and inflation. Economic growth should increase from 0.25% (government forecast) to 1.75% before accelerating to 3.25% in 2012.
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Markets Flash / November 2010
Growth and inflation in Ireland In terms of inflation, the deflator should move from negative to positive from 2011 with an acceleration in this inflation metric through to 2014. These forecasts are shown in the chart opposite. This profile is not without consequences for the profile of the public finances. The government considers that it is external trade which will underpin stronger economic activity and does not expect a marked pick-up in domestic demand. The chart opposite shows the structure of Irish exports and their significant dependence on Europe.
8.00
Government forecasts
6.00 4.00 2.00 0.00 -2.00 -4.00 -6.00
Annual growth GDP deflator
-8.00
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
CSO – Ministry of Finance - Ireland
Geographical breakdown of exports (€bn) 9.00 8.00 7.00 6.00
Others USA + Canada European Union excl. UK and Northern Ireland
Northern Ireland UK
5.00 4.00 3.00 2.00 1.00 0.00 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
CSO – Natixis AM
• Public debt forecasts The direction in the public debt will depend on the trend in the public deficit and the profile on growth and inflation. In the government’s document, the trend in the deficit is the overall deficit and there is no distinction made between types of expenditure and, notably, between interest charges on the debt and other spending. The Irish government’s clearly defined target is to reduce the deficit by €15 billion in 2014. Given the growth scenario, the profile on the deficit has been defined so as to enable the stabilization then reduction in the public debt by 2014.
Profil finances publiques (en PIB) based Profile of thedes public finances (%%ofduGDP) les hypothèses du gouvernement assumptions on selon the government’s 10
108
8
106
6
104
4
102
2
100
0
98
-2
96
-4
94
-6
Déficit public Dette Publique
-8 -10 2010
2011
2012
2013
92 90
2014
The 2010 deficit of -32% is not shown.
The profile of the deficit expected as of John McHale – Natixis AM 2011 and the direction in public debt are presented in the chart opposite. The central scenario on the deficit has, thus, been calibrated so as to enable a reduction in the public debt in 2014.
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Markets Flash / November 2010
> One might legitimately revisit the assumptions made on both the growth profile and the public deficits. The following alternative scenarios are based on the same central scenario but with slower growth assumptions (1% for GDP and 1% for inflation) and/or different assumptions on the public deficit. Three alternative scenarios :
Public debt trajectory as a % of GDP
125
Slower growth and identical assumptions on the deficit - Slow growth and a more rapid reduction in the deficit (1 point annual improvement) - Slow growth and a slower reduction in the deficit (1 point annual increase in the deficit)
Government assumptions Slow growth Slow growth but faster reduction in the deficit Slow growth and slower reduction in the deficit
120
115
110
105
100
95 > Based on assumptions 1 and 3, 2010 there is no stabilization in the public debt. Scenario 2 does enable this stabilization but at a higher level due to the reduced growth.
2011
2012
2013
2014
John McHale – Natixis AM
In the discussions on the European support, the trade-off between the macroeconomic scenario and that of the public deficit is abundantly clear. The options chosen must enable the stabilization in the debt ratio Against this backdrop, the risk is the political instability which could be seen following the calling of a general election for January. The internal strains are already high and, were there to be increased political instability, it will be more complex and difficult to implement the required constraint at fiscal level. This would then be reflected in instability with regard to the debt.
Investment management views by Fixed Income Investment Department
• Market Performance Levels
25-Nov-10
24-Nov-10
16-Nov-10
2-year Government Bond Yields
25-Nov-10
24-Nov-10
16-Nov-10
10-year Government Bond Yields
Germany
0.94
0.97
1.11 Germany
2.7
2.71
2.70
France
1.09
1.09
1.20 France
3.14
3.10
3.12
7.03
7.02
6.76
4.4
4.34
4.30
Portugal
4.48
4.42
4.31 Portugal
Italy
2.59
2.45
2.43 Italy
Ireland
5.82
5.73
5.14 Ireland
9
8.86
8.12
Greece
11.49
11.73
11.06 Greece
11.93
11.92
11.60
3.51
3.40
2.93 Spain
5.17
5.06
4.72
1198.35
1180.73
1178.59
19.56
20.63
21.76
107.3944
107.39
100.25
Spain FX & Emerging markets
Equities & credit
€/$
1.33
1.34
1.36 S&P 500
€ / CHF
1.33
1.33
1.36 VIX
223.74
223.74
EMBI
218.06 Itraxx Main
Source : Bloomberg
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Markets Flash / November 2010
• Market conditions as of 23/11/2010 The Irish crisis is finally being dealt with, as the government decided on November 21, to call for external financial aid. The bailout plan will build on the facilities put in place in the wake of the Greek crisis last spring, hence implying funding from the European Union, the EFSF and the IMF. Furthermore, Sweden and the UK offered to help though bilateral loans, which is fully justified considering the exposure of their respective financial sectors to the Irish risk. Ireland simply came to the conclusion that a small open economy cannot deal, on its own, with insolvency issues of a banking sector several times bigger than its underlying economy. Indeed, assets from the top 6 banks represent 330% of GDP. The collapse of the real estate sector resulted in a sharp contraction in nominal GDP, a deadly combination for an over-leveraged economy. Details of the bailout are not yet fully disclosed. Finance Minister Lenihan indicated that loans will amount to less than €100bn. The maturity of the loan may be 3 to 5 years with interest in the ball park of Euribor + 350/450bps. The 2011 budget (scheduled to be voted on December 7) will aim at a 6bn€ reduction of the public deficit, which could reach 12% of GDP in 2010, or even 32% if the September bank bailout cost is taken into account. Next year’s budget is part of a 4-year fiscal consolidation plan targeting savings worth 15bn€ (10bn€ by way of expenditure cuts) to bring the deficit down to 3% by 2014. Progress on fiscal consolidation will be closely monitored by the EU and the IMF, as a condition for the enacted aide. It looks like one third of the plan will be devoted to again recapitalising the banking sector (now largely under government control). Disposals of non-core assets are a priority to downsize the banking sector. In the near term, the ECB should maintain its support to Irish banks, heavily dependent on central bank funding (130mds€) and could keep intervening in sovereign debt markets to alleviate tensions. In the longer run, Ireland’s growth model – based on strong Foreign Direct Investment inflows and low corporate tax rates could have to be adjusted.
• Coming events ▪ November 26 General strike in Portugal, just before a line-by-line approval of the 2011 budget due Nov. 30. ▪ December 2 The ECB will make a decision on its liquidity provisioning strategy, notably 3-month LTRO and bond purchases. ▪ December 7 Ireland votes on 2011 budget. Social aspect of budget will be examined in December also. ▪ December 16/17 EU Council Meetings: Draft text for the orderly restructuring mechanism due (critical focus area for international bondholders) ▪ January 2011 Parliamentary elections
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Markets Flash / November 2010
• Investment management conclusions > Ireland The view of Natixis Asset Management teams has been consistently negative on Ireland since last summer on the grounds of the potential funding difficulties, expected to arise in the banking sector at the expiry of the government guarantee programme. Moreover, Ireland makes up just 2% of the Euro Area sovereign debt market, and liquidity has vanished during the crisis despite ongoing support from the ECB through purchases of Irish (and Portuguese) debt. However, the bailout plan should support the short end of the curve. For this reason, Natixis Asset Management opts for neutrality on Irish bonds with residual maturity of 1 to 3 years, which offer attractive carry at yields of around 4.80%. As concerns longerdated issues, Natixis Asset Management will review its strategy as details on the bailout plan are unveiled.
> Other « peripheral » countries Investment management exposures: - neutral (Spain), - overweight exposure on Greek debt very short term maturities (less than 1 year) - underweight exposure to Portugal. Indeed, Portugal is subject to contagion risk, whilst the Spanish government bond market may fare relatively better thanks to domestic banks..
Written on 23/11/2010 by Fixed Income and Economic Research departments of Natixis Asset Management
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