July 2010
Newsletter Natixis AM
Global growth, European debt: new investment strategies Is government debt holding back the recovery? What conclusions can be drawn from the recent performance of sovereign and corporate bonds? What effect will the disappearance of risk-free assets have on allocation? Analysis by Philippe Waechter, Chief Economist, Olivier de Larouzière, Head of Interest Rates & FX, and Franck Nicolas, Head of Global Asset Allocation & ALM.
Is government debt holding back the recovery? Public debt began to spiral at the time of the collapse of Lehman Brothers in 2008. There was a sudden change in the level of debt issues. From the fall of 2008, it has risen seemingly without a pause. As a result, public debt now stands at record levels: in France it represents 80% of GDP, compared with 20% in the early 1980s.
US public debt , 2010
Philippe Waechter Chief Economist
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Newsletter Natixis AM / July 2010 Public debt to GDP ratio 2007-2011
n Link between growth and debt In the case of France, there are three key factors: The direct link between growth and public debt is not direct. The growth trend was stable, whereas public debt was expanding rapidly. It may be the uncurbed nature of the debt that delayed the necessary adjustments.
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n Over the last thirty years, a GDP growth rate of 3% brought about a stable debt to GDP ratio. The potential growth rate of France’s economy is now around 2%. This may correspond to the gap between social needs and economic capacity. Reversing the trend and bringing down the debt requires a different model for growth.
The "Report on the Public Finance Situation", published in May 2010, set out three assumptions:
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1) i f the French economy makes up the ground lost in activity terms due to the crisis, the debt could be “limited” to 110% in 2020; 2) i f it returns to pre-crisis growth, but without making up the lost ground, the level of debt would be closer to 125%;
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Source: The Future of Public Debt: Prospects and Implications - BIS WP No. 300 (March 2010) • Asia = China + Hong Kong + India + Indonesia + South Korea + Malaysia + Philippines + Singapore + Thailand • Central Europe = Czech Republic + Hungary + Poland • Latin America = Argentina + Brazil + Chile + Mexico
many emerging countries (measured by the debt to GDP ratio). All of these countries therefore face differentiated constraints, which explains the diverging point of view at the 27th of June's G20 summit. Even within the EU, the situation varies significantly between countries. After a period of cooperation when the various stimulus packages were implemented in 2009, European countries are struggling to coordinate their exit from the crisis. For example, Germany does not suffer from the same "urgency" than the one affecting. In the latter countries, private debt is also particularly high. As a result, the introduction of overambitious austerity plans could weaken these countries excessively. A more gradual implementation of fiscal policy measures would lessen the risk of countries sliding back into recession. The markets, meanwhile, are clamoring for transparency. They are more concerned about debt getting out of control than absolute levels of debt, if this is then repeated in the future. In order to reassure investors, governments need to clarify their vision of the future and explain the way in which they plan to manage the debt over the next ten or twenty years.
3) if growth softens, the debt could rise to as much as 140% of GDP!
n Debt levels vary by region Levels of debt vary considerably depending on region. While debt has ballooned in Europe and the US, there have been only moderate – or negligible – increases in
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Written on 20/07/2010
Newsletter Natixis AM / July 2010 Government and corporate bonds: new points of reference The sovereign debt crisis has given rise to a new perception of risk. Market fears, which a few weeks ago still concerned countries’ public deficits and short-term solvency, have shifted to the impact of debt on economic growth. Investors are now worried that growth will continue to be weak over the next few years.
Euro-zone: inter-country 10Y spreads
Olivier de Larouzière Head of Interest Rates & FX
n A new division between countries European countries now seemingly fall into three groups. • Against a backdrop of risk aversion, Germany has seen its bonds outperform all other euro-zone AAArated debt, and is the sole representative of the first group. • Next in line are the euro-zone countries that command high ratings. The markets are keeping a watchful eye on the credibility of their fiscal policies, given concerns that some countries might go off the rails. • L astly, the third group contains the peripheral countries that have come under close scrutiny. The ECB’s buyback policy is providing them with short-term protection, but the risk over the medium and long term has not gone away.
n Sovereign debt: towards credit management On average, yields on European sovereign bonds have not suffered, but this generalized stability masks the fact that yields on peripheral country debt have risen, while they have fallen for the countries judged to represent the safest investment. Greece is a case in point: although its short-term yields had been very low in the past, the
yield curve inverted during the crisis – a very rare event for sovereign debt – before turning positive again in June 2010. While Greece has become a “normal” country once more, the bid-ask spreads on 2Y bonds are still 80 times wider than they were in 2007.
n Emergence of new risks In light of the emergence of sovereign risk, investors now tend to bracket this asset class together with corporate bonds, and to pick out the "best" from the "worst" of each bunch. They are therefore using the same tools to measure the risks attached to both sovereign and corporate bonds. The traditional approach does not provide a satisfactory assessment of the two aspects of credit risk: market risk (i.e. price changes) and default risk. The new indicators aim to measure the impact that a sovereign default would have on the returns from a bond fund. Similarly, more specific methods (such as “duration times spread”) can be used to calculate the impact of changes in the spread of various sovereign bonds.
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Written on 16/07/2010
Newsletter Natixis AM / July 2010 No more risk-free assets: what will this mean for allocation policy? There are two aspects to the risk-free asset class: first, sovereign debt yields are very low due to structural disinflation and a difficult economic environment; and second, the deterioration of the public finances of some European countries has triggered a flight to quality in favor of the bonds of the countries in best financial shape. Very quickly, real risk-free assets have become increasingly rare, and are offering ever-thinner yields.
n The strategic consequences The current situation raises question marks over the financing of European governments Franck Nicolas in coming years. Because Head of Global Asset of population ageing, Allocation & ALM savings rates are down while financing needs are growing, a situation exemplified by Japan. We could see a scenario whereby the emerging countries will be providing Europe with finance. In that case, they would likely demand an increase in risk premiums in return, which would push up yields. A somewhat paradoxical consequence could arise in the treatment of assets by the regulators, especially in the context of Solvency II. The new prudential rules favor the purchase by insurers of sovereign bonds rather than equities or corporate bonds. Solvency II thus implies that there is no issuer risk attached to OECD countries. This, however, is a favorable factor to the treatment of sovereign bonds.
Another tactical consequence is the rally of “agency MBS� (mortgage-backed securities guaranteed by government agencies) in the USA. However, this rally is now petering out as the US property market remains under pressure: many borrowers are unable to remortgage their properties despite historically low interest rates and there was no glut of advance payments, which benefited MBS, as the main risk of these instruments is early redemption.
n Should we accept a higher risk? In the current market environment, risk is generously remunerated. A corporate bond from an A-rated issuer offers a spread in line with that of government bonds: this is an unprecedented situation, where the risk premium is equivalent to the risk-free return. Meanwhile, the risk premium on equities is extremely high. There are undoubtedly some opportunities to be seized on a medium-term horizon.
n Tactical consequences The fall in sovereign debt yields will diminish the performance of absolute return strategies. With money market returns at 0-1%, the yield cushions have disappeared. This will put pressure on absolute return strategies, which will lead to more risk-taking. Written on 30/07/2010
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