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International Update

Written by Peter Vutz, Head of Corporate Credit;
International & Non-Dollar

The second quarter proved to be another challenging one for international bond market investors. The European political establishment’s initial inept response to the Greek debt crisis led predictably to a full-blown crisis, threatening peripheral European nations like Portugal and Spain and endangering the existence of the common currency. Finally giving in to the tremendous pressure of the financial markets, the governments of the European Union joined forces with the International Monetary Fund and crafted a rescue package totaling €750 billion to address potential liquidity problems in all peripheral European nations.

After months of wavering, the European Central Bank caved in light of the severity of the crisis, announcing its own tailor-made quantitative easing program to buy peripheral European government debt. The handling of the crisis may have caused permanent damage to the credibility of the ECB, and potential losses from the bond purchase program could lead to recapitalization needs that would further undermine the ECB’s strength and independence. The damage caused by the initially tepid response fostered speculation in the eventual demise of the euro. We find these predictions premature and, at least for now, do not buy into this swan-song theory.

We do believe that weaker members, most notably Greece, might be tempted to leave the European common currency notwithstanding collateral damage to their own reputations. The rescue package bought time for the troubled peripherals, but the structural problems will take a herculean effort to resolve. We continue to question the resolve and willingness of the Greek government to stick to its stringent austerity package. We believe Greece will succumb to the temptation of short-changing bond market investors, most of whom are domiciled outside of Greece. We believe that a Greek debt restructuring will take place at some point in the future, most likely in two or three years.

Spain appears to have adequately addressed its problems, which are concentrated in the savings bank industry, by creating a rescue fund for the financial sector and initiating voluntary and involuntary merger policies within the savings bank sector. These actions have taken the pressure off the Spanish markets. The total cost to the government will be vast, though, if we include the stress on the social system that results from unemployment rates in excess of 20%. Only time will tell if the Spaniards are up to the challenge, but their government is off to a good start. The weaker euro has acted as somewhat of a stimulus package for the more competitive, export-oriented nations of northern Europe, but has not filtered down to nations under siege due to their necessary austerity measures.

A more modest rate of growth, which is now generally anticipated, is a growing concern. Europe’s newfound faith in fiscal responsibility puts it at odds with our administration, which favors continued government intervention via public sector stimulus programs. If the Europeans succeed in averting a double-dip recession or deflation, they would certainly gain an edge over the public sector finances in the United States.

In the weeks to come all eyes will be on the stress tests which most European banks have to undergo. Not enough is known of the criteria used, but should they be perceived as too lenient, it would undermine the integrity of such tests and likely cause further market volatility. A credible test would certainly support a further relief rally in the financial sector.

Meanwhile, in the United Kingdom, recent elections produced no clear winner and led to a hung parliament. The conservative Prime Minister David Cameron formed a coalition government with the liberal party. His administration is off to a promising start, helping both U.K. asset prices and the British pound. While we give kudos to the early success of Mr. Cameron, we remain skeptical that such a tenuous coalition will survive the full term.

The Chinese government formally abandoned the currency peg, and the initial market reaction to predict a rapid appreciation of the renminbi versus the dollar was overdone and way too optimistic. We believe a carefully orchestrated move of 5% or less over a 12-month time horizon is most likely. The momentum of the Chinese economy is fading after months of double-digit growth. The tightening action by the Chinese central bank targeted an overheating property market and a worrisome trend in inflation. Growth was further impacted by a general slowdown in economic activity around the globe.

Low historical yields in the safe-haven markets like the United States and Germany leave little margin for error; however, the tenuous state of public sector finances favors quality and we believe that rates will stay low in Europe for some time. We see no real threat of inflationary pressures in most developed nations and therefore continue to like selective European sovereign markets and high-grade corporate bonds hedged back into U.S. dollars. We maintain our long-held view that the euro will resume its downtrend and that the recent relief rally represents a sell opportunity. We expect new lows by year-end and would not rule out parity to the U.S. dollar. We expect the yen to depreciate versus the dollar, weakening to levels in the mid-nineties or around ¥100/$ by year-end.