EU bail out has bought time, but great uncertainty remains

• The European Central Bank (ECB) has reacted in a pragmatic way, having had no alternative but to intervene
• In the near-term, the measures taken are likely to reduce inflationary pressures
• Fiscal austerity measures are likely to imply a cap on economic growth
• It is unclear to what extent a weaker Euro can help to compensate for tighter fiscal policy
• Country risk is likely to take on a new significance for investors

Stefan Hofrichter, Chief Economist at RCM, a company of Allianz Global Investors, gives his comments on the EU bail-out package:

“The EU bail-out package is likely to soothe markets, as the immediate risk of a Government bond default and, consequently, of eventual write-offs on banks’ holdings of Economic and Monetary Union (EMU) Government bonds has been reduced substantially by the size and design of the measures taken.  Most importantly, the package buys time: three years. However, economies with structural and inter-related problems – i.e. high Government debt levels, huge current account deficits, a corporate sector lacking power to compete in international trade - have to use this time to put their house in order. Otherwise, we cannot rule out that Government debts in some countries may be set on an explosive path. Admittedly, a rise in nominal gross domestic product (GDP) down the road is likely to help stabilise Government debt ratios.”

“While some have argued that the ECB has lost its credibility, by deciding to intervene in the bond market, there was, in our view, no realistic alternative. The ECB’s involvement is central to the overall bail-out package and without it there was the risk that important segments of the bond market, for example the market for selected EMU Government bonds, would remain paralysed. This would have resulted in liquidity problems for Governments and balance sheet problems for the financial sector. The ECB has reacted in a pragmatic way.”

“In the near-term, the measures taken are likely to reduce inflationary pressures as Governments need to tighten their belts drastically in order to benefit from the loans and guarantees.  If no action had been taken, a new financial crisis could have started which would have been deflationary.”

“It remains unclear whether these measures will lead to higher inflation in the long-run. The ECB intends to sterilise bond purchases, hence, base money may not increase. If that’s the case, the ECB would not be ‘printing money’ by monetising Government debts. But we have to watch this very carefully. If, in contrast to the original announcement, the ECB ends up buying Government bonds without sterilising the purchases, this would change the long-term outlook for inflation substantially. Indeed, historically, a financial crisis has typically led to high Government debt levels resulting in either outright default or implicit default via inflation.”

“This package has reduced the risk of the EMU breaking up as it actually leads to a quasi-fiscal union. Tight fiscal integration is a necessary element in a currency area.

“The Euro is likely to devalue structurally as tighter fiscal policy combined with more expansionary monetary policy are usually conducive to a weaker currency. Actually, a weaker currency is the usual way of stabilising economic growth when the public and the private sector are in a deleveraging process. We expect the Euro to devalue against the US Dollar, however, from a longer-term perspective, the US is facing a debt problem as well and it could be primarily emerging currencies which appreciate going forwards. This would also help to rebalance global economic growth. We think that  emerging economies need to become less reliant on exports and focus more on domestic demand. Stronger emerging currencies would accelerate this process.

“We expect EMU periphery bond spreads to tighten going forward and core-EMU yields to rise as the risk aversion of the past weeks may be unwound. Medium-term, with short rates in EMU remaining lower for longer, the long end of the yield curve is likely to remain anchored. We expect the curve to remain structurally steep as a consequence of very low interest rates and ongoing strong bond issuance.

“In the near term, risk aversion trades in the equity markets will most likely be unwound and we will probably get a technical rally (a good part of this may have already happened on Monday, May 10). In particular financial stocks/ banks should benefit in this technical bounce. In the medium-term, however, we are not sure that equity markets should be euphoric. Fiscal austerity measures imply a cap on economic growth. It is unclear to what extent a weaker Euro can help to compensate for tighter fiscal policy. Admittedly, the corporate sector in the EMU is cash positive and could start investing again, thereby stimulating the economic cycle. But the overall effect on economic growth is undecided. With leading indicators in the global growth region, Asia, rolling over as a consequence of tighter monetary policy, we think the cyclical headwinds are likely to cap the equity markets on the upside.

“Leaving the argument of attractive valuations aside, we would need to see strong nominal GDP growth in order to become positive on equities structurally. This is feasible in an economy characterised by public sector deleveraging, however, it necessitates that external demand is strong (perhaps from emerging markets); that the currency devalues sufficiently; and that domestic demand recovers after private sector balance sheets have recovered. In our view, all this clearly needs expansionary monetary policy and the return of inflationary expectations to the system. One way to measure this improvement is a pick-up in money velocity.

"Country risk may well become more important again for bond and equity investors structurally as the cost of capital could increasingly be impacted by country factors, as sovereign risk and fiscal policy have turned out to be less uniform than perceived by market participants in the past.”

- ENDS -

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