With Greece already written off, Citi's Steven Mansell does one of the better summaries of how Europe's Catch 22 should be played among the countries which are about to get his by the Contagion wave (pretty much all of them).
Greece and spreading EMU contagion risks
Greek bonds have suffered another major rout this week reflecting a near complete evaporation of investor confidence in Greek economic policy and increasing impatience with the drawn out negotiation process. This is finally spilling into other peripheral markets as contagion risks are spreading, but thus far this impact has been largely confined to the fiscally weaker countries (Figure 9 and Figure 10). Further fuel has been thrown onto the fire by Eurostat’s higher than official 2009 deficit estimate of 13.6% of GDP for Greece, casting further doubt on the reliability of national statistics.
To diffuse the situation it seems paramount that Greece should be provided with a clear and visible route to tapping into financial aid. This means that current political obstacles to the bailout plan under discussion, notably in Germany, will have to be overcome rather swiftly or Greece may have to be thrown a lifeline by other, more willing members of the euro group, or possibly the IMF. Time is of the essence, with market attention focused on the fact that Greece will have to find over €8bn to finance GGB redemptions on 19th May, while German political resistance ahead of the key 9th May state election in NRW seems capable of prolonging the impasse. However, our economists believe that any country specific hurdles to ratification should eventually be overcome as the political and economic stakes of failure are simply too high. Thus, we continue to expect that emergency aid will be provided to bridge any gaps in Greece’s immediate liquidity requirements. Once this aid is signed, sealed and delivered we expect to see some relief in EMU spread markets, but we doubt that there will be a lasting peace. As we have highlighted on numerous occasions, fundamental structural imbalances are the root cause of current market turbulence and these problems are shared by most non-core EMU markets, although on a less acute scale than Greece currently.
The bigger question in our view concerns the risk of medium-term insolvency which could necessitate some form of debt restructuring. The market is clearly embracing this risk, as evident from the sharp inversion of the GGB yield curve, which reflects a higher default risk for those bonds of a shorter maturity (Figure 11). Notably, the May 19th 2010 GGB was priced at over 800bp in ASW terms this week. This is not, for example, currently mirrored in the Portuguese curve, which has thus far suffered most from the fallout surrounding Greece. To date, we view the contagion effects as being of limited proportions but the risk is clearly tilted towards a much greater knock-on effect the longer that Greek insolvency risk remains unaddressed.
Our current thinking is that any risk of debt restructuring in Greece is not an immediate prospect as, from a pan European perspective, such an event would merely transfer the problem to other countries with significant exposure to the defaulting country and could prove catastrophic from both a growth and stability perspective. It is therefore in the interests of all euro bloc members to avert such a course of events at all reasonable costs.
While the multi-year nature of the bailout plan pushes the risk of a potential debt rescheduling into the future (by providing adequate funds to meet contingencies for several years to come), a future stabilization of Greece’s debt burden still looks unachievable on the basis of current consolidation plans, reasonable growth assumptions and prevailing funding levels. From a market perspective it is important that subsequent efforts to trim the liabilities of the public sector (wages and pension reform) tilt the balance in favour of stabilization. The risk surrounding such an adjustment process is that the political challenges involved prove to be too great over the medium-term. Hence, we expect the market to remain very sceptical about the prospect of Greece averting a future default scenario, even if a near-term default is probably a low risk event in view of the shared interests to pull out all of the stops to prevent a full blown euro debt crisis from emerging.
That said, we see considerable scope for other, fiscally weak EMU markets to underperform in the current environment. As highlighted, Portugal, another dual deficit economy, has underperformed sharply over the past week, with 10yr spreads to Germany reaching new wides and PGBs now trading around 20bp wider in ASW terms than Irish gilts in the 10yr sector. In our view, both markets carry similar aggregate risk parameters, as highlighted by our sovereign fiscal risk indicator (Figure 13) and we would continue to underweight both given their elevated levels of risk (compared to the EMU average) and potential for further fiscal slippage on disappointing growth performance.
Spain continues to defy its relative fundamental weakness and remains particularly rich in the EMU space, as shown by our rankings. However, we sense that SPGBs are starting to lose favour and increasingly Spain should be exposed to tighter liquidity conditions as the ECB withdraws its special OMOs. Following a period of consolidation, SPGBs are now underperforming BTPs, which now trade much tighter in 5yrs and approximately flat in the 10yr part of the curve (Figure 14). We have been long-term advocates of a long Italy short Spain exposure and continue to believe that BTPs should remain relatively well anchored to the non-core markets as contagion risks have a larger impact on the higher deficit countries.
The collapse of the Belgian government has finally been the catalyst for a repricing of OLOs, which in our view have already out-punched their weight relative to core EMU markets, notably Germany. We would also consider shorting OLOs versus the smaller core markets of the Netherlands, Finland and Austria or, indeed BTPs. Spreads versus Bunds have already started to move off recent lows but we believe that this move should have further momentum (Figure 15). 30yr OLO-Bund spreads look particularly attractive, in our view, given the relative cheapness of the 30yr Bund on the domestic curve (which still trades at wide levels in asset swap terms).