Line in the Sand : Peripheral Europe

The European Council, consisting European Heads of State, held a video conference today. One of the key issues that they tried to hammer out was how the fiscal action to counter Covid19 will be financed, joint and severely, individually or some fudge between the two. The outcome will be seen by many as key to the future finances of the European peripheral countries, and therefore the valuations of their bond and equity markets.

To put everything into context, this note looks at current and future sovereign debt trends in order to fully appreciate the magnitude of the problem at hand. The data to 2019 is sourced from the Eurostat database, whilst assumptions about future Debt and GDP are listed clearly below.

CURRENT SITUATION

There have been 3 major events that have impacted European debt dynamics since 2020:

1. The Great Financial Crisis (GFC) saw a substantial rise in deficits, leading to a notable rise in debt.

2. Some countries (IRE, UK, ESP, POR) also had a Real Estate/Banking crisis that further increased debt substantially.

3. Greece revised its reported debt levels upwards, which then necessitated a haircut.

Whilst the data above is from Eurostat (under the EDP classification), I have adjusted the Spanish debt to include the Government liabilities which jumped significantly in 2012 when debt (FLA, FFPP etc) was issued to support local authorities and regions. I believe these are interest bearing and whilst not included in the EDP Eurostat numbers, they have been included in the data above, taking Debt/GDP to 117% rather than 95%. The details are reported by the BoS.

CONSERVATIVE DEBT/GDP FORECASTS

Future GDP : The IMF World Economic Outlook has GDP projections for 2020 and 2021 for most of the countries in the table above. For those that do not, it seems fair to utilise the IMFs average Eurozone forecast. For the 2022 to 2027 GDP forecasts, it seems reasonable to use the actual GDP growth rates that occurred for each country between 2011 and 2016. The exception is for those countries that experienced the fallout from housing bubbles (ESP, POR and IRE) – the GDP has been modified using the Italian GDP growth rates.

Future Debt : The post GFC debt growth varied tremedously due to different impacts from Banking and Real Estate crises and drop in GDP. After 3 years of the GFC, Italy saw the smallest debt increase (+14%), Ireland the highest (+206%) followed by Spain (+63%). For the purposed of this exercise, a uniform 2020 deficit 7% of GDP is applied. The actual 2010-2016 debt growth rates for each country are then applied to extrapolate forward their individual debt growth rates. Again, the Italian debt growth rates are used for the countries that went through real estate crises post GFC. And finally, the 2012 Greek debt haircut is ignored and the average 2011/2013 debt growth rate is used instead.

These GDP and Debt assumptions should reflect a fair and conservative outcome. They show a recovery in GDP growth but a continued and only marginally improving deficit. It seems right to ignore the real estate bubbles which had huge impacts on sovereign indebtedness. In summary, the table and charts below show the development of each countries Debt/GDP ratios (full table at the end – note scale on Y axis is the same for all charts):

The resulting forecasts highlight a few key issues:

• Only Germany and the Netherlands will have ratios close to 70%. All the other major countries will see ratios of ~100% and above.

• The divergence of the Debt/GDP ratio between North and South widens, with the ratios of all the peripherals exceeding 150% by 2023.

• The growth of the French Debt/GDP ratio is similar to those of the peripheral countries.

• Greece will become a problem again.

• The ratios of Sweden and Denmark remain low, whilst the UK overtakes the average Eurozone ratio (NB The Swedish ratio will rise significantly if the housing asset bubble deflates).

DEBT SERVICEABILITY

In a much read and widely forwarded FT article about how the ECB could save the eurozone, Martin Wolf on commenting about debt growth concluded the “provided interest rates stay low and the ECB supportive, it may be surprising how much debt is sustainable. It is debt’s costs, not its levels, that determines sustainability”.

The last sentence is incomplete. As with all zombie companies whose cashflows are not enough to repay debt, government debt is only sustainable if interest rates are low and the debt can be refinanced, which Martin Wolf acknowledges in the preceding sentence by mentioning “ECB support”. Relatively recent post GFC refinancing issues with Irish, Greek, Portuguese and then Spanish and Italian debt show that that assuming refinancing certainty can be very dangerous for investments in their bond markets. The market in these instances needs to shift focus from Net Issuance to Gross Issuance.

NET vs GROSS DEBT ISSUANCE

The substantial rises in outstanding debt stock leads naturally to a larger redemption profile of bonds that need to be refinanced. The table below shows how the gross issuance of government bonds has grown substantially since 2007, due to both the rise in redemptions from a larger outstanding debt stock and the continued presence of deficits. In normal circumstances the large NET supply post GFC would have caused private sector assets to tumble, as private savings were diverted to fund the net supply, but the large QE programs led to a negative net supply of bonds.

For 2020, the market could naturally assume that there would be no debt financing issue, as the ECB QE is expected to be € 95bn more than the net supply (€ 35bn for Italy). However, that assumes that the € 721bn of maturing bonds will be rolled over and reinvested into newly issued debt (€ 202bn of redemptions for Italy alone). The numbers below are for bonds – they would be much larger should Bill refinancing be included.

RECENT AUCTION AND PRICE ACTION

Both Italy and Spain have recently used the syndicate process to issue new bonds. The price action before, during and after the debt issues, and the order vs allocation amounts, gave some very interesting information about the appetite for newly issued debt for the two large peripheral countries.

Tuesday 21st April : New € 10bn Btps 5yr (Jul25) and Tap of € 6bn Btps 30yr (Sep50)

On Monday the Italian Tesoro announced an operation to issue a new 5 Year Btps as well as a tap to an existing 30 year bond via a syndicate of 6 investment banks who are market makers of their debt. The banks opened the books on Tuesday for orders to purchase the two bonds. The demand was extraordinarily large, growing all day which prompted this headline :

But this demand came at a price. Even if the Tesoro decided to issue a slightly larger quantity than expected, yields on Btps rose substantially, despite the above mentioned huge orders.

The reason for this disparity between the huge demand and the rise in yields is obvious to those who have worked in bond syndicated issues – there was not real demand. Investors were most probably buying the new bonds (which were marketed a premium over existing bonds) against selling other bonds, and other investors most certainly inflated their orders to try and get a decent amount of bonds (investors will have known with such high demand they would have only received a % of their order).

Below shows the intraday yield of the 5 yr Btps from Monday to Thursday – it highlights that when the Tesoro announced the issue, the yield on the 5yr was c. 1.35%, and yet it was priced at c. 1.75%, i.e. with a 40bp concession. That yield increase is going to cost Italian taxpayers €40mm extra interest every year until this bond matures – this is the cost of the concession required to get its debt funded in the market. Subsequently the yield has dropped back to where it was trading pre-supply. The Btps 30yr supply came with a c.30bp concession, costing the taxpayer an extra €18mm a year in interest for 30 years, but unlike the 5 year, the bond’s yield is still 15bp above pre-syndicate trading levels. In total that cost will be ~€750mm over the life of the bonds.

This expensive yield concession needs to be seen in the context of an expected negative € 9bn of Btps supply for April. (Gross supply of €36bn less € 31bn redemptions and €13.5bn of expected ECB PSPP purchases). Rising yields and large auction concessions suggest that either investors with bonds redeeming are NOT rolling over into new debt, or there are more sellers that the net supply. That is not good news for holders of Italian debt or for the Tesoro.

Wedneday 22nd April: New € 15bn Bonos 10 year (Oct30)

On Tuesday the Spanish Tresor announced a new 10 year issue via a syndicate of banks. On Wednesday the operation was opened to the markets and a stream of orders piled into the syndicated banks, with headlines of € 66bn of orders and then eventually 97bn being reported. But as for the Btps issue the day before, the new Bonos bond came at a heavy price: 10 year yields rose by ~20bp, despite the “huge demand”.

And just like the Italian Tesoro the day before, the Tresor decided to issue an amount of bonds that was obviously too large for the market, and so yields climbed a further 7bp when they announced the bond size. Therefore the total concession was for 27bp for the new issue, equivalent to an extra €27mm of interest that the government will have to annually for the 10 year life of this bond (~€270mm in total).

Unlike the 5 year Btps, the yield of the new 10yr Bono remains 15bp above the pre syndicate announcement yield. Once again, net supply for the month of April, including the € 15bn new 10 year, should be a negative at ~€4bn (Gross Supply € 28 less redemptions of € 23bn and PSPP of € 9bn). Such a large yield concession to get bonds away and difficulty in retracing back to pre announcement levels speaks volumes about market sentiment for Spanish government bonds.

PRECEDENT AND FUTURE

Similar market behaviour requiring yield concessions to 1) refinance maturing debt and 2) absorb new debt has been seen at various times post GFC (eg 2011 or elections) and serves as a very important warning to politicians and central bankers that the market is fragile and under stress and they need to take action. This evenings’ Euro Council meeting finished with an agreement to a fund to help nations fight the repercussions from Covid19, but the size and timing has not been decided, and crucially there has been no decision on how this will be financed. The FT reports : France, Italy and Spain led demands for grants to stricken economies, whereas Ms Merkel insisted that any funding borrowed on the markets must ultimately be paid back. There were “limits” on what kind of aid could be offered, she told leaders, adding that grants “do not belong in the category of what I can agree”.

Two observations : Firstly note that FRANCE is sided with Spain and Italy – unsurprising the future debt profiles highlighted above. And secondly, and more importantly, the northern countries, who have a very different future debt trends to France and the peripheral countries, seem still to not be ready to provide grants, let alone cross the line in the sand of debt mutualisation. Until either change, the market should expect further concessions at peripheral auctions to refinance maturing debt, which given the size of redemptions are very frequent and regular.

If the past 10 years is a guide, then further market pressure will be put on the peripheral governments to find a compromise. But this time is very different……there is about to be an notable increase in the divergence of debt ratios that will make any agreement harder to find.