Tuesday, July 15th, 2014

One-Eyed Pigs

Our Eurozone government bond model has been inactive for so long that we had begun to wonder whether it was still alive. For the whole of 2014, there has been no virtually no change in its exposure to the periphery relative to the core. Two weeks ago the model twitched. Last week, there were clear signs of movement as markets became aware of the ECB’s intervention in Banco Espiritu Santo, Portugal’s largest bank, and began to fret about the possibility that other banks might fail the ECB’s stress tests. We also downgraded Eurozone Financials to Underweight, though we doubt that had quite the same level of market impact.

This week, Ireland has gone to the top of our Eurozone bond model (up from #4) and the previous three leaders, Portugal, Greece and Spain, have each moved down one position. As yet, there has not been a significant reduction in the recommended weights for these three countries, but after a long period of stability it will take time for this to develop. What we can already observe is that the probability curve (which measures the likely future direction of the recommended weight) has deteriorated for all of them. It has also deteriorated in Italy, which is currently ranked #5. For Ireland, it has improved, as it has done for the whole of the core, without exception. We need a few more observations to be certain of this new dynamic, but it looks as though Ireland has escaped from the periphery, but that the other countries haven’t. The PIIGS should now be spelt PIGS – with one “I”, not two.

Also noteworthy is that the rating and the curve of Austrian bonds have not been adversely affected by the write-offs at Erste Bank. This suggests that investors do not see a one-for-one relationship between the credit-worthiness of the sovereign and balance sheets of domestic banks. This is consistent with the Portuguese government’s refusal to consider the possibility of leading a rescue of BES or any other Portuguese bank. We have heard this before, but it is much more likely that some losses would be imposed on private sector bond holders this time round. The speedy ejection of incumbent management is in marked contrast to what happened previously.

But if Portugal and the ECB are really serious about “no public-sector bail-outs”, why are the sovereign credits reacting so badly? One possible exception is that the sell-off was a knee-jerk reaction, which will be unwound in coming weeks. The other, which we incline towards, is that the BES saga coincides with a realisation that there is nothing left to go for the peripheral bond markets.

There is a problem with the latent risks to do with bank-recapitalisation, but the real issue is the lack of apparent return. This view is supported by the latest Bank of America Merrill Lynch survey of fund managers, which rates the Long EU peripheral debt as the second most-overcrowded trade in global financial markets. Last month it ranked #1 on this measure. Ireland may not be one of the PIGS any longer, but it may still underperform, if investors think that future returns are simply not available.

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