Fixed Income Investment Outlook
Osterweis Capital Management
July 21, 2010
This past quarter, the number of negative headlines has escalated. These headlines include sovereign default and related banking failure risks in Europe, the possible dampening effects of European fiscal austerity programs on global growth, the Gulf of Mexico oil spill, geopolitical risks in the Korean peninsula, escalating tensions in the Middle East, and the effects of China’s changing exchange rate policy on global trade. The sheer quantity of negative headlines and the low probability of short-term resolutions to many of these issues have triggered a global flight to quality.
One of the major issues that cropped up this quarter is the financial stability of the European Union (EU), which began as a loss in confidence in Greek sovereign debt and has spread to other overly indebted EU countries, such as Spain, Italy, Portugal and Ireland. We fear the €750 billion ($900 billion) stabilization facility from the EU and the International Monetary Fund (IMF) may just be a down payment in the attempt to stave off sovereign defaults in the euro zone but, so far, it appears adequate. In our opinion, the fundamental problem is government over-spending, which when reversed could potentially sabotage economic growth. The European bailout package does not address the underlying spending issues, and is a big bet on the affected governments’ willingness and ability to implement austerity measures, and of their voters’ tolerance of such measures.
Specifically, Greece’s debt problem, and any other affected county’s problem, cannot be rectified by simply piling on more debt. Doing so may buy time, but eventually the piper must be paid. Politically, this bailout is the least painful fix in the short run, but we doubt the problem will go away without some longer-term pain. Currently, the market is skeptical that these actions will prevent a domino-like cascading debt crisis in other over-indebted countries. As a result, the euro, which as recently as last year was touted as the replacement to the ailing U.S. dollar as the world’s reserve currency, has been battered in the second quarter relative to the greenback. This devaluation may help exporting nations in Europe, such as Germany and Italy, but will probably not be enough to spur investment in Greece, Portugal and Spain, whose economies are supported mainly by domestic spending and tourism.
The Greek government owed €273.4 billion at the end of 2009, equivalent to 115.1% of the country’s gross domestic product. That ratio is expected to rise sharply through 2012 as Greece must continue to borrow to fund daily government operations and make interest payments on its existing debt. Greece’s interest payments are also growing rapidly, due to higher interest rates and increasing debt levels. It is estimated that by 2012, Greece will be paying €17.1 billion in annual debt service, up from €11.9 billion in 2009. If the market for Greek debt continues to weaken, those estimates may be low, as the interest rate the government must pay is likely to continue rising. It is not obvious how Greece will raise the necessary revenue to service this increasing debt load. As a result, a default and restructuring is not out of the question.
Why is the prospect of sovereign defaults in Europe so frightening for the non-sovereign financial markets? It is because a majority of the region’s sovereign debt is actually owned by European commercial banks. The toll of a sovereign default can be severe as we saw in late 2001 when Argentina defaulted on $82 billion of debt. Investors in that debt recovered only 30% of their principal. A similar magnitude of loss would be devastating to many European banks today because they have thinner capital cushions and heavier debt loads than their U.S. and U.K. counterparts did entering the sub-prime crisis. This leaves them quite vulnerable to any asset write downs. In 2008 and 2009, the U.S. and British governments moved aggressively to replenish their banks’ capital by injecting equity and buying many problematic assets from troubled commercial banks’ balance sheets. Unfortunately, most of Europe did not follow suit, since their banks owned presumably higher quality sovereign debt. The European Central Bank now finds itself needing to print money to fund its €750 billion rescue package to buy troubled euro zone government debt if necessary and save its fragile banking system. While many businesses may not be directly affected by potential principal write-offs on sovereign debt, EU economies will surely be starved of capital in the event of any major commercial bank failures.
If there is a lesson to be learned from this, perhaps it is that we should be wary of running large budget deficits. The U.S. Congressional Budget Office (CBO) projects that the U.S. deficit will hit $1.4 trillion this year, or 9.4% of gross domestic product (GDP). Even if our economy recovers, the CBO projects we will run deficits in excess of $400 billion a year later this decade. In addition, according to a U.S. Treasury Department report released in June, total U.S. debt will rise from $13.6 trillion this year to an astounding $19.6 trillion by 2015, four years earlier than previously estimated. The Treasury also expects that figure of $19.6 trillion to represent 102% of 2015 GDP, perilously close to Greece’s current debt to GDP figures. In testimony to the House Budget Committee in June, Mr. Bernanke said that “having a credible deficit-reduction plan in place will help keep interest rates down and help growth in the near term.” Let’s hope he’s right and that the politicians are successful in reducing our deficit. Although the Federal Reserve has been exiting some emergency support programs while planning a retreat from its easy money policies, near zero percent interest rates appear to be sticking around for quite some time, possibly fuelling another bubble. If our government reverts to more fiscal stimulus to sustain our fragile economic recovery, the U.S. may soon face financial instability not unlike what Europe is experiencing today. What deeply worries us is that if we create another asset bubble, the government may not have the wherewithal to bail us out again if it bursts.
The U.S. and certain European countries’ approaches to dealing with their respective economies and deficits have been quite different. While the U.S. continues to urge its counterparts to maintain some level of stimulus spending as a way of sustaining economic growth, some European leaders have been more cautious, chastened by the Greek example where investor confidence was shattered by mounting debt and the possibility of default. In fact, several European nations have pledged to focus on rigorous budget cuts in order to avoid another Greek-style crisis. German Chancellor Angela Merkel said that “if Germany cuts its budget deficit instead, then the citizen is more willing to spend money, because he knows that he can count on the pension, health and elderly-care system.” This seems like a rational approach. Since consumer spending is the largest portion of U.S. GDP, the Obama administration should perhaps heed Ms. Merkel’s comments, particularly since President Obama’s giant stimulus spending last year has had little impact on the country’s jobless rate, which remains stubbornly above 9%. During the recent U.S. financial crisis, faith was restored in large financial institutions when toxic assets were essentially exchanged for government bonds. If confidence in U.S. government bonds deteriorates, interest rates demanded by lenders would rise and debt service costs would become even more onerous. This would give policymakers even less room to maneuver. Let’s hope they strike the right balance of austerity and support and find clearer skies ahead.
With worries about the ripple effects from the European government debt crisis, coupled with meager job growth and low inflation in the U.S., we believe it is unlikely that the Federal Reserve will soon reverse its easy-money policies. We are concerned by the rising government budget deficits, the ballooning Federal Reserve balance sheet, and also by the quality of their financial holdings. In light of all these concerning developments, we continue to take what we believe is a conservative approach by focusing on securities that we believe will experience less volatility in the current unpredictable environment. These include short duration bonds and certain “cushion” bonds, which are longer-term, high coupon bonds that, in our opinion, will be refinanced in the near term, well in advance of their maturities.
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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