Clearing the cliff overhang

PORTFOLIO POINT: The European debt crisis appears to be over for now. The US fiscal cliff is the only thing potentially standing in the way of a solid market rebound.

If you recall last week’s note, I expressed some nervousness about the near-term outlook. It’s not that I’m concerned about a renewed deterioration or anything. I’m nervous about missing out on the next serious upswing – especially for commodities.

The entry point is critical and the key obstacle is the “fiscal cliff”. I really just have no idea how bad this whole fiscal cliff situation is going to be. On the economics, as I highlighted to readers, it’s not a problem at all (equivalent to a small increase in the Fed funds rate from 0). But psychologically for the market it could be devastating. Which, of course, would provide a great opportunity to re-enter, double up, or whatever the case may be, on some of my medium-term positions.

The reason I’m agonising over this is because, in the absence of the cliff, I’m not seeing too many headwinds to a strong market rebound. This may surprise some readers, but hear me out. I don’t dismiss the risks, I’m very conscious of them. However, it is my opinion that the European crisis is largely over. Ok, maybe not entirely over, but at the very least it’s entered a new and much less disruptive phase. That is, there is now little risk of a broader contagion disrupting the financial and real economies.

Now this is far from a consensus view among analysts I realise, especially as the German Chancellor Angela Merkel said just over the weekend that the crisis could last another five years. I’m sure that will be true, but I suspect the dramas will be increasingly political in nature and increasingly ignored by the market. Realistically it comes down to whether you think the European crisis, and in particular that of Spain and Italy, was one of solvency (too much debt that they could never hope to repay) or liquidity (fear or panic driven).

For mine, and with the exception of Greece, the issue was always and still is one of liquidity. Recent developments have given me much more confidence in that view. Greece was an issue of solvency – still is. But the outcome for Greece doesn’t matter anymore. The only reason why it mattered at all was because of the possibility of contagion – and we got that already. The real issue is Spain and Italy, and here the news is much better now.

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Chart 1 shows the spread of Italian and Spanish 10-year debt to German bunds. Note the sharp decline in spreads to bunds now. While spreads remain high to history, the market is very visibly less concerned about Spain and Italy (relative to Germany) than they were. Indeed, recent bond auctions show that neither Spain nor Italy is having any trouble tapping the markets for funds – and the ECB hasn’t actually started buying any bonds yet. Investors are happy to take the extra yield in most cases.

Now the fact there is still a premium suggests the market isn’t totally at ease, but the measures put in place have reduced the market’s assessment of any emergency. We also have to consider rating agency downgrades, which have meant that many investors simply can’t hold (well can only hold less) Italian and Spanish bonds – and I’m not the only one to suggest the ratings agencies are out of line on this front. Many would argue, in hindsight, that there should have been a more significant premium built into some sovereign yields decades ago to discourage borrowing then before the problem became too big.

Anyway, the point is, if the crisis was truly a crisis of solvency, the ECB’s decision to buy bonds, and the establishment of the ESM, should not have had much of an impact. It would really be irrelevant, because no matter what the interest rate, absolute debt levels are just too high. So according to that argument, this debt can never be repaid.

That significant spread compression shows that investors disagree. Why else would they be buying Spanish and Italian debt? They wouldn’t if either country was truly insolvent. Needless to say there are some who still view Spain’s and Italy’s problems as one of solvency, but there are a few reasons why this view is incorrect. Now I highlighted in my very first Eureka note Europe’s untold riches May 7 why I didn’t think the European crisis was one of solvency. Government debt (shown in Chart 2 below) was high for Italy (not Spain, although recent estimates suggest the ratio is over 90% now) but household balance sheets were just too strong for both Italy and Spain. Net household financial assets alone (shares and cash once debt was paid off) swamped, by a significant multiple, public debt.

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Now that analysis didn’t include the very obvious point that insolvency isn’t even determined by the absolute amount of debt that a country holds. It is determined by the capacity to repay that debt.

Here the news, even through the crisis, is very good indeed (take a look at Chart 3). What it shows is that despite higher (and more likely than not, rising) debt levels, the capacity to repay is actually the best it has been for decades – 4.2% for Italy and 1.5% for Spain. That is, debt servicing costs are historically low. This is what matters at the end of the day. Now fair to say this is 2010 data, and in 2010 Italian and Spanish bond yields were lower than what they got to at the peak of the crisis or are now. The 10-year was at just over 4% for Italy (now 4.9% with a peak of 7.5%), while Spain’s was 4.25% on average (now 5.6% with a recent peak of 7.7%).

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However this doesn’t really change the story, or average debt servicing that much. And that’s because of the long average maturity of Spanish and Italian public debt – six to seven years. This fact was taken up by one institution I have immense respect for, and that is the Bank for International Settlements (BIS). It showed that the high average maturity of debt held meant that even in a situation where the Italian bond yield was 500 basis points above the 2007 rate, which was 4.5% then (so we’re talking 9.5% or 200bp above the highest peak so far) and stayed there, then the debt servicing ratio would rise about 1.25% in 2012 and 1.75% in 2013. If rates were 200bp above (so a 10-year yield of 6.5% or 130bp basis points higher than it is now) then it would be around 0.5% or less in each year over the next three years (shown in figure 1). For Spain it would be even less, given its debt to GDP is much lower than Italy’s.

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Take another look at chart 3, or if you prefer chart 4, which shows debt servicing costs as a percentage of government revenue rather than GDP. You can see that Italy and Spain have both been here before – back in the mid 1990s. In fact the situation was much, much worse then, with debt servicing costs two to three times higher than they are now. Even under the BIS worst-case scenario of a 500bp spike in bond yields. If they got through it then, and they did, they’ll get through it now. Look back to Chart 2 – Italy’s debt/GDP shrank from over 120% to 100%, while Spain’s went from (a still low 70%) to 40%. It may have taken a decade to achieve, but they did do it. If they did it then with debt servicing costs two to three times higher, then they will surely succeed now – in fact it will be easier.

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You can sees why I’m not worried by Europe, why I don’t think the Spanish and Italian economies were ever insolvent, even including their banking sectors. They weren’t event close. Theirs, in contrast to Greece, was a liquidity crisis – sparked by fears over solvency, sure, but these fears were always misplaced.

Indeed they would have become self-fulfilling if not for the creation of the ESM and the ECB’s decision to buy short-dated bonds (if necessary, they have yet to do this). But those decisions by policymakers breaks the self-fulfilling cycle that the liquidity crisis would have caused. That is why it is critical and why investors have come back to the market – and why for mine, the crisis is largely over.