Blurring the boundaries of risk .......

Tuesday 7th March 2017

ref :- "Eurozone road map needs an urgent update" , The Financial Times, Analysis / Capital Markets

Ah yes, risk ..... an investor might legitimately argue that, when all's said and done, it's what markets are all about. How to control risk as far as is possible and still make a nice return, that's the challenge.

The problem facing the modern investor is that at the "macro" end of the scale judgement of risk, and therefore a valid assessment of what constitutes good value, has become a lot more difficult. In the Eurozone, the old order of things regarding the creditworthiness of nation states has been shaken up. In terms of how their debt should be treated, countries have long been split into three different categories : core , semi-core and peripheral (okay, four if you include an extra one for Greece) . To call Germany "core" and say Portugal "peripheral" seems pretty straightforward , but the accepted wisdoms of just a few years ago do not necessarily still apply.

The FT offers us Bankia, the Spanish banking group, as an example. Formed as a merger of seven separate Spanish banks in 2010, an alarming over-exposure to real estate loans that was so widespread in that country necessitated a government bail-out in 2012. The Spanish government still owns a majority shareholding. Not a happy story you might think .... but Bankia has just sold €500 million of Tier 2 debt (i.e. it is exposed to any bank losses and counts towards its capital levels) in an issue that was nearly ten times oversubscribed. What's more, they got it away with a coupon of just 3.4%. As a measure of how things have changed, Spanish 10yr government debt was trading with a yield of over 7% in 2012.

If it's correct to continue to label those powerhouses in the north of the Eurozone, Germany and the Netherlands say, as "core" nations, it's no longer automatically correct to cast the likes of Ireland and Spain in the "peripheral" category. Ireland has emerged from its own property-induced financial crisis in a robust recovery that has taken it firmly into "semi-core" territory. Spain is headed that way too, boasting impressive economic fundamentals and a banking system no longer vulnerable to systemic risk. Only an overlarge budget deficit needs to be addressed.

At the same time France, at the core of the European project in every way since its inception, may be headed the other way. The Germany / France 10yr yield spread, in other words the premium investors require to buy French bonds rather than German ones, traded out to 85 basis points recently. Six months ago, the spread was trading at just 24bp. Some (ABN Amro, for example) currently describe France as "semi-core". This would put it in the same category as Ireland, Austria and Belgium, and more than anything reflects the political risk attached to France and French assets.

Whether or not you believe that the chance of electoral success for Marine Le Pen is even credible is not really the point. The markets are wary enough of the possibility to push France down in its unofficial credit rankings. It's pretty extraordinary to rank French debt alongside Irish debt, but some would argue that in fact if you look at the way French bonds have behaved in advance of the crucial election, it's had more in common with the likes of Italian paper than it has with that of Germany and the Netherlands, which have been the beneficiaries of a flight-to-quality. Just in case anyone might have forgotten, Italy -- beset by systemic banking problems and political issues of its own these days -- is very much associated with the "peripheral" categorization.

To think of France as peripheral seems a stretch to say the least, but the point the FT is making is that the old order has changed and it needs to be recognized. They're right of course ..... beyond political considerations, the ECB's efforts to stimulate growth throughout the Eurozone by buying bonds across the board -- "core", "semi-core" and "peripheral" -- has compressed the differences in borrowing costs between member states to the extent that it has blurred the distinctions between different categories.

The irony is that because these boundaries should never be written in stone, it's very possible that as soon as one gets one's head around the up-to-date rankings so to speak, they're quite likely to change again. The return of growth and inflation, if continued, would at some stage induce the ECB to taper its support -- they have already said that monthly bond purchases will be reduced from €80bn to €60 from next month. If bond yields were to rise again, investors may want to reinstate the traditional distinctions that held all the way through the financial crisis.

The old order restored, perhaps ..... for a while.

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