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Euro zone bulls set off alarm bells

Improved market sentiment against a backdrop of anaemic growth and much-needed economic reforms is a warning sign for investors

PUBLISHED : Friday, 17 January, 2014, 1:09am
UPDATED : Friday, 17 January, 2014, 1:09am

Financial markets and real economies often seem to exist in parallel worlds. And that makes the current rally in the bond and equity markets of the euro zone's most vulnerable members all the more alarming.

These assets are now pricing in a substantial and strengthening recovery. That is despite domestic demand in the euro zone shrinking, the bloc's unemployment rate remaining stuck in double digits - in the high 20s in the case of Greece and Spain, to say nothing about the significantly higher levels of youth unemployment - bank credit to the private sector continuing to contract and the public debt burdens of eight member states exceeding, or approaching, 100 per cent of gross domestic product. The rally woefully misprices those facts.

Sentiment towards Europe's single currency area is being buoyed by growing confidence that the worst of the crisis has passed, but the rise in asset prices should not be seen as anything other than portfolio rotation.

Put simply, the appeal of euro zone peripheral debt is rising vis-à-vis the bonds of emerging markets because the latter have fallen out of favour with investors since the United States Federal Reserve signalled in May last year that it would start winding down its asset purchases.

Many emerging market assets are more vulnerable to rising US treasury yields because of their heavier reliance on inflows of foreign capital, persuading investors to buy underowned and, what are now perceived as, safer assets in the euro zone periphery instead.

Last week, bids for an issue of Irish 10-year paper reached nearly four times the amount Dublin eventually raised, a mere three weeks after Ireland exited a bailout programme. Not only did Ireland pay a yield of just 3.5 per cent on the bond issued - down from a high of 12 per cent in 2011 - its five-year borrowing costs even dropped below those of Britain at one point last week.

Such is the strength of demand for higher-yielding debt that even Bankia, the state-owned Spanish lender whose spectacular collapse forced Spain to request a bailout for its banking sector in June 2012, raised €1 billion (HK$10.5 billion) in five-year unsecured paper with a coupon of 3.5 per cent.

What is more, Portugal, which only a few months ago was perceived as a prime candidate for a second bailout after its current rescue programme expires in June, received more than €11 billion of orders for a sale of five-year debt in which Lisbon had initially planned to issue up to €3 billion. The €3.2 billion eventually raised covers half its funding needs for this year and has convinced many analysts that it will be able "go it alone".

The speed and scale of the improvement in market sentiment towards the euro zone against a backdrop of anaemic growth, mounting political resistance to much-needed fiscal and structural economic reforms and persistent problems in the governance of the ill-managed bloc should set alarm bells ringing.

Throughout the four-year-old crisis in the bloc, there have been numerous episodes of market prices - in particular those of government bonds - becoming detached from countries' economic fundamentals.

Investors have either been too bearish about the prospects for the euro zone, notably at the end of 2011 when fears were rife that the bloc was about to break up, or have proved overly bullish. The current mood of the markets smacks of the latter.

To be sure, the outlook for the euro zone economy has brightened somewhat in the past several months. The bloc emerged from recession in the second quarter of last year, with manufacturing and service sector activity expanding over the past several months. Indeed retail sales in November rose at their fastest pace in four years, and even grew 3 per cent in Portugal.

But the best that can be said about the euro zone economy is that it has stabilised, with household and business confidence still fragile and scant prospect of meaningful growth.

That the European Central Bank is still considering further measures to ward off the acute threat of deflation speaks volumes about the persistent weakness of the economy.

The woes of emerging markets may be playing in favour of the bonds and equities of the euro zone periphery, but they should not mask the underlying weaknesses of Europe's single currency area.

Investors are taking far too much for granted in the euro zone, particularly on the banking and political fronts.

The ECB, in its new role as a banking supervisor, is overseeing the most comprehensive vetting of euro-zone banks' balance sheets without a common fiscal backstop in place to cover the sizeable capital shortfalls which are expected to be revealed in this year's asset quality review and stress tests. This is a case of putting the cart before the horse. There is no banking union in Europe because there is still no fiscal and political one.

The politics of economic reform are also souring significantly. France and Italy, which together account for nearly 40 per cent of euro zone GDP, have failed to improve their competitiveness during the crisis and have become the "sick men of Europe", incapable of meaningful reform and politically volatile.

Investors may be in no mood to focus on these issues, but they ignore them at their peril.

Nicholas Spiro is the managing director of Spiro Sovereign Strategy in London



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