New Dawn for Peripheral Europe?

Darren Williams (pictured) and Dennis Shen

When Mario Draghi pledged to do “whatever it takes” to save the euro in July 2012, nobody expected things to change so quickly. Peripheral bond markets have since turned around sharply, supporting the European economic recovery. But can the improvements be sustained after countries exit their bailouts?

The commitment by European Central Bank President Draghi was a decisive moment in the crisis. Less than two years later, borrowing costs for bailed-out countries have tumbled back to pre-crisis levels and, in many cases, stand near all-time lows (Display). Current favorable market conditions have prompted Ireland, Portugal and Greece to take steps to exit their bailout programs and the associated harsh conditionality. This return to private financing marks an important transition from the worst of the crisis.

Ireland Leads the Way

The story started last December, when Ireland left its three-year bailout from the European Union (EU) and International Monetary Fund (IMF) without additional support and/or intervention. In our view, Ireland’s “clean exit” was justified by its large cash balance, low financing rates, manageable near-term funding needs and improvements in its economy.

Next up is Portugal. In the last five months, Portugal has knocked about €15.5 billion from its near-term funding needs in its return to international bond markets, culminating in last month’s resumption of regular bond auctions. On Sunday, Portugal announced it will make a clean exit when its bailout expires on May 17. Portugal probably isn’t as prepared to go it alone as Ireland was. Still, the recent sharp improvements in its circumstances make a successful clean exit more likely than we thought just a few months ago.

Can Greece Exit?

That leaves Greece. The country’s policymakers are visibly opposed to a third bailout from the EU when the current second bailout facility expires at the end of 2014. However, Greece’s ability to go without additional loans depends on whether it can raise a limited amount—estimated by the IMF at €11 billion for 2014 and 2015—from private sources.

Until very recently, a Greek bailout exit in late 2014 appeared unthinkable. However, rapid improvements in market conditions and this month’s successful bond auction—just two years after the largest default in sovereign history—make it more likely now that Greece will be able to meet its limited near-term financing needs via private sources. This increases the chances of a bailout exit later this year, in our view. However, it would not solve Greece’s many fundamental problems and any reduction in external pressure could reduce momentum for critical reforms.

Challenges Ahead

In our view, the jury is still out for countries that exit the bailouts. Despite meaningful progress, peripheral European economies still face many tough challenges. Structural adjustments are not complete and policymakers must ensure that they sustain an early recovery and combat high unemployment.

Moreover, debt ratios are still at peak levels—Greece’s public debt stands at 175% of GDP, Portugal at 129% and Ireland at 124%. Against this backdrop, continued fiscal restraint and efforts to boost nominal growth rates will be required to address longer-term debt sustainability.

Investors must pay close attention to how these challenges are going to be met as the bailout exodus gathers momentum.

Darren Williams is Senior European Economist and Dennis Shen is Economic Associate, both at AllianceBernstein.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

 

Darren Williams

Darren Williams is responsible for economic analysis, interest-rate forecasting and bond-market strategy for western Europe. His research focuses mainly on the euro area and the UK, although he also covers the Nordic countries. Williams has covered the major economies of western Europe for over 20 years, and has written extensively on the European Monetary Union and the monetary policy decision-making process of Europe’s central banks. He joined the firm in 2003, having previously held senior positions in the economics departments of several leading investment banks, including Citigroup, UBS and Merrill Lynch. Williams received a BS in banking and finance from Loughborough University (UK). Location: London

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4 thoughts on “Note to Bond King: Check Your Math

  1. “Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%.”

    No, that”s not really what needs to happen.

    US population does not have to shrink at all, rather only that it grow less than the “little over 1%” figure indicated.

    US annual population growth rates have generally been below 1% since the early 70s (but for a brief & unsustained surge in the early 90s), and the historical population growth rate trend has clearly been trending downward in the US for over a century now (was nearly 2% around the turn of the last century, and has been in the lower 0.9% for the most recent decade+). During the Great Depression (the last time we went through a Fisherian debt-deflation following a Minsky-ian financial crisis), population growth rates fell from “a little over 1%” to the 0.6% range. Add to the mix the right”s antagonism towards immigration, and it not at all difficult to conceive of relatively lower population growth that the ”norm” suggested by Seth.

    Ditto re: productivity gains: Productivity does not have to actually reverse into negative territory (although that has happened for brief periods of time), rather the rate of productivity gains merely has to slow from the assumed 2% rate, which is entirely reasonable (see, e.g., http://www.bls.gov/lpc/prodybar.htm).

    Over the course of the “Great Moderation” [which is now long gone & replaced by the ''new normal'' of delevering our way out of a balance sheet recession] nonfarm business sector prductivity trended from approx. 1.1% during the 1973~1979 stagflation era steadily upward to 2.5% for the 2001-2007 period of the Bush policy area… only to start falling again (1.8% average for the post-bubble era). Without a clear path out of our current debt-deflation induced economic malaise, it is hard to see how 2%+ productivity gains can be sustained over the next decade in the face of dampened aggregate demand & ongoing deleveraging… unless corporate America resorts to yet more unemployment. It is not all that hard to envision an extended period of low productivity gains of, say, only 1%, as has happened for multi-year steches over the last 40 years.

    As for inflation: Maybe not ”forever”, but perhaps for the next 10 years. Until the private sector”s balance sheets are sufficiently repaired – which then allows aggregate demand to rebound sufficiently to start making a run towards full employment & full use of productive capacity – it is unlikely that inflation is going to consistently generate even your ”modest” 3% target. The Fed has already set a 2% inflation target – which it has barely met even in the face of energy price spikes & a domestic drought”s impact on agricultural commodities – through 2014 ~ 2015. With Europe on its knees, unemployment stubbornly high & capacity utilization stubbornly low, and the US dollar still the reserve currency of choice, there is little if any inflationary pressure anywhere, that I can see.

    So, at the end of the day, all that is needed to see 4% nominal equity returns is, let”s say (just for the sake of argument), 0.7% population growth + 0.7% productivity growth, then real stock returns are a measly 1.4%. What is unreasonable with that? A bit pessimistic, perhaps, but certainly not unreasonable.

    Add back the Fed”s targeted 2% rate and you get 3.4% nominal equity returns… below Gross” estimate, without much stretch of the imagination at all. And without population shrinkage or productivity collapses of any sort.

    • Your scenario is possible, but it’s just one scenario, and not the most likely one, in our view. In any case, even 3.4% nominal equity returns would beat prospective long bond returns. You’d still get to Dow 20,000, but it would take longer. In my next blog post, I will discuss a number of different scenarios and how long it would take the Dow to reach 20,000

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