European Economic Risks to the Downside, Yet Financials Trade to the Upside
It seems that the banking crisis in Cyprus has quickly become old news in investors' minds and the market appears to be discounting the potential for contagion and runs on weak banks in other peripheral eurozone nations. Credit spreads of European banks rebounded significantly from the prior week's Cyprus-induced sell-off.
Japan has more than JPY 1 quadrillion (yes, that's correct) of outstanding debt, representing about 200% of GDP.
While tightening credit spreads on the sovereign debt would typically indicate declining credit risk, economic metrics out of Europe continue to indicate that the eurozone's recession is deepening. In addition, at the European Central Bank press conference, chairman Mario Draghi made several bearish comments about the eurozone economy, in particular admitting that the economy faces several downside risks. Unemployment is running at a 12% rate and appears poised to rise further. The purchasing managers index for eurozone manufacturing fell to 46.8 (a reading below 50 indicates contraction). Based on economic indicators, most forecasters expect that the eurozone probably contracted in the first quarter, which would be its sixth consecutive quarterly contraction. As the economy weakens, we expect nonperforming bank loans will rise, further pressuring banks' creditworthiness.
The ECB held its key short-term interest rate steady at 0.75% but indicated that it was contemplating additional measures targeted at improving credit to small and medium-size businesses, which have had difficulty securing reasonably priced loans. With the eurozone economy contracting and the euro strengthening versus other currencies, making eurozone exports less competitive internationally, we suspect the ECB will cut its short-term rates sooner rather than later. Outside the eurozone, UK policymakers have also discussed the possibility of additional easing.
At the beginning of March, we revised our outlook on the US banking sector to neutral from overweight. The impetus for that change was our increasing concern about the continuing growth of nonperforming loans in Spain and Italy. We think the increasing non-performing loans will probably lead the markets to further question the stability of many European banks. Subsequent to the restructuring template set in Cyprus, bondholders are also assuming a greater risk of impairment in a bailout situation. Therefore, we expect credit spreads of European banks will probably widen, which may then lead to widening credit spreads among US banks.
Japan Goes All In
In an attempt to generate a 2% inflation rate, the Bank of Japan announced it will undertake a new quantitative easing programme that will double its monetary base by the end of 2014. The BOJ hopes the combination of modest inflation, low interest rates, and negative real yields will stimulate Japan's moribund economy.
The BOJ plans to purchase long-dated Japanese government bonds at an annual rate of JPY 70 trillion (approximately JPY 6 trillion per month). At current exchange rates, that's about $520 billion a year ($43 billion per month). While these numbers are smaller than the Federal Reserve's asset-purchase programme, keep in mind that Japan's GDP is about one third the size that of the US.
Japanese policymakers will be walking an especially perilous tightrope, balancing the desire to generate a modest amount of inflation yet preserve confidence in their currency and keep interest rates from rising too much, too quickly. Given Japan's outsize debt load and its already high debt service expense, the country cannot afford to let interest rates rise much in the short to medium term. This year, Japan is currently budgeted to finance about 46% of spending through new bond issuance and debt service costs account for 24% of budgeted spending (or 45% of the country's tax revenue). Japan has more than JPY 1 quadrillion (yes, that's correct) of outstanding debt, representing about 200% of GDP.
While Japan has long had a large domestic pool of sovereign debt investors thanks to its high saving rate, demographics will soon begin working against the country. As the rapidly ageing population begins to retire, those employees who had previously been buying debt through savings and investments in their pension funds will become retirees and will begin to drain assets from their pension funds and savings. If domestic investors lose faith in Japan's creditworthiness or international investors are not willing to purchase long-term debt at current low yields, interest rates will rise. Every 1% increase in the country's average interest rate would add another JPY 10 trillion to debt service costs. If the country's average interest rate were to rise rapidly by 3%, then the entire country's revenue base would be required to service debt.
After the BOJ's announcement, the yield on Japan's 10-year bonds initially dropped as low as 0.32%, but soon sky-rocketed to 0.53% by the end of the trading day. The yen's value fell 3.7% last week versus the dollar and has dropped 12.8% since the beginning of the year. While the weaker yen will help Japanese exporters, it will also dramatically increase the cost of agricultural and energy imports, which will pressure the margins of industries with high exposure to commodities.
While Equity Markets Rally, Fixed Income Starts 2013 With a Weak Tone
The Morningstar Core Bond Index—our broadest measure of the bond market—declined 0.06% in the first quarter. Losses were driven by rising interest rates as the 10-year Treasury rose 9 basis points to end the quarter at 1.85% and the 30-year Treasury rose 16 basis points to 3.11%.
While the S&P 500 hit new highs, corporate bond investors have grown relatively more cautious in their outlook as the average credit spread in the Morningstar US Corporate and Eurobond indices widened over the first quarter by 1 and 3 basis points, respectively, to +142 and +143. Typically, corporate credit spreads will tighten in conjunction with a rallying equity market; however, with corporate credit spreads near their tightest levels since May 2011, credit spreads have not participated in the current "risk on" attitude in the marketplace. For comparison, since the 2008-09 credit crisis, the tightest spread level that Morningstar's Corporate Bond Index has traded at was +129 in April 2010 and the average credit spread since 1999 is +176. Corporate bonds in the emerging-markets segment declined 0.28% last quarter, but outperformed our Emerging Market Sovereign Index, which fell 2.51%.
We view the corporate bond market as fully valued at current spread levels and expect returns in the low- to mid-single-digit range this year. To generate a higher return, one would have to assume that either interest rates will fall below their already low levels or credit spreads will tighten toward the historically tight levels experienced before the 2008-09 credit crisis. While credit spreads may tighten modestly due to strong investor demand for corporate bonds, over the longer term we think the preponderance of credit spread tightening has run its course.
Among the government indices, Morningstar's Global Ex US Government Bond Index declined 4.33% as foreign exchange movements from the strengthening dollar more than offset underlying bond price appreciation. For example, Morningstar's Japanese Bond Index declined 5.96% in the first quarter. Although interest rates in Japan plummeted to new lows as the yield on Japan's 10-year government bond declined 24 basis points to 0.55%, the weakening yen more than offset higher underlying bond prices. While foreign exchange movement was the greatest determinant of returns this quarter, the banking crisis in Cyprus in March caused a flight to safety in the short end of the interest rate curve. Bond prices for both German and Swiss 2-year bonds increased so much that their yields dropped into negative territory for the first time since the end of last year. Among longer-dated bonds, the yield on Germany's 10-year bond dropped 9 basis points to 1.38%.
