One of the unspoken truths about financial market operators is their inability to focus on more than one key issue at any given time. There is no criticism intended here, only the recognition that what we call “the market” is a collective of human beings, with all their natural shortcomings. This of course is not without consequences for financial market pricing dynamics and certainly makes for an interesting field of research. But let’s not go deep into behavioural finance. Suffice to say that with the market now focusing on the revolutionary episodes affecting the Arab world, the Eurozone sovereign debt crisis has fallen off the popularity perch. This is good news for Eurozone policymakers, suddenly afforded the luxury of breathing space to get on with the business of devising a more credible (and permanent) crisis-management mechanism. Let’s see if they do not fall foul of that other human shortcoming, that of falling into a false sense of security as scrutiny levels temporarily ease.
The fact is that even before the Arab world hit the headlines, one could sense a growing feeling of fatigue with the sovereign debt crisis story. Don’t get me wrong; the problem is still there. However, so is the Euro with all its country members. And this matters. It matters because the working assumption for a considerable swathe of operators was/is that the Euro cannot survive in its current form. That market prophecy may still come true; but it may do so in a way those operators had not envisaged. Indeed, “the market” may have unwittingly forced the Eurozone policymaking machine into delivering the previously unthinkable: some solid form of fiscal and economic policy coordination. No unburdening of the unruly periphery here, but rather legally-binding firm tutelage by the well-behaved core. Or as Germany’s Finance Minister Wolfgang Schauble put it: “how to strengthen the Eurozone is a systemic question and we must find a systemic answer that goes beyond merely looking to government budgets”.
The implications of this non-scripted take of events should not be dismissed lightly. Reduced to its ultimate expression we could be presented with a comprehensive package of notional fiscal transfers from core to periphery, and with it a transfer of notional risk from periphery to core; all done in the name of a policy harmonisation agenda. The loss of sovereignty would be very palpable (isn’t it already?), and lest we forget, legally enshrined, but it could be a price the periphery might be willing to pay if the comprehensive harmonisation process were to effectively address economic structural imbalances, including those of Germany.
Now, what has this got to do with ETFs, I hear you ask. Well, plenty. Any transfer of notional risk must ultimately find a translation into pricing of the securities making up the underlying fixed income indices ETFs track, and thus their NAV. We have already observed a fairly substantial narrowing of some cross-country sovereign bond spreads over the last few weeks. Take the 10y Spanish-German cross, now down to 185-190bps from 250bps at the start of the year. Some of this narrowing may have been caused by the policy hyperactivity shown by the Spanish government over the last two months, which has already resulted in the fast-tracked approval of a pension reform package and, more importantly, a restructuring plan for the financially-troubled saving banks (e.g. Cajas). But the key driver of the narrowing of the spread is to be found on the German leg of the trade; the recognition that Germany is willing, grudgingly, but nonetheless willing, to take on additional risk in order to preserve the common good (e.g. the Euro).
If one accepts this central premise as true, then it opens up a whole raft of strategic opportunities in the European fixed income space which can be put to work via ETFs going forward. Asset allocations would have to be re-balanced to account for the shift in risk valuations, with the likes of German-centric sovereign bond ETFs losing ground vis-à-vis those encompassing a broader country universe, let alone vis-à-vis those opting to track an ex-AAA index. We may even find that on the most commonly cited shortcomings of fixed income indices, namely the overrepresentation of highly indebted countries, suddenly turns into something of a strategic advantage.
At this stage, all of the above is just “food for thought”. However, as we write, YTD returns data collated by Morningstar already fit in with the broad story. We have taken a sample of four pairs of EUR-denominated government bond ETFs from four providers (iShares, Lyxor, db x-trackers and Amundi), with one ETF in each pair either German or AAA-centric and the other spanning out to a wider sovereign issuer universe. In all cases, the latter have performed better over the month, with Amundi’s Ex-AAA EuroMTS Government Bond ETF (X1G) top of the monthly performance list.
We certainly stop short of pretending that one-month set of returns data make for a trend. But what investors might want to ponder about is whether it could herald the beginning of one predicated on a process of shifting fundamentals that is unlikely to be derailed. Fundamental changes can be hard to spot, not least if the road ahead is filled with plenty of contrarian signals (e.g. Portugal forced to take up a bailout? Greece forced to restructure its debt payments?). Still, to get caught up in short-term distractions while ignoring the bigger picture developing behind rarely delivers in the medium to long term.
