The latest Greek bailout was positive, but the flawed EFSF remains a concern .
Paul Brain, manager of the Newton International Bond Fund, reacts to the announcement of the latest Greek bailout and looks at the looming deadline for the US to deal with the pressing issue of its debt ceiling.
"Last week's news that an agreement had been reached over Greece's sovereign debt issues was undoubtedly positive, but it's not all good news. When the European Financial Stability Fund (EFSF) was first created, the major fault with it was the high interest rates that those receiving economies had to pay on their loans. The good news is that this has now been lowered, and maturities extended," Brain explains. "As such, the interest burden is suddenly much more manageable for the likes of Greece, Ireland and Portugal. Furthermore, the EFSF will be able to buy in the secondary market, which is also a positive," he adds.
"Now for the bad news: this whole process has taken far too long, growth remains week, and many of those countries which need to pay down their debt are yet to even start. Given the time that it has taken to come to an agreement over Greece, the spotlight has shifted to Italy and Spain, putting undue pressure on their already weak economies." He continues, "Furthermore, the 21% haircut agreed on Greek government bonds is certainly a positive step and should, together with the other measures, roughly equate to a reduction of around 25% of Greece's debt to GDP, meaning that Greece's debt to GDP could be reduced to be around 140%. That's all good and well but if, as seems very likely, Greece is still without positive growth over the next two years, its deficit is likely to expand once more. That's why we believe that the 21% haircut should have been closer to 50%, in order to factor in the next few years of soft economic growth," says Brain.
"Meanwhile, the use of the EFSF as a bailout fund continues to cause problems. Use of the fund requires political agreement from all Eurozone states, so there is plenty of scope for further bumps in the road. Indeed, the Slovakian government is expressing its concerns about the latest Greek bailout. As we have explained before, the EFSF has many flaws." He continues, "For example, it can't be expanded as it couldn't cope if Italy or Spain sought help, given that they would no longer be contributing and the core Eurozone countries would then be required to increase their share of the burden. This is something which they would understandably be reluctant to do.
"Ultimately, the EFSF doesn't solve the problem," says Brain. "The issue is not one of liquidity, but of solvency and the urgent need for economic growth. There have been suggestions of something similar to The Marshal Plan - the large scale US programme to aid Europe where it sent monetary support to help rebuild European economies after the end of World War II - through which the EU would grant money to fund ‘growth' projects in struggling peripheral Eurozone countries. How this would work in practical terms remains to be seen, but more importantly, we believe there needs to be a broad realisation that the focus needs to be on growth, rather than austerity," he adds.
US politicians play with fire...
Across the Atlantic, the US is less than a week away from technical default should the Democrat and Republican parties fail to reach an agreement over the raising of the US debt ceiling. The parties are haggling over the make-up of any austerity measures, with the Democrats aiming for a 70:30 ratio of spending cuts:tax rises, while the Republicans favour 100% spending cuts. The debate is further complicated by the Republicans' dominance in the House of Representatives. Meanwhile, credit rating agencies have already warned that the US is likely to lose its prized AAA rating if it fails to agree on a deficit reduction plan to the tune of around US$4 trillion over the next few years. Brain thinks that a downgrade to AA is possible, he explains, "We currently can't see an agreement over the next week which would appease the ratings agencies, but we may see the Democrats and Republicans coming to some sort of short-term agreement over a reduction plan of around US$2 trillion, raising the debt ceiling temporarily, and readdressing the issue once again this time next year during the run-up to the Presidential elections.
"Should the US lose its AAA rating, there would be the inevitable questions over the future of Treasuries as collateral, as well as the likelihood of some forced money market sellers, leading to a small but not insignificant underlying reduction in liquidity," he explains. "We expect there to be much greater clarity on this front after the 2nd August deadline. On a positive note, at least the issue of the debt ceiling has forced the hands of US politicians and made them address the deficit, but, much like the Eurozone, the delaying tactics and time taken to find a resolution are not a good thing.
"In terms of portfolio positioning, we continue to steer clear of much of the peripheral Eurozone government debt, but hold an underweight position in Italian government bonds. We have been selling US Treasuries in recent months and adding to supranationals - these offer better spreads and diversification away from the US government and the political shenanigans in Washington," he says. "Meanwhile, we can find plenty of attractive investment opportunities in those markets which are relatively immune to the risks associated with the US and Eurozone, but still offering high yields. In this vein, we currently favour the government debt of Norway, New Zealand, Sweden, Australia, the Czech Republic and Poland. More broadly, the events of the past weeks and months have changed a lot, but little in terms of the uncertainty that continues to abound. In such an environment," he concludes, "the challenge is to pinpoint those relatively risk-free investment opportunities."
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