Asset management 19 August 2013

Economist Insights
Summer breeze
Joshua McCallum
This summer has been less heated in the Eurozone
Senior Fixed Income Economist
sovereign markets than the past three summers. The
UBS Global Asset Management
economic outlook has improved and the Eurozone
joshua.mccallum@ubs.com
finally resumed growth in Q2 2013 after six quarters
of contraction. The headwinds facing the Eurozone are
still strong but are less intense than last year. It is likely
that the recovery will be gradual and relatively muted. Gianluca Moretti
Some progress has been made in structural adjustment Fixed Income Economist
but some of the structural causes behind the crisis have UBS Global Asset Management
not been fully resolved. The worst of the crisis may have gianluca.moretti@ubs.com
passed but the crisis itself is far from over.

Over the past three years, thanks to the Eurozone crisis, we grew somewhat over the last year, and many sectors of the economy
accustomed to very heated summers in the sovereign markets. are still deleveraging but at a less aggressive pace than before.
This summer, the temperature of sovereign markets has been
Chart 1: Getting cheaper
remarkably cool with sovereign spreads tightening to their
lowest levels since 2011. This is even more surprising given that Unit labour costs (2000 to 2008, 2000 =100)
the political climate has remained hot, driven either by domestic 135
politics (Portugal, Spain and Italy) or by doubts around the 130
ongoing adjustment programs (Portugal and Greece). 125
120
The Outright Monetary Transactions (OMT) programme
115
announced one year ago likely remains the main driver of the fall
110
in sovereign spreads over the last year. However, it is probable
that the recent improvement in economic outlook has also 105
played a role. Last week Eurostat revealed that the Eurozone 100
finally resumed growth in the second quarter of 2013 after six 95
consecutive quarters of contraction. The positive reading was 90
2000 2001 2002 2003 2004 2005 2006 2007 2008
entirely driven by Germany and France which both surprised Core Coreiphery Periphery
substantially to the upside. But there was also a significant
improvement in the periphery: Portugal came out of recession Unit labour costs (2008 to present, 2008 =100)
while the contractions in Italy and Spain were the least severe 135
since 2011. 130
125
Although the contribution of the different spending components 120
is not available yet, it seems likely that the improvement was 115
driven not only by external demand but also by a stabilization
110
of domestic demand. Despite the recession ending sooner than
105
markets were expecting, it is likely that the recovery will continue
100
this year and next.
95
The headwinds facing the Eurozone are still strong but are 90
2008 2009 2010 2011 2012 2013 2014 2015 2016
less intense than last year. As such, it is quite likely that the Core Coreiphery Periphery
recovery will be gradual and relatively muted. Fiscal consolidation
Source: Eurostat, UBS Global AM
continues to weigh on the economy but less so than last year. Core = Germany, Austria, Slovakia and the Netherlands. Coreiphery = France, Italy,
Borrowing rates for the private sector remain high but have fallen Belgium and Slovenia. Periphery = Spain, Portugal, Ireland and Greece.
Another driver of the fall in sovereign spreads could be the a large part of the adjustment occurred within the Eurozone
progress in the adjustment of Eurozone imbalances. The itself. The trade deficit of the periphery versus the rest of
periphery entered the crisis with a high level of debt, an the Eurozone almost closed in 2012: the periphery still has
uncompetitive external position (with no control over the a small deficit with the core, but it now has a trade surplus
exchange rate to compensate) and a large reliance on foreign with the coreiphery. This is probably a reflection of the sector
funding both from the public and the private sector. specialization between the three areas: the composition of the
trade flows between Italy and Spain is likely to be more similar
Four years on, some of the imbalances have shown signs of than that of flows between Spain and Germany.
reversal. Between 2000 and 2008 the competitiveness of both
the periphery (Greece, Portugal, Spain and Ireland) and the Chart 3: Relative gains
coreiphery (Italy, France, Belgium and Slovenia) had deteriorated Periphery intra-Eurozone trade balances (% of GDP)
significantly relative to the core countries (see chart 1). In the last
2
few years, this trend has partially reversed and unit labour costs
in the core have increased somewhat while they have fallen 1
in the periphery. The adjustment is likely to continue: it took 0
almost ten years for the loss of competitiveness to build up, it -1
could easily take a similar length of time to reverse it.
-2
Unlike the periphery, the coreiphery seems to be lagging behind -3
as unit labour costs have continued to increase in the last few -4
years (albeit not as quickly as the core). In part this may reflect
-5
temporary factors such as an aggressive fiscal consolidation
in Italy and a disappointing recovery in France. However, if -6
2006 2007 2008 2009 2010 2011 2012
this trend continues it could heavily penalise the already weak
Core Coreiphery Total
growth prospects in these coreiphery countries.
Source: Eurostat, UBS Global AM
Chart 2: Current adjustment
These recent economic improvements and the progress in
Current account balance (% of GDP)
structural adjustment could suggest that the worst of the
10 crisis is (probably) over. However, the crisis itself is far from
over as some of the structural causes behind it have not yet
5 been fully resolved.

0 The current account in the periphery has improved but

external debt is still at historically high levels. The progress
-5
in some areas of the economy has not been mirrored by the
implementation of structural reforms. And the combination
-10
of a stressed social fabric, fragile political environment and
low sovereign spreads could slow the whole process. Despite
-15
2003 2005 2007 2009 2011 2013 the harsh fiscal adjustment, public debt has surged in many
Core Coreiphery Periphery countries and, combined with low potential growth, this still
represents a threat going forward.
Source: Eurostat, UBS Global AM

The autumn will be intense with important political events:

The other area of improvement has been in the current
accounts. After reaching a staggering deficit of 10% of GDP
in 2007 (chart 2), the current account in the periphery turned
positive last year. This reflects the periphery’s harsh fiscal
adjustment, but with the deleveraging process far from over, the
improvement will not reverse any time soon. Interestingly,
general elections and the constitutional court ruling on the
OMT in Germany, local elections in Portugal, the review of the
Greek and Portuguese programs and the Italian parliamentary
vote on Silvio Berlusconi’s conviction. We can only hope that
the summer breeze that has kept markets cool in the past few
months won’t portend a cold and stormy winter.

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