Asset management

19 August 2013

Economist Insights Summer breeze
This summer has been less heated in the Eurozone sovereign markets than the past three summers. The economic outlook has improved and the Eurozone 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. Some progress has been made in structural adjustment but some of the structural causes behind the crisis have not been fully resolved. The worst of the crisis may have passed but the crisis itself is far from over. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

Over the past three years, thanks to the Eurozone crisis, we grew accustomed to very heated summers in the sovereign markets. This summer, the temperature of sovereign markets has been remarkably cool with sovereign spreads tightening to their lowest levels since 2011. This is even more surprising given that the political climate has remained hot, driven either by domestic politics (Portugal, Spain and Italy) or by doubts around the ongoing adjustment programs (Portugal and Greece). The Outright Monetary Transactions (OMT) programme announced one year ago likely remains the main driver of the fall in sovereign spreads over the last year. However, it is probable that the recent improvement in economic outlook has also played a role. Last week Eurostat revealed that the Eurozone finally resumed growth in the second quarter of 2013 after six consecutive quarters of contraction. The positive reading was entirely driven by Germany and France which both surprised substantially to the upside. But there was also a significant improvement in the periphery: Portugal came out of recession while the contractions in Italy and Spain were the least severe since 2011. Although the contribution of the different spending components is not available yet, it seems likely that the improvement was driven not only by external demand but also by a stabilization of domestic demand. Despite the recession ending sooner than markets were expecting, it is likely that the recovery will continue this year and next. The headwinds facing the Eurozone are still strong but are less intense than last year. As such, it is quite likely that the recovery will be gradual and relatively muted. Fiscal consolidation continues to weigh on the economy but less so than last year. Borrowing rates for the private sector remain high but have fallen

somewhat over the last year, and many sectors of the economy are still deleveraging but at a less aggressive pace than before.
Chart 1: Getting cheaper Unit labour costs (2000 to 2008, 2000 =100) 135 130 125 120 115 110 105 100 95 90 2000 Core 2001 2002 2003 2004 2005 Coreiphery Periphery 2006 2007 2008

Unit labour costs (2008 to present, 2008 =100) 135 130 125 120 115 110 105 100 95 90 2008 Core 2009 2010 2011 2012 2013 Coreiphery Periphery 2014 2015 2016

Source: Eurostat, UBS Global AM Core = Germany, Austria, Slovakia and the Netherlands. Coreiphery = France, Italy, Belgium and Slovenia. Periphery = Spain, Portugal, Ireland and Greece.

Another driver of the fall in sovereign spreads could be the progress in the adjustment of Eurozone imbalances. The periphery entered the crisis with a high level of debt, an uncompetitive external position (with no control over the exchange rate to compensate) and a large reliance on foreign funding both from the public and the private sector. Four years on, some of the imbalances have shown signs of reversal. Between 2000 and 2008 the competitiveness of both the periphery (Greece, Portugal, Spain and Ireland) and the coreiphery (Italy, France, Belgium and Slovenia) had deteriorated significantly relative to the core countries (see chart 1). In the last few years, this trend has partially reversed and unit labour costs in the core have increased somewhat while they have fallen in the periphery. The adjustment is likely to continue: it took almost ten years for the loss of competitiveness to build up, it could easily take a similar length of time to reverse it. Unlike the periphery, the coreiphery seems to be lagging behind as unit labour costs have continued to increase in the last few years (albeit not as quickly as the core). In part this may reflect temporary factors such as an aggressive fiscal consolidation in Italy and a disappointing recovery in France. However, if this trend continues it could heavily penalise the already weak growth prospects in these coreiphery countries.
Chart 2: Current adjustment Current account balance (% of GDP) 10 5 0 -5 -10 -15 2003 Core 2005 2007 Coreiphery 2009 Periphery 2011 2013

a large part of the adjustment occurred within the Eurozone itself. The trade deficit of the periphery versus the rest of the Eurozone almost closed in 2012: the periphery still has a small deficit with the core, but it now has a trade surplus with the coreiphery. This is probably a reflection of the sector specialization between the three areas: the composition of the trade flows between Italy and Spain is likely to be more similar than that of flows between Spain and Germany.
Chart 3: Relative gains Periphery intra-Eurozone trade balances (% of GDP)

2 1 0 -1 -2 -3 -4 -5 -6 2006
Core

2007
Coreiphery

2008 Total

2009

2010

2011

2012

Source: Eurostat, UBS Global AM

These recent economic improvements and the progress in structural adjustment could suggest that the worst of the crisis is (probably) over. However, the crisis itself is far from over as some of the structural causes behind it have not yet been fully resolved. The current account in the periphery has improved but external debt is still at historically high levels. The progress in some areas of the economy has not been mirrored by the implementation of structural reforms. And the combination of a stressed social fabric, fragile political environment and low sovereign spreads could slow the whole process. Despite the harsh fiscal adjustment, public debt has surged in many countries and, combined with low potential growth, this still represents a threat going forward. The autumn will be intense with important political events: 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.

Source: Eurostat, UBS Global AM

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,

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