Across the Pond: Europe’s bond stress test

Frederick Mellors · UBS

French sovereign stress is spreading to Italy, Greece, the Baltics, Belgium, and to UK and US bonds.

Mellors argues that France's idiosyncratic fiscal issues have spread quickly to other indebted European sovereigns, including Italy, Greece, the Baltics and Belgium. He also sees correlation with UK and US government bonds, which run large deficits and debt. Because France is about 20% of Eurozone GDP and systemically important, its problems have a global influence on sovereign debt.

“So these idiosyncratic French issues have very quickly spilled over to other indebted European sovereign bond markets such as Italy, Greece, The Baltics, Belgium, and not just within the Eurozone.”at 8:26

Frederick Mellors · UBS

Many French corporates now borrow more cheaply than the French sovereign, thanks to strong balance sheets.

Mellors notes that roughly 38% of French corporates that issue public debt can borrow more cheaply than their own sovereign, which is rare. He attributes this to strong balance sheets and international diversification. These companies have come through the French stress relatively well, while the sovereign itself has been under pressure.

“roughly 38% of French corporates that issue public debt ... can actually borrow cheaper than their own sovereign.”at 10:19

Frederick Mellors · UBS

German Bunds, backed by low debt and AAA rating, tend to rally when European sovereign stress rises.

Germany runs a deficit of about 3% of GDP after amending its debt brake to fund defense and infrastructure, but its debt is only about 60% of GDP, so it keeps fiscal space and a triple-A rating. Mellors argues that in times of stress German sovereign bonds tend to do well, as they have done during the current French issues.

“So whenever you see times of stress, German sovereign bonds tend to do quite well as we're seeing at the moment with the issues around France.”at 13:02

Frederick Mellors · UBS

Euro investment-grade yields of about 4–5% and high yield of 6–7% look very attractive versus cash.

Mellors argues fixed income is attractive because yields have risen significantly. Euro investment-grade credit yields about 4–5%, which is very appealing against cash at about 2.5%. Lower-quality euro high yield offers around 6–7%. He expects outright interest rate levels, rather than price moves, to be the primary driver of total returns, even though volatility in rates and credit will continue.

“So if we think about European investment grade credit, at the moment, yields are between [4 and] 5%, which is very appealing, particularly relative to cash at about two and a half.”at 19:09

Frederick Mellors · UBS

France's deficit trajectory keeps worsening, and investors are increasingly worried about its borrowing path.

Mellors argues the core French problem is that the market is growing more concerned about the trajectory of France's deficit and high borrowing. Evidence: the deficit is over 5% of GDP, France has not run a budget surplus since 1974, and the level of the deficit keeps rising. Presidential elections in April add political uncertainty on top of this, which is why French sovereign risk is being priced differently from the rest of the Eurozone.

“So with France specifically, as I said, the trajectory of their deficit continues to worsen. In fact, France has not run a budget surplus since 1974.”at 4:39

Frederick Mellors · UBS

French banks are under pressure because sovereign stress spreads quickly to domestic banks holding government debt.

Mellors describes a sovereign-bank doom loop: domestic banks typically hold large amounts of their own government's debt, so when the sovereign gets into trouble the stress passes quickly into the financial system. French banks, on both the credit and equity side, have been under pressure throughout the recent French bond sell-off.

“we call it essentially a sovereign bank doom loop because typically domestic banks do hold a large amount of their sovereign debt. So when the sovereign gets into trouble, it very quickly spills over into the financial system and domestic banks.”at 9:24

Frederick Mellors · UBS

ECB bond-buying to backstop France would add to inflation risks, so the ECB must stay cautious.

Eurozone headline CPI is trending toward 4%, largely from higher energy prices, and the ECB has already hiked twice this year to a deposit rate of about 2.5% with signalled further hikes. Mellors argues that using crisis-era tools such as the OMT or TPI to buy French bonds would be inflationary and would add to existing upside inflation risks. The episode is a stress test rather than a full crisis, so the ECB has to balance financial stability against moral hazard. Tools would only come into play if the situation evolved into a true crisis.

“for the ECB to embark on some of the policy measures that they used in the eurozone crisis would have inflationary consequences. It would add to the existing upside risks to inflation.”at 15:21

Frederick Mellors · UBS

Bond-market pressure is forcing French politicians toward fiscal discipline, as Le Pen's deficit pledge suggests.

Mellors sees the French bond sell-off turning into a political issue. Le Pen's pledge to bring the deficit below 3% by 2030 calmed volatility, even though it lacks detail and credibility. He reads this as evidence that the bond market is exerting discipline on the current government and on potential future leaders to correct fiscal policy, which he regards as a positive development rather than a death spiral.

“the market is exerting discipline on the French government and on the next potential French leaders to rectify the current trajectory of fiscal policy.”at 16:50

Frederick Mellors · UBS

Selective European equities look attractive, given well-run companies that benefit from German fiscal stimulus.

Mellors argues that investing in European equities means investing in companies rather than countries. Large French multinationals have strong earnings power, and they can borrow more cheaply than their sovereign. German fiscal stimulus directed to infrastructure and defense is boosting German growth. He sees opportunities in companies that are well managed, cost-disciplined and benefiting from these developments, so investors need to be selective.

“there's obviously opportunities there in European equities because there are a number of companies that are very well managed with cost discipline and are benefiting from some of these developments.”at 21:01