I have been saying for a while now that if there were to be a serious shock to U.S. and even global markets this year, Europe would be the most likely catalyst. At the start of the year it was top of my list of areas with potential for trouble. As recently as May I was still going on about the disconnect between sovereign bond rates and economic conditions in the area, particularly in the countries that had precipitated the last "crisis"... the peripherals such as Portugal, Italy and Spain.
Now I wake up this morning to see that everybody agrees with me! All of a sudden, as European stock markets lose heavily overnight everybody is granted 20/20 hindsight and talking heads on TV are telling us how obvious it was that European assets were overvalued. The sell off was prompted by several factors. Weak industrial production numbers from Japan and disappointing trade numbers from China set the tone, but it was reports that the owners of Banco Espirito Santo, Portugal’s biggest lender, were seeking to restructure some short term debt payments that reportedly really got things going.
A drop of over 4 percent in the Portuguese stock market and big losses in equities throughout Europe have followed, but those pointing to that as evidence of a bubble bursting or panic setting in are missing the point. The fact that European stock prices had been on a tear is a symptom of the problem, but not the problem itself. The correction that is now taking place is natural, and is probably more about the Fed news yesterday and today’s weak numbers than about any collapse. There is little sign of panic in the market that houses the real problem.
That lies in the sovereign bonds of these countries. I have said till I’m blue in the face that 10 year Spanish Government paper trading at very close to the yield for the U.S. 10 year is simply crazy. Some look and say that those lower rates indicate that the risk of holding Spanish sovereign bonds must have gone away, or at the very least be seriously reduced. Unemployment, though, is still over 25 percent in the country and around half of those under 25 aren’t working.
Obviously, the institutional investors who really drive international markets cannot see the Spanish economy as an investment roughly on a par with that of America. They don’t, but in a world where yield is scarce, those same investors will take it anywhere they can find it. If your performance is judged quarter by quarter or, at most, year by year compared to the return on the US 10 year, then anything that yields above that note is attractive. This is especially so if the bond in question has, in the past, been effectively underwritten by Germany.
It is this detachment of reward from risk that has created the potential for a problem, and that problem is concentrated in the government bond market, not the stock market. Recently, those government bonds have not behaved as if disaster is upon us. Taking a snapshot this morning, the Italian and Spanish 10 year notes were yielding 2.80 and 2.92 percent respectively. Portugal was lagging somewhat with a 3.85 percent yield, but Greece, who actually defaulted just a few short years ago, is seeing good demand for a bond auction this week with yields expected to be around 3.5 percent. For comparison, the U.S. 10 year yield is hovering around 2.5 percent. In a sane word, where reward is demanded by investors based on risk, that would be impossible.
The yields in the peripheral countries of Europe have been edging up a little over the last month or so, but we are a long way from panic, as evidenced by the ability of Greece to go ahead with their auction of 10 year paper. As I mentioned, I have been warning for some time that the next big problem could come from Europe, but this isn’t it... or at least not yet. Daily gyrations in the stock markets there do not tell us anything, but if investors begin to logically assess risk and the European sovereign bond markets begin to show real signs of a mass exodus then I, for one, will be worried.