April 10, 2013

Ken Orchard Ken Orchard, portfolio manager and analyst of European sovereigns.

The last two years in the eurozone saw periods of calm and of stress, and 2013 should too. The extremes of 2011 and 2012 may not be reached, but periods of stress will remain a constant. Investors should keep in mind that stress could help resolve the crisis by forcing needed changes. The following represents the views of Ken Orchard, T. Rowe Price portfolio manager and European sovereign analyst, as of April 4, 2013.

Eurozone economic growth surprised to the downside in three of the past five years. That may not happen again this year. For 2013, eurozone economic forecasts were marked down when recovery did not emerge in late 2012. The most recent forecasts are now for the economy to contract 0.3% this year.

This may be too pessimistic. The eurozone has already been in recession for five quarters. Even Japan during its "lost decades" did not have more than four straight quarters of negative gross domestic product (GDP) growth. A mild recovery, beginning in the second or third quarter, seems likely.

Although fiscal austerity will be a drag on the economy, it should not have the same impact in the second half of 2013 as it did last year. There are two material unknowns: the state of the global economy and social unrest. Only a gradual, shallow recovery is likely as headwinds continue from fiscal consolidation, high private sector debt, and banking sector deleveraging. An acute phase has passed, but the crisis is not over.

Fiscal austerity has been the eurozone focus. This has been somewhat successful: Despite recession, the region's weighted average budget deficit for 2012 declined by 0.7% to about 3.5% of GDP.

Yet the push for fiscal austerity is weakening. The European Commission and European Central Bank (ECB) seem to be realizing that an endless recession will undermine public support and make solving the crisis more difficult. French, German, and Italian leaders are not as willing to sacrifice economic growth in pursuit of fiscal sustainability. Fiscal policy will still tighten in 2013, but there will not be a round of midyear fiscal tightening as there was last year. This should give some breathing room to an incipient economic recovery.

Eurozone Fiscal Stress Situation Improved From 2011

This index shows the level of financial stress in the eurozone. The index measures stress on the eurozone financial system using a combination of various credit spreads, bank equities, and borrowing from the European Central Bank.

Financial Stress Index

The eurozone stress index is comprised of a number of stress indicators. We standardize these indicators using a z-scoring method before calculating an average value that makes up the final stress index. The construction of this index, its direction, and its current level should not be viewed as an investment recommendation by T. Rowe Price.
Source: T. Rowe Price

Eurozone sovereign rating downgrades were abundant in 2011 and 2012, but we expect few in 2013 for two reasons. First, actions by the ECB and eurozone governments have stabilized—for now—sovereigns' creditworthiness. A death spiral of rising yields and falling GDP growth leading to liquidity crises is now unlikely. Second, most sovereigns are now fairly rated based on their fundamentals. There are a few countries that are still overrated, but the differences have narrowed. Multi-notch downgrades, commonplace in 2012, should disappear.

Two countries that could see mild negative rating pressure in 2013 are Italy, whose debt nonetheless should remain investment grade, and the Netherlands, which could be placed on a negative outlook.

Social unrest was not a big factor last year. We suspect that 2013 will be more tumultuous, with a return of protestors to Syntagma Square in Athens (and similar venues in Madrid, Rome, and Paris). The major driver of social unrest is likely to be unemployment. The official eurozone unemployment rate reached 12% in March, the highest ever. Official unemployment in Spain and Greece exceeds 26%. The eurozone is expected to exit recession this year, but economic growth is unlikely to be strong enough to create many jobs.

Other potential causes of social unrest are reduced protections for workers, pension and retirement reforms, higher taxes, and public service cuts. All are necessary to solve the crisis in the long term, but all will exacerbate short-term social stress. The risk from social unrest should not be underestimated. Governments must be determined to enact reforms despite public opposition. If reforms stall, the eurozone could become trapped with high debt and no growth.

Greece may be perceived as "solved" because Germany has decided that Greece should remain in the eurozone. Also, Greece cannot be kicked out of the eurozone—it can only leave of its own accord. This would be an extreme act by Greece and is unlikely to occur in 2013.

Still, the common perception that Greece is solved is too sanguine. There is still much potential for the situation to deteriorate again in 2013. Its high and rising unemployment rate, combined with the cuts to pensions and public sector employment, could lead to a resurgence of public protests. Then concerns over Greece could rise again. The government is divided and may not survive an attack on its policies. If there are new elections, support for traditional mainstream parties could shift to a far-left party, Syriza, which in turn may not continue the European Union (EU) program and could try unorthodox moves to loosen fiscal and monetary policy.

Broader rescues of Spain could be in the offing by the International Monetary Fund (IMF) and the EU. The Cypriot rescue has made Spain more fragile. Although the depositor bail-in and capital controls put into place in Cyprus are unlikely to be repeated, large depositors and bondholders may be quicker to move out of periphery countries than in the past. The Spanish financial system, with shaky assets and liabilities of almost €3 trillion (280% of GDP), is probably the most vulnerable in the region.

That said, a new Spanish rescue program should not be overly traumatic for financial markets, as Spain already is in a banking sector program that includes many features of rescue programs. So even with a rescue, Spanish debt should not be downgraded, and it should not face the forced selling that hit Ireland and Portugal in 2011.

ECB easing could occur. The central bank's balance sheet rose by about 50% from mid-2011 to mid-2012. The surge, combined with ECB bond purchases in the fall of 2012, had a powerful effect on eurozone fixed income markets, gradually reducing short-term interest rates and pushing investors into more risky instruments.

However, the ECB's balance sheet has started to shrink because many banks are repaying ECB loans taken out more than a year ago. In order to keep interest rates down, the ECB is likely to take measures to offset a contraction of its balance sheet as it does not want a tightening of liquidity conditions across the eurozone.

The cycle of hope, disappointment, and crisis continues. We're now in the "hope" phase. "Disappointment" and "crisis" are likely to return.

The crisis will not be solved without new institutions and changes to the eurozone that transfer fiscal and financial risks from the national level to the eurozone level, making it more federal. These changes would make the eurozone more stable and permanent, thereby reducing the probability of a breakup and increasing the chances of solving the crisis.

The problem is that there will be winners and losers. The transfer of risk, resources, and decision-making powers will benefit some nations while hurting others. Politicians in the losing countries can only justify the changes when financial stress is high enough that the transfer leaves them better off. This link—between market stress and progress toward institution-building and greater integration of nations—is fundamental to the crisis. Lack of stress leads to procrastination, which leads to crisis, and that can lead to progress on necessary reforms. Market stress is a symptom of the crisis, but also should drive the eurozone toward a solution. Although we will not see a final solution in 2013, it should be a little bit closer by this time next year.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of April 4, 2013, and may have changed since then.