QUARTERLY INVESTMENT FOCUS

Greek sovereign debt – the eurozone

papers over the cracks
Pictet Asset Management

Q2 2010
“In a crisis government debt burdens
often come pouring out of the woodwork,
exposing solvency issues about which
allowed Greece to continue to access the Greek borrowing costs remain elevated (1)
credit markets, with the recent sale of
Greek 10 year bond yields (12 months to 31/03/10)
EUR 5 billion of seven year bonds at a
%
coupon of 5.9 per cent, a 325bps 7.5

the public seemed blissfully unaware.” premium over German bunds. Greece still 7.0

needs to raise some EUR 20 billion by the 6.5

Carmen Reinhart (University of
end of May in order to meet debt rollover 6.0
Maryland) and Kenneth Rogoff and repayment requirements, so funding GREEK 10Y
5.5 BOND YIELDS
(Harvard University). remains a substantial test. As the appetite 5.0
for Greek debt in Europe dwindles, 4.5
Europe agrees a tentative solution the Greek Finance Minister, George
A M J J A S O N D J F M
to the Greek problem Papaconstantinou, plans to undertake 2009 2010

Following weeks of growing tension
within Europe over the risk of Greek
default, the immediate pressure eased in
late March as eurozone members unveiled
their response. Under an agreement,
principally reached between Chancellor
Merkel and President Sarkozy, should
Greece be unable to meet its debt
commitments it would receive co-
ordinated bilateral loans from both the
eurozone and the IMF, with the European
a tour of the US to target American Source: Bloomberg
investors, promoting Greece for the first
time as an emerging markets country Can the euro hold the line? (2)
(fig. 2). USD v EUR 12 months to 31/03/10
1.55
USD/EUR
Eurozone members under pressure 1.50
in their first major test 1.45
The immediate objective for the eurozone
1.40
has been to avoid risk contagion across
1.35
heavily indebted member nations, which
ultimately might fatally undermine the 1.30

member states providing two-thirds and
the IMF one-third of the funding. The
intention is only to provide such loans at
rates of interest which adequately reflect
market risk. This solution is aimed at
reassuring eurozone voters, in Germany
in particular, that Greece is not being
provided with a subsidized bail-out, while
maintaining pressure on the Greek
government to reduce its deficit. The
agreement has eased pressure on the
euro, at least temporarily, but done little
to reduce the cost of Greek financing.
Greek ten year bonds now yield 7.35 per
cent, some 442 bps above equivalent
German bunds, compared to 396bps in
January (fig. 1).
The “ouzo crisis” held at bay but
remains broadly unsolved
The wide and continuing premium
reflects the enormous hurdle faced by
Greece if it is to meet its fiscal reduction
targets. It also suggests a degree of
uncertainty over whether the IMF, if
called upon to provide funds, would apply
a ‘haircut’ to existing holders of Greek
bonds. The announcement has at least
euro. In the short term this aim seems
to have been achieved, but the longer
term direction of the eurozone model,
in the wake of its first real economic
stress-test, remains unclear. The evident
unwillingness of Germany, as the largest
member nation, to provide a financial
bail-out for what is seen as Greek
profligacy, is understandable. However,
the goal of economic convergence, in
which one interest rate policy would be
appropriate across the member states
under a single currency, remains as
elusive as ever. With Greece still paying
punitive rates to access credit markets,
the country faces an extended period of
economic underperformance.
When the eurozone was established,
the Stability and Growth Pact (SGP) was
put in place to guard against any dilution
of fiscal rectitude, as practiced mainly
by Germany. In the recession of the early
2000s, the terms of the SGP were diluted
or ignored and the ensuing economic
bubble saw countries such as Greece
entering the eurozone despite having
structural deficits that should have
disqualified them. The underlying
1.25
M A M J J A S O N D J F M
2009 2010
Source: Datastream
problem remains: some member countries
(mainly in southern Europe) have an
uncompetitive labour force, which is
reflected in a substantial current account
deficit. Excessive demand for goods,
exported from countries such as Germany,
has not been moderated by local currency
weakness because of their euro.
Even if Greece avoids a default, in the
absence of a large downward adjustment
in domestic wages it will remain deeply
uncompetitive. Resolving this conundrum
remains a huge test for not only the
heavily indebted and uncompetitive
member countries, but for the eurozone
as a whole. Not least Germany, which is
somewhat polarised in its stance to
restrain demand for imported goods,
while also being Europe’s chief exporter.
Higher yields “The canary in the
mine” – Alan Greenspan
Equity markets showed renewed strength
in March as investors continued to enjoy

1|QUARTERLY INVESTMENT FOCUS|APRIL 2010

 Pictet Asset Management Limited
Moor House
120 London Wall
London EC2Y 5ET

www.pictet.com

Equities rally sharply in March (3) spread—the difference between LIBOR US yields start to reflect debt burden (4)
based pricing for corporate funds and that
Monthly & YTD returns 12 months to 31/03/10
of US government debt—recently
+6.2% %
World Equities +3.2% inverted as US 10 year yields edged 4.2
Emerging Equities +8.1% US 10 Y TREASURY
+2.4% towards the 4.0 per cent level. That such 4.0
World Bonds -1.7%
-1.3%
+2.3%
government sponsored “risk-free” capital 3.8
Emerging Bonds +4.2% 3.6
+1.23%
should trade at a higher yield than that
Hedge Funds +1.5% 3.4
Global REITS +6.5% demanded of prime commercial paper
+3.9% 3.2
GSCI* TR -0.9%
+1.9% may reflect quarter-end technical factors, 3.0
GSCI* Spot +2.0%
+2.5% but equally it suggests that sovereign debt 2.8
*Goldman Sachs
Commodity index
-2 0 2 4 6 8 10 issues remain a substantial uncertainty for 2.6
A M J J A S O N D J F M A
investors (fig. 4). 2009 2010
North America +6.2%
+5.3% Source: Datastream
Europe ex UK +6.7%
-2.4%
UK -0.6%
+6.0% Improving corporate sector against
Pacific ex Japan +3.1%
+7.3% a back drop of government corporate cash-flows suggest that rising
+5.0%
Japan +8.2%
+6.2%
indebtedness dividends and stock buy-backs, together
EAFE +0.9%
Europe -1.8%
+6.5% The developing economic cycle seems to with a steady recovery in M&A activity,
+8.1%
GEMs +2.4% be characterized by a healthy corporate provide investors with attractive prospects.
+6.6%
Europe ex Swiss -2.6%
+5.6% sector which has, on a broadly global At the time the optimistic sentiment
Switzerland +4.0%
MSCI World +3.2%
+6.2% basis, cut costs and achieved substantial pervading markets could be vulnerable to
-4 -2 0 2 4 6 8 10 improvements in productivity. This disappointment. The principal risks to the
March 2010 returns
YTD returns contrasts sharply with government sanguine outlook include the continuing
Source: Bloomberg finances throughout the developed world possibility that the recovery stalls as
which generally remain in a dismal state. QE is withdrawn and that the extent of
rising financial markets and growing While investors adopt a positive risk government indebtedness results in
confidence in the real economy (fig. 3). position, they seem to conclude that further sovereign risk dislocations, forcing
Global bond markets meanwhile have fiscal retrenchment will be a long drawn- bond yields to a level which causes the
been generally stable, with the marked out affair which will subdue growth, but current bullish momentum to evaporate.
exception of the US, where yields have also keep inflation dormant and so allow
Disclaimer
risen across the maturity spectrum. Over for an extended economic upswing. This document is for distribution to professional or institutional clients
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the past month 10 year US Treasury yields These conditions should allow monetary or any person or entity who is a citizen or resident of or located in any
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this document is based upon sources believed to be reliable, but no
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of those sources. Any opinion, estimate or forecast may be changed
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as the US attempts to fund its USD1.4 landing in China, together with a steady regulated by the Financial Services Authority, and may not be
reproduced or distributed, either in part or in full, without their prior
trillion fiscal deficit. Recent bond auctions exit from quantitative easing (QE) authorisation.
Pictet Asset Management (“PAM”) definition
have been met with only lukewarm interest programmes which does not unduly upset In this document, Pictet Asset Management includes all the operating
subsidiaries and divisions of the Pictet group that carry on institutional
and the combination of improving cyclical bond markets, paints a bullish scenario for asset management: Pictet Asset Management SA, a Swiss corporation
registered with the Swiss Financial Market Supervisory Authority
momentum and high levels of debt financial assets. In the context of renewed (FINMA), Pictet Asset Management Limited, an English company
authorised and regulated by the Financial Services Authority, and
issuance is likely to continue to dampen growth, equity valuations do not appear Pictet Asset Management (Japan) Limited, a Japanese company
regulated by the Financial Services Agency of Japan.
enthusiasm for the asset class. The swap to be particularly extended and strong

QUARTERLY INVESTMENT FOCUS|APRIL 2010|2