This article was originally published on forbes.com on 13 January 2010.
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While the recovery is indeed underway, investors still need to pay attention to two important – and related – themes in the new year: differentiation and sovereign risk.
During the financial crisis of the past two years, macro trends played out in fairly synchronised fashion across the world, accentuated by the shock of Lehman Brothers’ failure and its aftermath. A recovery is underway but, rather than ongoing synchronisation, it is likely that we will see far greater differentiation in terms of economic performance. A clear example is the far superior growth momentum of a number of systemically important emerging market countries compared to the industrial nations.
Government intervention helped stabilise financial markets and the global economy in 2009. As the crisis morphed from the US housing sector to the consumer and financial sectors and to the world, sovereign balance sheets wrote checks, made guarantees and engaged in other policy interventions such as quantitative easing. The result has been a big increase in sovereign balance sheets globally. The Organisation for Economic Co-Operation and Development estimates that gross government debt issuance for its member countries will stabilise at about $16 trillion this year, similar to 2009. That compares to gross debt issuance of $12 trillion in 2008 and $9 trillion in 2007.
Investors are being asked to absorb a lot more sovereign paper. And following their large-scale purchases of government bonds and mortgage-backed securities in 2009, the Federal Reserve and the Bank of England are poised to wind down their quantitative easing programs. Increased focus on sovereign risk is inevitable, not just for smaller economies or emerging markets, but for all – including the United States.
Bill Gross, PIMCO’s co-chief investment officer, in his recently published Investment Outlook: “Let’s Get Fisical,” cites the familiar thank you from airline pilots, “We know that you have a choice of airlines.” Similarly, investors have a choice of sovereign and non-sovereign assets around the world. One example of the blurring of the decision on sovereign and non-sovereign assets that has attracted attention is the convergence between the credit default swap spreads of European sovereigns (equally weighted) and the European investment grade credit universe, as spreads on Greece, Ireland and other sovereigns have widened.
Indeed, while the focus on sovereign risk is important across the world, it has particularly important implications within the euro zone. Here there is differentiation among countries, including their initial conditions, growth outlook and debt profiles, but this is juxtaposed against a synchronised monetary policy and a common currency. The exit from policy interventions in 2010 is much simpler for the European Central Bank, compared with the Federal Reserve and the Bank of England, because the ECB did not engage in large-scale quantitative easing. But there are significant fiscal challenges at the individual country level in the euro zone, and these challenges are even more difficult in a weaker growth environment.
Investors must make decisions based on clear analysis of the fundamentals, country by country, ensuring they receive the appropriate compensation for taking individual country sovereign risk. Ultimately, we see the euro zone as a very strong club, but macroeconomic performance and asset market returns are likely to be clearly differentiated. There have been various indications that cross-border support will be available in extremis, but the onus is clearly on individual member countries to take care of their own fiscal affairs.