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Economist InsightsSummer breeze

19 August 2013Asset management

Over the past three years, thanks to the Eurozone crisis, we grew

accustomed to very heated summers in the sovereign markets.

This summer, the temperature of sovereign markets has been

remarkably cool with sovereign spreads tightening to their

lowest levels since 2011. This is even more surprising given thatthe political climate has remained hot, driven either by domestic

politics (Portugal, Spain and Italy) or by doubts around the

ongoing adjustment programs (Portugal and Greece).

The Outright Monetary Transactions (OMT) programme

announced one year ago likely remains the main driver of the fall

in sovereign spreads over the last year. However, it is probable

that the recent improvement in economic outlook has also

played a role. Last week Eurostat revealed that the Eurozone

finally resumed growth in the second quarter of 2013 after six

consecutive quarters of contraction. The positive reading was

entirely driven by Germany and France which both surprised

substantially to the upside. But there was also a significantimprovement in the periphery: Portugal came out of recession

while the contractions in Italy and Spain were the least severe

since 2011.

Although the contribution of the different spending components

is not available yet, it seems likely that the improvement was

driven not only by external demand but also by a stabilization

of domestic demand. Despite the recession ending sooner than

markets were expecting, it is likely that the recovery will continue

this year and next.

The headwinds facing the Eurozone are still strong but areless intense than last year. As such, it is quite likely that the

recovery will be gradual and relatively muted. Fiscal consolidation

continues to weigh on the economy but less so than last year.

Borrowing rates for the private sector remain high but have fallen

somewhat over the last year, and many sectors of the economy

are still deleveraging but at a less aggressive pace than before.

Joshua McCallum

Senior Fixed Income Economist

UBS Global Asset Management

joshua.mccallum@ubs.com

Gianluca MorettiFixed Income Economist

UBS Global Asset Management

gianluca.moretti@ubs.com

Source: Eurostat, UBS Global AM

Core = Germany, Austria, Slovakia and the Netherlands. Coreiphery = France, Italy,

Belgium and Slovenia. Periphery = Spain, Portugal, Ireland and Greece.

Chart 1: Getting cheaper

Unit labour costs (2000 to 2008, 2000 =100)

90

95

100

105

110

115

120

125

130

135

PeripheryCoreipheryCore

200820072006200520042003200220012000

90

95

100

105

110

115

120

125

130

135

PeripheryCoreipheryCore201620152014201320122011201020092008

Unit labour costs (2008 to present, 2008 =100)

This summer has been less heated in the Eurozone

sovereign markets than the past three summers. The

economic outlook has improved and the Eurozone

finally resumed growth in Q2 2013 after six quarters

of contraction. The headwinds facing the Eurozone are

still strong but are less intense than last year. It is likely

that the recovery will be gradual and relatively muted.Some progress has been made in structural adjustment

but some of the structural causes behind the crisis have

not been fully resolved. The worst of the crisis may have

passed but the crisis itself is far from over.

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Another driver of the fall in sovereign spreads could be the

progress in the adjustment of Eurozone imbalances. The

periphery entered the crisis with a high level of debt, an

uncompetitive external position (with no control over the

exchange rate to compensate) and a large reliance on foreign

funding both from the public and the private sector.

Four years on, some of the imbalances have shown signs of

reversal. Between 2000 and 2008 the competitiveness of both

the periphery (Greece, Portugal, Spain and Ireland) and the

coreiphery (Italy, France, Belgium and Slovenia) had deteriorated

significantly relative to the core countries (see chart 1). In the last

few years, this trend has partially reversed and unit labour costs

in the core have increased somewhat while they have fallen

in the periphery. The adjustment is likely to continue: it took

almost ten years for the loss of competitiveness to build up, it

could easily take a similar length of time to reverse it.

Unlike the periphery, the coreiphery seems to be lagging behind

as unit labour costs have continued to increase in the last few

years (albeit not as quickly as the core). In part this may reflect

temporary factors such as an aggressive fiscal consolidation

in Italy and a disappointing recovery in France. However, ifthis trend continues it could heavily penalise the already weak

growth prospects in these coreiphery countries.

The other area of improvement has been in the current

accounts. After reaching a staggering deficit of 10% of GDP

in 2007 (chart 2), the current account in the periphery turned

positive last year. This reflects the peripherys harsh fiscaladjustment, but with the deleveraging process far from over, the

improvement will not reverse any time soon. Interestingly,

a large part of the adjustment occurred within the Eurozone

itself. The trade deficit of the periphery versus the rest of

the Eurozone almost closed in 2012: the periphery still has

a small deficit with the core, but it now has a trade surplus

with the coreiphery. This is probably a reflection of the sector

specialization between the three areas: the composition of the

trade flows between Italy and Spain is likely to be more similar

than that of flows between Spain and Germany.

These recent economic improvements and the progress in

structural adjustment could suggest that the worst of the

crisis is (probably) over. However, the crisis itself is far from

over as some of the structural causes behind it have not yet

been fully resolved.

The current account in the periphery has improved but

external debt is still at historically high levels. The progress

in some areas of the economy has not been mirrored by the

implementation of structural reforms. And the combination

of a stressed social fabric, fragile political environment and

low sovereign spreads could slow the whole process. Despite

the harsh fiscal adjustment, public debt has surged in many

countries and, combined with low potential growth, this still

represents a threat going forward.

The autumn will be intense with important political events:

general elections and the constitutional court ruling on the

OMT in Germany, local elections in Portugal, the review of the

Greek and Portuguese programs and the Italian parliamentary

vote on Silvio Berlusconis conviction. We can only hope thatthe summer breeze that has kept markets cool in the past few

months wont portend a cold and stormy winter.

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Source: Eurostat, UBS Global AM

Source: Eurostat, UBS Global AM

Chart 3: Relative gains

Periphery intra-Eurozone trade balances (% of GDP)

Chart 2: Current adjustment

Current account balance (% of GDP)

-15

-10

-5

0

5

10

PeripheryCoreipheryCore

201320112009200720052003

-6

-5

-4

-3

-2

-1

0

1

2

2006 2007 2008 2009 2010 2011 2012

Core Coreiphery Total