Is Europe Finished? Should we short EU Govt Bonds soon?
We are seeing significant nationalistic and populist trends worldwide, Europe is no exception. 2017 is the year of significant change in the European political landscape with France going to the polls in the very near future. Far-right National Front candidate Marine Le Pen has pulled ahead in polls for the first round of the French election. While we do not believe she will win the presidency (excellent Bloomberg article explaining the French process here), she does however represent the extreme right, anti-immigration, nationalistic, and isolationist trends that have been brought to the fore of public attention by the victory of Trump in the US and UK Brexit.
European fixed income government markets have begun to price the risk of separatism and nationalism in France and Italy. This has manifested itself in a higher French government bond yields relative to fellow Eurozone Core country Germany
In the graph below you can clearly see a widening of France relative to Germany in the 10 year government bonds. This indicates risk is rising in France relative to Germany.
10 year yield differential for France vs. Germany last 6 months
We believe that this change in the yields of the two countries related to each other is not a specific idiosyncratic phenomenon that we are simply seeing in France due to the upcoming elections, but part of a broader theme where the potential for Europe to break up and trade separately based on economic fundamentals of each country has begun to reprice investors expectations of where the weaker slower economies of Europe should be trading relative to the financial and economic engine of Europe, Germany.
If you look at the spread of Italy against Germany you will see that it is not purely down to nationalistic expectations and upcoming elections but has a lot to do with the peripheral nature of France and Italy relative to Germany. What we mean by that is that economic growth of these two countries is at best zero, they have higher unemployment, and most importantly have much higher Debt/GDP ratios. Whereas we are seeing a 1.7% growth in GDP in Germany, basically these countries are significantly worse creditors on a stand-alone basis. The market is beginning to price in the possibility that they may be stand-alone credits in the upcoming future.
10 year yield differential for Italy vs. Germany last 6 months
In other words the Eurozone generally speaking created an average yield where the economies were not evaluated on a stand-alone basis but the greater Eurozone economy and the central bank’s ability to fund itself and set yields was prevalent.
We believe we are moving towards a potential breakup of Europe and certainly believe the financial markets are beginning to price that in. Therefore investors should consider that rate expectations are not the only force driving yeilds higher in Europe but that the probability of Eurozone reassesment and fragmentation will also drive yeilds.