Euro zone pension funds find themselves in an acute quandary. The inclement economic atmosphere in the euro zone threatens to turn into a tempest, despite the rather murky and incomplete progress towards a solution in last week’s EU summit. But the funds must nonetheless find a safe harbor within the boundaries of the currency union, to avoid the risk that billions of euros worth of assets held in another currency will not match billions of euros worth of future liabilities. Where can they go?
The sovereign debt of peripheral euro zone countries remains unsafe as long as their economic growth remains low or negative. Against this backdrop, the yield on Spanish 10-year bonds reached euro-era highs above 7 percent in June, on fears that the harsh budget measures imposed to reduce the deficit would actually increase the deficit by torpedoing economic recovery. Similar question marks, based on similar reasoning, trouble the debt markets of Italy, Portugal and Greece. Despite falls in peripheral yields on Friday, they remain extremely high by the standards of the current low-inflation era.
Many investors have responded to this by transferring their money into the government bonds of the so-called core euro zone countries — those whose debt is considered relatively safe because of manageable debt balances and annual deficits.
However, analysts fear that the low yields of Dutch, Finnish, and above all, German bonds — the most liquid by far among the core countries — are based to a dangerous degree on the unattractiveness of the alternatives in the periphery rather than any unbounded sense of safety in the core bonds themselves.
Germany’s stock of debt is likely to total 78.9 percent of gross domestic product (GDP) this year, compared with only 65.2 percent in 2007 on the eve of the credit crunch, according to the International Monetary Fund. Nevertheless, the yield on 10-year Bunds is near record lows. At the close of European Friday trading it was 1.58 percent — compared with 4.32 percent on the last day of 2007. Many investors think the widening spread between German and Italian 10-years is untenable at a time when policy makers’ proposals for stronger pan-euro zone rescue funds and banking integration suggest that fiscal systems are likely to become more interdependent. The differential between German and Italian 10-years was 422 basis points (bp) on Friday, compared with only 196bp a year before and a miniscule 31bp in December 2007.
Pension funds are therefore taking a risk in investing in such low-yielding bonds — but with little corresponding reward in terms of possible upside, say some observers. Even if sentiment towards Bunds remains strong, analysts see little potential for a significant further rise in prices, because yields are already so low.
A potential solution to this low-yield problem is to put money in the sovereign bond markets of countries that are neither in the core nor the troubled periphery. These include France — with a 10-year yield of 2.69 percent on Friday — and Austria, at 2.43 percent.
However, the difficulty that analysts face in coining a term for these countries, which stand outside both core and periphery, reflects more than just a semantic problem. French and Austrian yields are currently both low, but fears about the sustainability of their government’s debt burdens, and their banks’ exposure to peripheral euro zone bonds and loans, pushed down their prices sharply during crisis moments last year. Pension funds seeking safety fear the same might happen again.
Another alternative for pension funds is euro zone equities, which now look attractive when measured by the earnings yield — the inverse of the price to earnings (P/E) ratio. Spanish equities are trading on a P/E of around 10, with the safer German market at about 11. Both are below their long-term averages.
But investors based outside the euro zone, which are not forced by their liabilities to show any enthusiasm for investing in euro zone assets, sold a hefty €19 billion ($25 billion) of euro zone equities in April, according to the European Central Bank. The implication — that anyone who has a choice about where they invest is not choosing the euro zone — is making pension funds in the currency union think twice. Many investors are wary of devoting money to such "risk assets" at a time when survey data suggest the euro zone economy may once more be shrinking, putting the screws on corporate earnings.
Dan Morris, global strategist at J.P. Morgan Asset Management in London, is doubtful about large investment in euro zone risk assets such as equities, because of fears about the currency union’s economy. In this environment, euro zone equity prices may struggle. His solution: “We suggest focusing on those companies with high and/or rising dividends.”
This strategy of seeking dividend yield rather than earnings yield fits well with a growing tendency among pension funds to match their annual income and liabilities more closely by seeking stable streams of cash. The technique of looking for higher-income European equities is also espoused by Peter Sullivan, strategist at HSBC in London — but with a serious caveat.
Sullivan notes that even though low interest rates should theoretically have increased the relative attractiveness of European yield stocks — equities with relatively high dividends — this asset class has not outperformed European equities as a whole since 2009. However, this is because the ultra-high-yielders — whose yields reflect their risky earnings profile — have underperformed. He sees investment opportunities instead in the so-called marzipan layer: those equities offering moderately high dividend yields of between 4.5 and 8 percent.
HSBC’s moniker for them comes from that sugary stratum of confectionery that lies just below the surface of so many cakes in a wide range of euro zone countries belonging to both core and periphery. Common tastes unite the euro zone, at least, even if common bond issuance — which might boost risk assets considerably — does not yet do so.
