This is for investment professionals only and should not be relied upon by private investors
FIXED INCOME
Euro-zone sovereign risk: Will the Greek
debt crisis be contagious or contained?
AT A GLANCE: TIMELINE
 23 April: Greece formally applies for
financial assistance from the IMF. Instead
of calming investors, it triggers panic in
Euro-zone sovereign bond markets.
 28 April: Fears over Germany’s
willingness to agree an EU bailout sees
the yield on Greek 2-year bonds soar past
the 25% mark (now back to around 10%).
 28-29 April: Standard & Poor’s cuts the
sovereign ratings of Greece, Portugal and
Spain to ‘junk’, ‘A-‘ and ‘AA’ respectively.
 02 May: Euro-zone finance ministers
approve a $110 billion finance package.
 03 May: Euro slides to a 12-month low
against the US dollar as short positions
against it hit a record high.
KEY POINTS
 There has been limited new factual news-
flow behind recent events. Most market
observers anticipated Greece would
require emergency funding.
 Confirmation of the need for a bail-out
raised the fear level and attention quickly
focused on other ‘suspect’ economies
such as Portugal, Spain and Ireland.
 Global economic conditions remain robust
and the corporate sector has been
reporting healthy earnings.
 The crisis should largely be contained to
Greece and the global economic and
stock market recovery left intact.
 The slide in the euro is actually a net
positive for European equities. This
combined with attractive valuations in
many areas, means there are attractive
opportunities available.
MAY 2010
Fear and contagion have broken out in European sovereign bond markets. The well-
documented government debt problems in Greece - which are by common consent much
worse than anywhere else in the Euro-zone - prompted the Greek government to ask for
emergency funding from the IMF.
Despite fears over Germany’s lack of political appetite, Euro-zone finance ministers green-
lighted a $110 billion rescue package, which significantly reduces the danger of a debt
restructuring in the short-term. The larger than expected package, which includes painful
austerity measures and quarterly IMF spot-checks, seems to have credibility.
However, it remains to be seen whether this will restore confidence in all Euro-zone bond
markets and the single European currency. Could the contagion spread to other peripheral
European economies? And, could it derail the global economic and stock market recovery?
GREECE IS A BASKET CASE
We have known for some time that the Greek economy is in a very bad state. However, that
weakness now threatens to cast a dark cloud over the entire Euro-zone. Despite the fact that most
market observers anticipated Greece would need IMF help, the confirmation of the need for a bail-
out nevertheless inspired panic in sovereign bond markets.
Bond investors pushed up yields in Portugal, Spain and Ireland, concerned by the possibility that
these economies might be next in the IMF queue. Standard & Poor’s reacted by downgrading
Greece by three notches to BB+ or junk status, while reducing Portugal’s sovereign rating from A+
to A- and Spain’s by one notch to AA. If Greece is in such a bad way, should we be worried about
other Euro-zone economies with, what are on the face of it, a similar set of fiscal pressures?
On balance, probably not. Greece is a basket case. It is the ‘weakest link’ in the Euro-zone by a
significant margin. And, while other economies have their problems, there are reasons to believe
they are surmountable. On the other hand, there are reasons to doubt Greece’s problems can be
overcome and austerity measures can be successfully implemented. This is because Greece’s
dire financial situation is exacerbated by some specific structural weaknesses that are specific to
its economy, Greek working practices, retirement laws, political stability and the size of the state.
While the $110 billion emergency funding stabilises the short-term situation, these structural
issues are likely to challenge the austerity plan and cloud the medium to long-term outlook.
THE SPIKE IN BOND YIELDS – GREECE IS THE ‘WEAKEST LINK’
12
Portugal Greece Germany Ireland Spain UK
10
Redemption Yield
8
6
4
0
May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10
Source: DataStream, as at 30.4.10. Redemption yields on Benchmark 10-Year Government Bonds for countries shown.
 

SENTIMENT IS DRIVING MARKET BEHAVIOUR

While there has been some clarification on the size of Greece’s government debt, there has been
little new information on economic growth and government finances in peripheral European
economies that explains the recent market action.
The upward pressure on Irish government bond yields and CDS spreads is particularly interesting.
This is because Ireland was widely applauded by bond investors for tackling its deficit and laying
out what was considered to be a credible restructuring plan. The fact that Irish bond yields were
pushed out tends to suggest recent market behaviour has been driven by sentiment rather than
fundamentals.
CDS spreads, which represent the cost of insuring against default in the underlying bonds spiked
sharply higher in Greece, but have also risen for Portugal and Ireland. In the CDS market, the
buyer does not need to own the underlying security; when they do not, this is known as being
‘naked long CDS’ and is a pure play speculation on default. The climate of political scrutiny on the
financial sector was expected to limit the extent of speculation on sovereign debt, with many
hedge funds, for example, fearing a political backlash at being seen to be profiting from crisis.
We can see some of the moves in CDS spreads have exceeded the moves in bond yields
suggesting there is a material element of speculative money behind recent market action.

CDS SPREADS – A MEASURE OF THE MARKET VIEW OF SOVEREIGN DEFAULT RISK

900
Greece UK Portugal Spain Ireland Germany
800

700

600
Basis Points

500

400

300

200

100

0
May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10

Source: DataStream, as at 30.4.10. 5-Year CDS spreads.

IMF PACKAGE REMOVES SHORT-TERM GREEK WORRY, BUT GENERAL FEARS REMAIN
Many observers within the Euro-zone and the IMF will now be hoping that the agreement of the
$110 billion package for Greece will represent a line in the sand. The loan effectively removes the
need for the Greek Government to issue debt for 2 years. Greek two-year bond yields have
responded positively with yields falling back significantly.
The decision by the European Central Bank (ECB) to suspend their minimum credit-rating
requirements - so that they can accept Greek junk-rated bonds as collateral - is another positive
that will help to shore up liquidity requirements amongst Greek banks.
On the basis of the new tougher austerity measures on which the package is conditional, the
Greek economy is forecast to contract 4% this year and 2.6% next year. The longer term outlook
is much more challenging but we must remember that Greece represents less than 3% of the
Euro-zone economy.
However, there is still widespread caution among investors and we are likely to see nervousness
remain a feature of sovereign bond markets and currency markets for the next few weeks. The
record short interest (the numbers of down bets) that has built up in the Euro provides an
indication that we can expect more volatility in the coming weeks as traders bet against the single
currency in expectation of further fall-out from this rapidly evolving crisis.

 
 
 

MIGHT WE SEE A DOMINO EFFECT?

The concern now is whether the Greek scenario might be repeated in another peripheral
European economy. The markets seem to believe the prime candidates are Portugal, Ireland and
Spain. All three economies have their problems but none are remotely in as dire a position as
Greece.
Spain is not the next Greece. While the economy suffers from high unemployment and the
government needs to undertake fiscal tightening, there are signs of cyclical recovery. The bleak
debt environment seems to have been priced into stock markets; however the potential to be
gained from the rapid growth of Latin American markets seems to have been underestimated on
the basis of current valuations.
Likewise, at first glance, Portugal has similarities with Greece. The European Commission
believes government assumptions of positive growth this year and next are over-optimistic,
particularly given the fact that Spain, its principal export market, has its own challenges to
overcome. However, like Spain, Portugal is not Greece. Its 9.4% 2009 Budget Deficit is more than
3 percentage points lower than Greece’s 13.6% and, crucially, the country has successfully cut its
debt before.
Ireland’s 2009 budget deficit is actually higher than Greece’s; however, in terms of the total stock
of public debt, Ireland’s is estimated to be a still manageable 65% of output while Greece’s was a
ruinous 110%.
Overall, European banks have a limited exposure to this potential crisis in comparison with sub-
prime mortgages. The Bank of International Settlements estimates that European banks’ total
exposure to Greek, Spanish and Portuguese debt represents only 5% of total bank assets. So, the
idea of persistent contagion seems unlikely given the relatively better economic and corporate
situation in the other peripheral economies, the better credibility of their governments and the lack
of exposure among the European banking sector, in general.

ACTUAL AND EXPECTED GOVERNMENT BUDGET DEFICITS (AS A %OF GDP)

GREECE SPAIN PORTUGAL ITALY IRELAND

0

-2

-4

-6

-8

-10

-12 2008
2009
-14 2010

-16

Source: Thomson DataStream for 2008-9 figures. Economist for 2010 figures based on forecasts by the Economist Intelligence Unit.

THERE ARE STILL BIG ISSUES TO BE RESOLVED

Nevertheless, recent events point to a worrying division within the European Union and the
possibility of a two-tier Euro-zone economy. This could be exacerbated by a greater willingness on
the part of Germany to look after its own interests. The realisation that monetary union may be the
underlying root of many of the problems could see the euro come under continued pressure.
Rather than convergence, many experts are willing to argue it is the euro and centralised ECB
policy which have ultimately caused divergences between economies to become entrenched.
These divergences in economic competitiveness, fiscal policy and now sovereign credit ratings
are raising questions over the rights and wrong of a common currency and centralised monetary
policy. During the good times, prices and wages rose more strongly in Portugal, Spain and Ireland
than they did in Germany. Property bubbles in the former countries were responsible for much of
this effect. This loss of competitiveness could historically be resolved by currency devaluation.

 
 
 

However, ‘competitive devaluation’ is no longer an option. One alternative solution would be to

end the hard-line inflation targeting policy of the European Central Bank and promote
expansionary policies across the Euro-zone that would lift the ‘second tier’. However, ‘inflation
fundamentalism’ is deeply embedded among the elite central bank and European economic
officials. In short, they might see the risks of allowing inflation to climb above 2% as worse than
the benefits of avoiding a two-tier Euro-zone. There still appears to be little room for economic
growth considerations in the ECB’s mandate.

VIEWS FROM FIDELITY’S FIXED INCOME TEAM

David Simner - Manager of FF Euro Bond and FF Euro Corporate Bond
"We were running short Greece until recently. The rationale for covering the short was the German
finance ministers’ appearance in front of a German parliament committee stating that Germany
would provide funds and that it was likely to be greater than was envisaged. We took this as a
green light, and once the Greeks formally asked for assistance on Friday 23 April we added a little
more, taking the funds to a slight overweight position. We have been running short of Spain and
Portugal and have had a small long to Ireland. I think Greece (and the peripheral economies
generally) will face enormous headwinds but that we will see enough cohesion in Europe for the
project to limp along, albeit with bouts of volatility and doubt".

VIEWS FROM FIDELITY’S EUROPEAN EQUITY TEAM

Alexander Scurlock, portfolio Manager of the FF European Growth Fund
"The ongoing crisis in Greece has affected sentiment towards European equities with many
investors currently shunning the region. It has also somewhat obscured the good news coming out
of Europe, with the region continuing to benefit from the recovery in global trade, inventory rebuild
and a more competitive currency. Indeed, industrial production within Europe is running at
impressive levels, while strong exports and high margins are likely to provide a further boost to
company profits as the recovery unfolds. Furthermore, inflation remains subdued, which should
mean that monetary policy stays accommodative for longer. As credit concerns about peripheral
countries ease, and the EU/IMF package for Greece comes into place, there should be a
significant reduction in the chance of debt-restructuring taking place and, as a result, we could see
markets improve on the back of strong earnings growth and attractive valuations."
Fabio Riccelli, portfolio manager of FF European Dynamic Growth
"National Bank of Greece is a stock that, along with all other Greek banks, has suffered in the
recent turmoil over Greek fiscal deficit. I am taking a long-term view on this stock as I believe that
there is significant potential for this bank, in particular in the Turkish market, where it is already a
key player. The under-penetrated Turkish banking market is and National Bank of Greece is well
positioned to benefit as this market grows."
Firmino Morgado, Portfolio Manager of FF Iberia and FF European Aggressive Fund
"Issues over sovereign debt in the peripheral economies and the subsequent downgrades in
Greek and Portuguese debt are not a surprise. The markets have reacted strongly, but there is a
possibility that they have overreacted. The likely disbursing of the EU/IMF aid should see Greece
through the forthcoming redemptions/coupons. However, the solvency question depends on the
Government's ability to convince the market that it can deliver on its austerity programme.
The markets attention has been increasingly focused on Portugal and Spain due to heightened
concerns of a contagion effect from Greece. However, Portugal and Spain have been better
economic fundamentals than Greece. So, while Portugal and Spain still face having to implement
tough fiscal measures and economic reforms, there is more confidence in both governments.
Furthermore, Spanish companies are internationally diversified with only 42% of sales coming
from the domestic economy, while over 30% of the total comes from outside of Europe.
As a stock picker, this high volatility event offers the opportunity to buy stocks that the market has
been selling indiscriminately, purely because of where the companies are listed. This throws up
attractive valuation opportunities for fundamentally strong, internationally diversified companies."

 
 
 
 

CONCLUSION
Global economic growth remains robust. Corporate earnings are healthy. The recovery in stock
and credit markets is unlikely to be materially derailed by the recent events in Greece, which
should ultimately be contained. Greece was always going to need a bail-out, given the severity of
the problems. That is not to say that other countries in the Euro-zone such as Spain, Portugal and
the UK do not have tough choices to make however, unlike Greece, they have more scope with
which to make them.
We know that there are pockets of slower growth in the Euro-zone, but the Euro-zone will also be
a beneficiary of healthy global and emerging market growth. Emerging market economies continue
to contribute significantly to global growth and the Euro-zone is a key market for imports of
machine goods, commodities, services and finished products. In this light, European markets
could offer excellent opportunities for investors looking for relative value. Another net positive for
many European shares is the fact that the weakness in the Euro makes their products more
attractive in export markets.
The midst of a crisis very often presents a rich vein of attractive, valuation-based opportunities for
those astute investors prepared to take a medium-term view.
Our fixed income portfolio managers have limited exposure to what are seen-to-be the likeliest
‘contagion’ economies of Spain and Portugal, but recently started to buy Greek bonds on a short-
term tactical basis due to the yield available and the likelihood of the IMF package improving the
outlook. This position has already performed well in the light of the rescue package being agreed
and announced.
Meanwhile, our equity managers are united in their thoughts. There is significant medium-to-long
term value to be found amongst this volatility in European equities. Many European shares are
under-bought, overlooked and under-valued and our portfolio managers continue to find interesting
ideas in an equity market that has more capacity than most to surprise positively.

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