Occasionally, ETF Strategy publishes articles from respected external contributors. Here, Neil Williams, Chief Economist of Global Government & Inflation-Linked Bonds at Hermes (www.hermes.co.uk), considers the euro and argues that it is still in search of a government. Following the article, we list a selection of government and inflation-linked bond ETFs available to UK-based investors.

The euro is still in search of a government, says Neil Williams, Chief Economist of Global Government & Inflation-Linked Bonds at Hermes.

The euro – still in search of a government…

Proposed Treaty changes for strengthening the eurozone’s inadequate economic union are, as Germany’s Chancellor Merkel had promised, “a step forward”. However, while suggesting speed limits for fiscal profligacy (structural deficits to be capped at 0.5% of GDP, and headline deficits at 3%), the proposals are not binding, and still look more a political compromise than the economic solution the eurozone’s needs.

Even if credible, the proposals will be no panacea.

First, by seeking fiscal deficits significantly below current levels, but offering no obvious growth plan to get there, the changes would address only future crises. Deficits in 2011 will have ranged from near balance (Estonia) to about 10% of GDP (Greece and Ireland). Spain has admitted that its 2011 deficit will be closer to 8% of GDP than their 6% target.

Second, ratifying the proposals by March looks optimistic, especially where there are new administrations or elections (Spain, France), and where the smallest countries (Slovenia) are averse to cutting their growth to help bigger ones (Greece). In which case, S&P’s own March deadline will be tested, probably triggering downgrades for Germany, France and the four other AAA-rated sovereigns, and further undermining the European Financial Stability Facility (EFSF).

Third, the biggest challenge will be to appeal to Germany’s hawkish principles, and still head off the economic and market tensions now spreading to the core members like Germany and France. We expect the ECB to ultimately capitulate on QE, but not soon enough to stave off the pressures converging to the core. To sanction a sizeable expansion of the ECB’s balance sheet, the Bundesbank and German government will need more evidence of its own economic and financial conditions imploding.

The economic deterioration has started; activity levels are becoming so stunted that recession looks inevitable. Even if a common ‘euro-bond’ follows, ‘haircuts’ on orderly defaults will probably just crimp growth further.

Back to the problem

Fourth, even if the EFSF/ESM plan works, it would simply take us back to the problem – disparate competitiveness. As a bloc, the zone has become steadily less competitive with the euro, only part of which can be laid at the weak US dollar’s door. The zone’s unit labour costs have risen a hefty 21% relative to its trading partners, contributing to an erosion of its current account position, not helped by oil. By contrast, the US’s have fallen 38%; the UK’s by 11%.

Within the zone, there have been widely disparate shifts in competitiveness. The deciding factor is whether members do or don’t undertake the cost adjustment necessary given the devaluation route is closed off.

The biggest winners include Germany, important given it accounts for about a third of eurozone GDP. However, most members have experienced deterioration. While Germany has managed to cut its relative unit labour costs by over 1%, Spain and Italy have seen theirs rise a whopping 23% and 35% respectively. Their competitiveness has deteriorated fastest of all members, while Ireland has had to suffer deflation to ‘improve’ its position.

This reminds us of the cause of the tensions, arising from a monetary union with some political union, but nowhere close to enough economic union.

So, more structural reform will be needed from fiscally erring members like Spain, already grappling with soaring unemployment. Judging by the progress so far, this may need years of austerity and low growth, keeping a dark cloud hanging over the US, UK, and China.

In the meantime, outright monetisation will need the ultimate capitulation from a German government yet to fear the deflation risk ahead. In which case, the euro will for some time yet have to remain a currency ‘in search of’ a government.

For investors seeking exposure to government or index-linked bonds, there’s a huge number of ETFs to choose from, tracking a range of different indices. The following list is just a selection of the many government bond and index-linked ETFs available to UK investors.

UK Gilts
iShares FTSE UK All Stocks Gilt ETF
iShares FTSE Gilts UK 0-5 ETF
Lyxor iBoxx £ Gilts ETF

Index-Linked Gilts
Lyxor iBoxx UK Gilt Inflation-Linked (£) ETF
iShares Barclays Capital £ Index-Linked Gilts ETF

German Bunds
DB X-trackers iBoxx € Germany 1-3 TR Index ETF
DB X-trackers iBoxx € Germany TR Index ETF

US Treasuries
Lyxor ETF iBoxx $ Treasuries 1-3Y
Credit Suisse iBoxx USD Govt 1-3 ETF
SPDR Barclays Capital US Treasury Bond ETF

Eurozone
SPDR Barclays Capital 1-3 Year Euro Government Bond ETF
iShares Barclays Capital Euro Government Bond ETFs (various maturities available)

Eurozone Inflation-Linked
Credit Suisse iBoxx EUR Inflation Linked ETF

Emerging Markets (Sovereign & Quasi-sovereign)
PIMCO EM Advantage Local Bond Index Source ETF
iShares Barclays Capital Emerging Market Local Govt Bond ETF
iShares JPMorgan $ Emerging Markets Bond ETF
DB X-trackers Emerging Markets Liquid Eurobond Index ETF
Lyxor iBoxx $ Liquid Emerging Markets Sovereigns ETF

Global
DB X-trackers Global Sovereign Index ETF