European spot fires

07 December 2011

The second half of 2011 has been a difficult one for investors, with markets extremely volatile and sentiment fragile, fluctuating on various pronouncements from European policymakers.  After a broad ‘risk-off’ trade prevailing during September, this reversed significantly to a ‘risk on’ trade during October as perceptions of the European debt crisis improved, before deteriorating again in mid-November as debt fears re-emerged.

Sentiment (or lack thereof) in Europe is driving markets...

Markets are intensely focused on the evolving situation in Europe.  The situation deteriorated for several months to early October as European policymakers remained intransigent in the face of a deepening and broadening crisis, fuelling financial fear and provoking a wide-spread shift to safe havens – such as into long term US government Treasuries and away from equities and Australian dollar exposure.

Yet this was strongly reversed during October as European policymakers finally appeared to appreciate the severity of the situation and announced a package aimed at stemming the crisis.  Specifically, 3 key issues were agreed.  First, European banks will undertake a ‘voluntary bond exchange’, involving a 50 per cent ‘haircut’ on holdings of Greek sovereign debt.  Second, ratification by all EU member states has seen the firepower of the European Financial Stability Fund (EFSF) leveraged from €440 billion to €1 trillion.  And finally, agreement for the recapitalisation of European banks (excluding UK banks) with the requirement for 9 per cent core capital – after accounting for market valuation of sovereign debt exposures – by 30 June 2012.  This will require over €100 billion in additional capital.

Markets reacted positively to the announcement of this resolution to European sovereign debt concerns.  Equity markets rebounded, with the S&P500 up 10.8 per cent over the month to the end of October and the ASX200 up 7.2 per cent.  Likewise, currency markets also reversed some of their earlier momentum towards the US dollar, with risk appetite and commodity currencies such as the Australian dollar (up 10.7 per cent) and the New Zealand dollar (up 8.1 per cent) all posting significant gains over the month to the end of October.

...and it isn’t over yet as spot fires continue to emerge

However the optimism of late October did not last long, as there remain a number of unanswered questions for resolution to the European crisis.  This includes the willingness of holders of Greek debt to accept a 50 per cent ‘haircut’, especially if holding a credit default swap providing a 100 per cent payout.  The voluntary take-up of this program will become apparent in early 2012, and in the meantime interest rates on 10 year Greek debt have hit over 31.5 per cent (compared to 1.8 per cent in Germany).  

Likewise – and despite a surprise 25bp rate cut in early November – a question mark remains over the willingness of the European Central Bank (ECB) to provide further support – via lower interest rates, liquidity support, and direct buying of sovereign debt to prevent a blow-out in interest rate spreads.  

And unwillingness from politicians is not helping.  Intransigence from Italian policymakers in implementing the necessarily severe fiscal consolidation measures has already seen Italian interest rates hit 7.2 per cent in early November, above the 7 per cent level that is notionally considered ‘sustainable’ given Italy’s debt levels.  And in the face of poor bond market sales across the Euro zone, there is now significant financial pressure on Spain, as well as the smaller economies.  There is also the risk of a sovereign credit rating downgrade to France.
Aside from the risk of financial contagion, the economic fundamentals are also deteriorating rapidly within Europe as manufacturing surveys, and other leading activity indicators all point to economic contraction, coupled with a very weak credit environment as banks rein in their lending in order to meet capital requirement ratios.  The likely coming European recession is also serving to slow the global trade cycle, given, for example, that Europe accounts for just over 21 per cent of Chinese exports.

Playing policy chicken...

Given the sizeable risks, this raises the question of just what policymakers are doing?  

In short, while there are ongoing questions about their willingness to move, the ECB does actually have the financing available to support Italy and Spain until the end of 2014, but is trying to achieve two key objectives.  First, to avert a collapse of the banking system and depression style economic catastrophe; and second, to ensure governments undertake the structural reform necessary to save the Euro and get the Euro area back on to a sustainable long-term growth path.

To achieve both objectives requires a delicate balancing act from the ECB.  If it intervenes too aggressively in bond markets, politicians incentive for reform will fade, putting the second objective at risk. If it is too passive, it puts the first objective at risk.  In essence, the question is ‘how long does the ECB have to wait and how much pain does the ECB have to allow to ensure countries adopt the necessary fiscal reform’?  

Likewise, politicians, while publicly unwilling to implement electorally unpopular reform, also appear to understand the importance of the Euro area.  For example, should periphery economies leave the Euro and Germany again revert to the Deutschemark a significant appreciation in their currency would be expected, leaving the German economy internationally uncompetitive.  Government changes in Spain, Italy and Greece may also yield progress on the implementation of reform.

...so the question is more ‘when’ than ‘if’ for a resolution

Importantly, all the dire news around the European sovereign debt crisis does not necessarily imply that the global economy is headed towards Global Financial Crisis Mark II.  Indeed, unlike the 2008/09 crisis, the risks are relatively well known, there are few complex financial instruments involved and the financial counterparty exposure of each institution is clearer.  Nor is sovereign default the only answer, with history providing a number of examples where countries have reduced debt levels from the currently elevated levels through a combination of growth, fiscal austerity, inflation or devaluation.  

Hence, in this instance, the European sovereign debt crisis should been seen through the prism of not just high sovereign debt levels, but of a lack of confidence in European policymakers to resolve the situation.  But this issue is able to be resolved, even if, to date, there has not been adequate commitment to do so.  Put simply, the sooner European politicians act, the sooner Europe will emerge from the growth funk it is now entering.