Stick a fork in it, the eurozone as we know it is done
S&P may have just killed the European sovereign market by saying out loud what only “fringe bloggers” dared suggest in the past
Here are the key take home messages from the FAQ (source):
- We believe that as long as uncertainty about the bond buyers at primary auctions remains, the risk of a deepening of the crisis remains a real one. These risks could be exacerbated should renewed policy disagreements among European policymakers emerge or the Greek debt restructuring lead to an outcome that further discourages financial investors to add to their positions in peripheral sovereign securities.
- The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. According to our assessment, the political agreement reached at the summit did not contain significant new initiatives to address the near-term funding challenges that have engulfed the eurozone.
- Instead, it focuses on what we consider to be a one-sided approach by emphasizing fiscal austerity without a strong and consistent program to raise the growth potential of the economies in the eurozone.
- Financial solidarity among member states appears to us to be insufficient to prevent prolonged funding uncertainties. Specifically, we believe that the current crisis management tools may not be adequate to restore lasting confidence in the creditworthiness of large eurozone members such as Italy and Spain. Nor do we think they are likely to instill sufficient confidence in these sovereigns’ ability to address potential financial system stresses in their jurisdiction. In such a setting, the prospects of effectively intervening in the feedback loop between sovereign and financial sector risk are in our opinion weak.
- Despite these encouraging developments on domestic policy, we downgraded both sovereigns by two notches. This is due to our opinion that Italy and Spain are particularly prone to the risk of a sudden deterioration in market conditions.
- While we see a lack of fiscal prudence as having been a major contributing factor to high public debt levels in some countries, such as Greece, we believe that the key underlying issue for the eurozone as a whole is one of a growing divergence in competitiveness between the core and the so-called “periphery.”
- We believe that the risk of a credit crunch remains real in a number of countries as economic conditions weaken and banks continue to consolidate their balance sheets in light of tighter capital requirements and poor market conditions in which to raise additional equity
- We estimate a 40% probability that a deeper and more prolonged recession could hit the eurozone, with a likely reduction of economic activity of 1.5% in 2012.
- We believe an even deeper and more prolonged slump cannot be entirely excluded. We expect this weak macroeconomic outlook if realized would complicate the implementation of budget plans, with slippages to be expected, which would likely further dampen confidence and potentially deepen the recession, as funding and credit is curtailed and the private sector increases precautionary savings.
- Reports indicate that many investors had hoped that a breakthrough at the December summit would have enticed the ECB to step up its direct government bond purchases in the secondary market through its Security Market Program (SMP). However, these hopes were quickly deflated as it became clearer that the ECB would prefer to provide banks with unlimited funding, partly with the expectation that those liquid funds in banks’ balance sheets would find their way into primary sovereign bond auctions. This indirect way of supporting the sovereign bond market may yet be successful, but we believe that banks may remain cautious when being faced with primary sovereign offerings, as most financial institutions have aimed at shrinking their balance sheets by running down security portfolios in order to comply with higher capital requirements, which become effective in 2012.
Shockingly, S&P dares to challenge not only the status quo, but “powerful national interest groups” – easily the first time we have seen something like this out of a “status quo” organization, let alone a rating agency.