Introduction
With panic sweeping across global equity markets, it is important to take a step back and consider what has changed and whether the sharp decline in risk assets represents a buying opportunity or is the beginning or a more pernicious move. After heavy falls in share prices last week events have moved quickly over the weekend. Firstly, the credit rating agency, S&P, downgraded the rating on US government debt from AAA to AA+ with a negative outlook. While this was not totally unexpected (S&P had already threatened a downgrade if the US did not raise its debt ceiling enough to present a credible fiscal consolidation plan to address the huge public sector deficit), it was, nonetheless, a nasty surprise coming just after such a turbulent week on world markets.
S&P downgrade the US credit rating
The downgrade is important symbolically but is much less significant than what is going on in the Eurozone debt crisis which we will come to below. It is a loss to the US's prestige and a sign of the times that the financial power base is gradually shifting from the West to the East but it is unlikely to have much effect on what matters: the yield on Treasury bonds themselves and the dollar. Paradoxically, the former may be seen as an even greater safe haven as the risks of a global sovereign debt crisis and recession have materially increased in recent days. Indeed, the initial reaction has been for Treasury bonds to strengthen slightly in the open market. The main short term concern is what the knock on effect of the lower rating will be to US financial institutions and whether they will also be downgraded.
In the longer term, the downgrade carries more significance as it underlines the fragility of the US public sector balance sheet and how difficult it will be to restore financial health to such an over indebted country. S&P cited the lack of credible political leadership in the recent unseemly dispute over raising the debt ceiling that was only agreed at the eleventh hour. The continuing gulf between the political parties as to how to address the debt problem will continue to weigh on the economy and will erode investor confidence in the US.
The ECB agree to buy Italian and Spanish bonds
With regard to the Eurozone debt crisis, the announcement that the ECB is prepared to buy Italian and Spanish bonds in the open market is of more relevance to the global markets and economy alike. To re-cap, the ECB agreed last year -reluctantly- to intervene to buy Portuguese and Irish bonds as the crisis escalated in those countries. However, following the respective bail outs, the ECB suspended its Securities Market Programme (SMP) and had not bought any further bonds until last Thursday despite the further deterioration of the crisis centred on Greece. At the ECB press conference last Thursday, the ECB President, M Trichet, was asked repeatedly whether the Bank would be prepared to buy Spanish and, especially, Italian bonds. He conceded that the ECB had already re-opened its SMP but it then transpired that it had bought not Italian bonds but more Portuguese and Irish debt and, furthermore, the decision had not been unanimous on the ECB committee. Far from reassuring markets it had the opposite effect and equities went into freefall.
Over the weekend, the ECB came under huge pressure to extend its SMP to Italy and Spain and an announcement was made to this effect. It should be remembered that one of the measures of the recent Greek bailout was the enhancement of the powers of the European Financial Stability Fund (EFSF) to be allowed to buy bonds itself in the secondary market. This move was applauded but it cannot yet be implemented because it requires legislation to be drawn up and approval by all 17 member states' Parliaments. Even though the politicians are trying to fast track the new law it is unlikely to be passed before the end of September at the earliest. The ECB has argued that it is not its responsibility to intervene in the bond markets and it is up to the governments to enable the EFSF to do so. However, given the gravity of the situation it has agreed to act as a stop gap until the EFSF is ready.
The effect of the ECB's intervention will be to reduce the borrowing costs of Spain and Italy in the short term. Not least the short sellers of these bonds may be forced to cover their positions and produce a sharp rally in the market. As a buyer of last resort, therefore, the ECB intervention will buy some time but it will not alter the dynamics of the crisis. The size of the Italian and Spanish debt markets mean it will be even more difficult for official intervention to bully bond yields down. Italy and Spain owe some €1580bn and €550bn respectively, 7 times the size of Greece's huge debt. The strategy of supporting bond markets in the periphery failed in the case of the much smaller Portuguese and Italian bonds markets and will fail with Spain and Italy. It is no more than a short term palliative and if the markets believe that these countries are potentially insolvent bond prices will continue to reflect it.
Furthermore, the resources of the ECB and EFSF will be severely stretched by the size of the Italian and Spanish debt markets to have a meaningful effect, expect over the short term. At present, the EFSF has only about €100bn of uncommitted funds and the Spanish and Italian bond markets are 3 times the size of the central bank's own capital base that limits the scope to intervene effectively. Also, the ECB does not buy bonds in the same way as the UK and US central banks did with their quantitative easing (QE) programmes because it has to absorb all the money it prints to purchase bonds with corresponding sales. This does not carry the inherent inflationary risk of full QE but imposes a constraint on the bank as well as diluting the quality of its balance sheet. If the crisis escalates further it may be that the ECB will be forced to do full QE itself but this would only be a last resort after every other policy option has been exhausted, such is its aversion to this monetary tool.
Once the EFSF is fully empowered to buy bonds in the open market itself it is likely the ECB will cease its own operations. However, the size of the bailout fund will have to be increased considerably to have a meaningful effect and this provision was strangely omitted in the recent Greek bailout agreement. The EFSF funding comes from the bonds sold under its name that are dependent on the AAA credit rated countries subscribing capital to the fund. Perhaps the most concerning aspect of this weekend's credit rating downgrade of the US is that the AAA rated countries of the Eurozone could themselves be vulnerable. Indeed, there has already been signs that contagion is spreading to France, the second biggest Eurozone economy, and if it was downgraded it would imperil the efficacy of the EFSF as it is constituted at the moment.
Ultimately, the outcome of the Eurozone debt crisis will be either a full or partial breakup of the union or greater fiscal and political integration. I still think the latter outcome is more likely with the creation of a common debt instrument that consolidates all the members' debt so there is a collective guarantee. This is more of a political than economic challenge but needs must. The impediment is that markets are moving faster than the authorities can respond and they may not be able to impose a sustainable and permanent solution in time. It is this which has sapped investors' confidence in recent days. It is hoped that events will create a greater sense of political urgency while there is still time.
Market reaction
Markets are clearly oversold and overdue a technical bounce. The last week has seen some capitulation as markets have dramatically broken down from the narrow trading range they had been locked in for the last several months. Despite this, most economies, even those with high debt burdens, are still growing, albeit slowly and companies remain in strong financial shape and are delivering good profit and dividend growth. Based on current forecasts the valuations on equity markets are at levels rarely seen over recent decades and are particularly attractive against nominal and real government bonds. For instance, the UK market is on about 9x PE for December 2012 that equates to an earnings yield of over 11% compared to a 10 year gilt yield of about 2.75% and a negative equivalent real gilt yield.
The problem is that if a financial crisis ensues as a result of the debt problems of Europe it could create a global recession, similar to events following the demise of Lehman's in September 2008. It is the recent memory of these events that is rattling markets at present and while banks are better capitalised and companies financially stronger, the balance sheet of sovereign states are markedly weaker.
For markets to have a sustained rally it is necessary for the Eurozone to come up with a credible solution to its debt crisis. It will have to demonstrate it can be durable and address the burning issue of solvency rather than the liquidity based approach that the ECB purchases of Spanish and Italian debt is another example of. If this can be done then a recession can be avoided and a sense of stability will return to debt markets which are the necessary condition for risk assets to rally. In the meantime, the political tensions of the Eurozone and the ECB and IMF will probably mean more market turmoil and markets could fall further until a valuation base is reached. Unlike in 2008, the valuation floor is not far below current levels because so much bad news is already discounted. Share prices are already implying a significant downgrade in earnings over 2011-12 and if equities fall a further 5-10% they will be worth accumulating despite the risk of recession (for the UK around 2500 on the FTA All Share Index). In the meantime, gold and precious metals will continue to flourish despite the strong rise in prices already seen. It is likely the end game to this crisis is the creation of more money and liquidity in debt affected countries and that is also an attractive scenario for gold. Although, high credit rated bonds will remain relative safe havens in financially stressed markets the low yields do not compensate for the risk, as witnessed with the downgrade to the US this weekend. EM debt offers better compensation and generally public sector balance sheets are stronger in faster growing economies.
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