– As concerns spread to Spain and Italy, and EU leaders debate how to deal with Greece, investors lose patience.
– Our central view is that the crisis is ultimately resolved – provided there is political commitment, growth, and investor confidence.
– We would argue that recent developments have been uncomfortable for Spanish markets but the situation is retrievable.
– In the short-term, though, expect volatility given investors’ current doubts. The crisis in the Eurozone is deepening by the day as concerns spread beyond Greece, Ireland and Portugal, and into Spain and, more worryingly, Italy. The latest sharp rise in peripheral bond spreads is occurring while European finance ministers have been meeting to discuss the next move for Greece …
Azad Zangana – David Scammell
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For some time now we have warned that should Spain come under pressure and is forced to follow Portugal, Ireland and Greece in seeking a bail out, then Italy, and potentially Belgium, would also be seen as targets by bond vigilantes. The European Commission forecasts Italian public debt as a share of GDP to hit 120% by the end of this year, while Belgian public debt is expected to reach 100% of GDP. These large outstanding stocks of debt make both Italy and Belgium more vulnerable to a sustained rise in the cost of borrowing, even if they are keeping current borrowing low.
In our view, the cost of bailing out all the above-mentioned countries could exceed €3 trillion, which could prove to be the straw that breaks the camel’s back. However, this is not our central view as outlined in more detail below. Nevertheless, this is a very real threat to the current make-up of the currency union, which should serve as a powerful motivator for European politicians to make some progress on not only Greece, but the future direction of Europe.
David Scammell, Head of European and UK Interest Rate Strategies:
Our baseline scenario remains that the euro crisis is ultimately resolved and that spreads between the core and the peripheries narrow over time. Such an outcome will allow the ECB to continue on its tightening path and yields in core Europe will subsequently rise from present levels. However, this will require three things: namely, political commitment, growth and investor confidence. The issue short-term is that the market has serious doubts on all three issues, and volatility is to be expected over the next few months.
Growth is very dependent upon the global economy. We remain of the view that this is a “soft patch” within a subdued global recovery, but recent data would suggest that risks are now tilted to the downside. In particular, the US economy looks vulnerable, with the prospect of fiscal tightening next year. Whatever the outcome, Southern Europe seems set to underperform. Whilst recent surveys suggest that the Spanish economy is holding up better than most, despite the larger drag from fiscal adjustment and from the ongoing housing adjustment, news elsewhere in the region has been disappointing. If growth disappoints, countries such as Greece will fail – already it is hard to see how this year’s objectives will be reached, even after the latest tightening measures – and countries such as Italy will get negative headlines.
The political commitment to the euro remains for now, but investors increasingly fear that the politicians are getting it wrong. The discussion on debt restructuring and private sector involvement has been badly managed and is arguably misplaced. We are strongly supportive of the arguments put forward by Trichet – no credit event, no involuntary private-sector involvement. The politicians seem unaware of the dangers of going down the debt restructuring path – the way in which Greece is handled sets a roadmap for the rest of Europe. The markets will punish the peripheries if the politicians get it wrong.
Investor confidence is deteriorating fast. The issue here is that the problem is not just Greece but it is a bigger story. Portugal and Ireland look destined for years of further support, whilst Spain remains clearly vulnerable to another downturn in the housing market and/or further banking sector losses. Meanwhile, Italy (which has a smaller budget deficit) is held back by structural problems in the economy. Investors are becoming increasingly divided into two camps – those who feel that the euro muddles along and those that believe that it cannot survive in its present form. The longer the politicians dither, the more ammunition for the latter group.
We would argue that recent developments have been uncomfortable for Spanish markets but the situation is retrievable. The problem may become insurmountable if investors continue to push yields significantly higher. Given debt/GDP numbers, the situation with Italy starts to become problematic around 7% – given that the market is trading Spain and Italy as a bloc (within reason), this would imply a similar crisis level for Spain.
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