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Can Europe's Leaders Live Up to Market Expectations?

10/11/2011 

   

 

     Financial markets experienced a sharp relief rally in risk assets in the past week, on the back of renewed optimism that Europe’s leaders will reach a comprehensive solution by the end of the month with regards to the ongoing banking and sovereign debt challenges. Although the willingness to act decisively appears to be rising in the face of increasing systemic risks, it remains to be seen how far-reaching any decisions will be and how any proposed decisions for bank recapitalizations and sovereign debt restructurings will be financed and implemented.

 

     At the core of the problem, the Euro zone is burdened with high levels of debt. Even the strongest economies of Germany and France have debt/GDP ratios of 80-85% for 2011, whilst the challenged economies of Italy and Spain (which account for 32% of the gross Euro zone government debt) have 70% and 120% debt/GDP ratios respectively. It is noteworthy that the current Euro zone bailout fund of EU 440 billion is largely financed (77%) by these four countries (i.e. 27% Germany, 20% France, 18% Italy and 12% Spain). After existing commitments for Greece, Ireland and Portugal, the fund is left at best with EU 250 billion for any future bailouts, an amount which is too small when considering Italy’s EU 1.6 trillion and Spain’s EU 678 billion gross government debts. Therefore, when considering future probable sovereign debt restructurings and bank recapitalizations the Euro zone really needs to have a minimum bailout fund of EU 1 trillion. Given already stretched sovereign balance sheets, the question remains therefore as to how these funds will be raised and at what cost, especially as the ECB is not keen on monetizing debt as it is deemed inflationary.

 

 

   

 

     An example of the overstretched nature of the core economies’ sovereign balance sheets is really seen by the recent case of Dexia. Over the weekend, the embattled Franco-Belgian bank received state guarantees of up to EU 90bn by Belgium (60%) and France (40%) for the next 10 years, in support of its ‘bad assets’. Last Friday, Moody’s put Belgium’s Aa1 rating under review due to the impact of additional bank support on the already pressured balance sheet. With an existing debt/GDP of 92% it is not surprising that the cost of insurance rose (pink line on credit default swap graph) and the yield on its 10 Year government bond (blue line) rose to 4.1%. Therefore, the Merkel-Sarkozy weekend pledge for a ‘sustainable and comprehensive plan’ needs to address both excess sovereign debt and the consequent bank recapitalization needs. At the moment, the only topic of discussion out of the Euro zone is for renewed banking stress tests assuming only a Greek sovereign default. Thus, it remains to be seen how far-reaching sovereign debt restructuring assumptions will be.

 

   

  

 

 

     On a more encouraging note, as the above charts attest, the good news is that the ECB is finally taking a more aggressive stance by expanding its balance sheet (as the Fed did back in 2009) in order to address liquidity needs and encourage banks to lend to each other instead of depositing their excess funds at the ECB’s overnight facility. Lastly, interest rates in Europe will have to be cut in the near future in order to reduce borrowing costs and thus ease monetary conditions. Given that the Federal Reserve has already gone to large extents to ease monetary conditions in the U.S., our expectation is that over the next 6-12 months, the EUR/USD will depreciate, which should put upward pressure on the USD index (58% Euro weighted) and thus ease price pressures in the crude oil market. 

 

      On the U.S. front, economic data have been on the ‘better than expected’ side but we note that the ECRI leading economic indicator has shown further deterioration and unemployment rates remain uninspiring. With regards to the leading indicator, it typically leads coincident data by three months; therefore it will be interesting to see how fundamentals develop in Q4 of 2011 and into next year.

 

 

  

 

 

     In conclusion, given the depth and complexity of Europe’s macroeconomic and political challenges, it remains to be seen whether European leaders can address effectively the banking and sovereign solvency issues. Europe also needs to put into place structural reforms that will promote critically needed growth across the Euro zone and in the peripheral countries in particular. Therefore, given the underwhelming results of previous decisions by Europe’s leaders, we look forward to meaningfully adjust our investment stance only when we encounter a credible and truly comprehensive plan.

 


 

 


 

Christos Charalambous CFA  

Senior Strategist

christos.charalambous@edgewealth.com

 

 

 

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