Global financial markets have returned their attention to Europe. On Friday, January 14, Standard and Poor’s downgraded the credit rating of nine Eurozone countries. European financial markets on the following Monday were for the most part unmoved by the development, which was largely anticipated and already priced in. Indeed a positive aspect was the removal of uncertainty about this matter which had been disturbing markets. Late in the day Monday, S&P announced that it had also downgraded the Eurozone bailout fund, which relies on the credit ratings of its guarantor Eurozone states. This development also should have been anticipated; but some hoped the Europeans, namely Germany, would take action to forestall it by strengthening the fund’s resources.
The S&P downgrades on Friday were the following: one-notch downgrades for Austria (to AA+ negative), France (AA+ negative), Malta (A- negative), Slovakia (A stable), and Slovenia (A+ negative); two-notch downgrades for Cyprus (BB+ negative), Italy (BBB+ negative), Portugal (BB negative), and Spain (A negative). The outlook term “negative” means the chances are one in three that the rating will be taken down further by the end of 2013. The current ratings of 7 Eurozone countries were reaffirmed (Germany, Finland, Luxembourg, the Netherlands, Belgium, Ireland, and Estonia). The S&P’s rationale for the downgrades emphasized “insufficient” policy responses at the Eurozone level to “fully address ongoing systemic stresses” in the Eurozone. S&P argues that the focus has been too heavy on fiscal consolidation rather reforms that would contribute to a recovery of economic growth in the region.
When European markets opened the following Monday, European equities edged down initially and then recovered, with the FTSE Eurofirst 300 closing up 0.8%. European bonds were mixed. French bonds actually advanced, with France successfully selling 1.895 billion euros ($2.41 billion) of one-year bills. The yield was 0.406%. As recently as January 9, the rate was 0.54%. The yield on France’s 10-year bond slid 4 basis points, while that on France’s 2-year note was 5 basis points. Spanish and Italian bonds rose, presumably in response to purchases by the ECB. Funding pressures on European banks have eased, with the 3-month euro-dollar basis swap now at only 80 basis points, the lowest since last August.
In contrast to these positive developments, Portugal’s sovereign debt was hit by its two-notch downgrade to below investment-grade, which means it will drop out of a number of indices. The 10-year yield soared to 14.48%. (This compares with the 1.77% yield for Germany’s benchmark 10-year bund). Portugal’s 2-year note now yields 15.78%. The euro was also hit, closing at $1.2674 on Monday, following the late-day S&P cut of the bailout fund. However, today (Tuesday, January 17, the Euro is trading close to $1.28.
The downgrade of the bailout fund, formally known as the European Financial Stability Facility (EFSF), was an understandable result of the downgrades from AAA of France and Austria, two of the guarantors of the fund that together account for 180 billion euros of the fund’s credit guarantees. The borrowing costs for the fund will now be somewhat higher. While member countries could put in place credit enhancements to offset the effects of the downgrade, Germany’s Finance Minister Schauble implied this course is unlikely. He argued that the fund “is sufficient for what the EFSF has to do in the coming months.” Beyond that point, Germany is putting its emphasis on the EFSF’s planned successor, the European Stability Mechanism (ESM), which Eurozone members are seeking to bring into being by mid-year. This will be difficult to achieve, as it will require ratification by the 17 Eurozone members and an amendment of the Lisbon treaty that all EU governments must ratify. The ESM will be less sensitive to the credit ratings of its guarantors, as it will have paid-in capital. A substantial increase in its size above the initially planned 500 billion euros seems necessary to convince markets that it will be sufficient should the crisis become more critical in larger Eurozone countries. Germany is resisting this.
As we have written, the Eurozone crisis is continuing in the New Year despite some positive developments, including successful funding operations by Spain and Italy in addition to France. Also very positive is the evident increased flexibility of the European Central Bank, with indications that it will significantly loosen its collateral requirements and provide to the European banking system whatever liquidity is needed. Nevertheless, we are likely to experience further periods when tensions in Europe cause global markets to retreat. We continue to anticipate that financial markets will stabilize in the second half. Cumberland Advisors’ International and Global Multi-Asset Class portfolios, which are fully invested, remain underweight with respect to the Eurozone. Within the zone we are favoring Germany and the Netherlands.