FYI | Jan 17 2012
GaveKal offered the following observations this week: Does Friday's Nine-Country Downgrade Matter?
This is undeniably the question that, over the weekend, every investor has had to ponder. On the one hand, it could be argued that rating agencies are, as always, a "day late and a Euro short" and simply telling the market what it already knows. After all, the yield on the Eurozone debt-weighted average 10-year bond yield rose considerably in October and November, to over 6%. The OAT-BUND spread also reached new record highs and has fluctuated between 100bp and 200bp since mid-September. So the market has been saying for a while that France and Germany were not quite the same credit risk. Moreover, one could argue that this summer's S&P downgrade of the US actually marked the nadir for US growth and that, since then, US growth prospects have been bouncing back nicely.
Finally, we know that with Mario Draghi at its head, the ECB is actively helping European banks repair their balance sheets by capturing the extra yield on the more dubious government debt. So with all that in mind, why should we care what S&P has to say? There are many reasons:
– The first is that with France losing its AAA, the EFSF will also now be downgraded (happened overnight). Demand for EFSF bonds from non-European investors (already demand from Asian investors in the last two auctions was anemic) will most likely dwindle to nothing. So that is one (ill-designed) instrument of European financial stabilization down the drain… a fact which does not boost the already shattered credibility of European policymakers.
– Talking of credibility, the loss of AAA status is a clear blow to the electoral prospects of Nicolas Sarkozy. Ahead of the upcoming elections of April-May, Nicolas Sarkozy remains well behind Francois Hollande in the latest opinion polls (44/56 on average), and it is no longer even certain that he will be able to qualify for the second run, as both Marine Le Pen and Francois Bayrou are making solid runs. The French political risk is thus likely to increase rather than decrease (as the socialists run on a campaign of why bother with cuts if we get downgraded anyway?), and along with many other problems in the Eurozone, this has the potential to revive investors' fears.
– Ratings agencies tend to be fairly lemming-like and so with S&P placing the debt-weighted average rating of the Euro area somewhere between A+ (same as South Korea) and AA- (same as Japan), Moody's & Fitch are bound to follow in the not-too-distant future, thereby almost guaranteeing a future flow of negative headlines.
These risks are amplified since the main catalyst for the rating agencies' pessimism has been the sharp deterioration of economic growth in the Eurozone. And, on that note, the outlook at least for France is getting cloudier. After all, which entrepreneur will invest a) before an election in which the various candidate's economic programs remain murky at best (except for the Front National's program, unveiled last night, with its unsurprising focus on protectionism as the main cure to all of France's ills)? And b) in a country still running a twin deficit at an unsustainably high 9% of GDP?
So bad news for Europe. But will the rest of the world care? At this stage, the fact that the Euro has gone from a solution looking for a problem to a problem without solution has, we believe, been mostly priced in. This is why we would look to any pull-back in Asian or US equities (following this weekend's news) as a buying opportunity.
The above expressed views are GaveKal's, not FNArena's (see our disclaimer). All copyright GaveKal.
GaveKal is a financial services firm that offers institutional investors and high net worth individuals fund management, independent research on global macro-economic trends and events, and independent advisory work on China and its impact on the global economy.
For more information, visit www.gavekal.com
