The Overnight Report: Europe Tanks, Wall Street Follows

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This story features WESTPAC BANKING CORPORATION.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The Dow fell 225 points or 2.0% while the S&P fell 2.4% to 1173 and the Nasdaq crashed 3%.

There is a thick, black slick on the other side of the world spreading ever wider, threatening economies, threatening livelihoods, and threatening to send markets tumbling.

There is also an oil slick in the Gulf of Mexico.

Last night represented the second session of trade in Europe following Sunday's confirmation of a 110bn euro rescue package for Greece in exchange for stricter Greek austerity measures. London markets were, however, closed on Monday for the Labour day holiday. I noted yesterday that anticipation of the Greek announcement had sent the euro bouncing up (to US$1.33) late on Friday night but then back down again (to US$1.31) by Monday night, and that bond spreads in Portugal, for example, had only slightly ticked down. It was not convincing.

That lack of conviction was telling, because last night Europe made a vote of no confidence with its feet. The bottom line is markets do not necessarily believe (a) that 110bn euros is enough to fix the Greek problem rather than simply prolong it, or to nip contagion fears in the bud, and (b) that Greece can actually make good on its new austerity measures, particularly given building civil unrest. And we can add in (c), being whether the passage of emergency bills through eurozone member parliaments to allow the rescue package is actually a given. Germany's state election on May 9, if lost by Angela Merkel's party, would mean a hung parliament.

(Note also that Britain – EU but not eurozone – could have a hung parliament after tomorrow night.)

Contagion fears reemerged with gusto in Europe last night. Despite the Greek credit default swap spread edging in slightly from its earlier wide level, the Portuguese CDS blew out 82bps to 366bps, Ireland's added 36bps to 225bps and Italy's 16bps to 158bps. Most alarmingly however, the Spanish CDS blew out 49bps to 212bps. While Portugal is considered next in line for a bail-out, it is the state of the fourth biggest economy in the eurozone the world really fears. (The Spanish economy is half again bigger than Australia's).

Markets cited fears of further downgrades for Spanish sovereign debt following last week's downgrade by Standard & Poor's from AAA to AA. But both Moody's and Fitch came out last night to confirm their own AAA ratings and stable outlooks for Spain. It didn't seem to matter.

Adding to the heightened level of desperation in the eurozone, ECB president Jean-Claude Trichet has announced the eurozone central bank will accept any form of Greek paper as collateral, no matter how lowly rated, in an effort to stem the tide. This is a complete turnaround from Trichet's stance earlier this year when he emphatically suggested no one eurozone state would be afforded special treatment. This is the second capitulation from the embattled president, given he had initially stringently opposed any IMF involvement in the Greek rescue as well.

The eurozone seams are cracking. Economists suggest Trichet has one chance to put a lid on the contagion problem and that is by cutting the ECB cash rate at the regular meeting on Thursday night from its current 1.0% down to zero, a la Fed, and opening up the ECB balance sheet to all eurozone bonds in a renewal of quantitative easing.

The stock market reaction in Europe was similarly dire, with the UK index falling 2.5%, Germany 2.6%, France 3.6%, Italy 4.7% and Spain 5.6%. The euro crashed through the US$1.30 level and at last count was at US$1.2977.

Across the globe, the flight to quality was on. This means dumping stocks and commodities and pouring into US Treasuries and the safety of the world's only reserve currency. The US dollar index jumped a huge 1.2% to 83.38 last night while the yield on the US benchmark ten-year bond fell 10bps to 3.59%.

Gold could not fight against such a big jump in the US dollar after a solid run recently, and fell US$10.10 to US$1172.20/oz. Silver fell 5%, and there was carnage on the London metal markets as commodity funds bailed out.

Tin fell 2.5%, aluminium 3.5%, copper 5%, zinc 7%, lead 7.5% and nickel 8%.

On a day when the world was wondering whether the Gulf oil spill can ever be controlled or plugged, and what failure might do to immediate supply and ongoing Gulf oil production, oil fell 4% or US$3.35 to US$82.74/bbl.

But it was not just Europe, or the US oil spill, that spooked Wall Street last night. While Wall Street had assumed on Monday the Greek rescue package was the end of that story for now, such that a parochial return to focusing on solid local manufacturing, consumer spending and corporate earnings could be made, the storm clouds were gathering.

Monday's US session had ignored the Australian proposal for a resource tax, which would impact on the many large US resources and energy companies with operations downunder. Then yesterday HSBC came out with its own, privately calculated, Chinese PMI manufacturing number. While the official government index released on Sunday showed a tick up from 55.1 to 55.7 in April, the HSBC number, released yesterday, showed a drop from 57.0 to 55.4.

The HSBC number should come as no shock, given monetary policy tightening measures are being applied in China to slow its runaway economy, but as Australia's late stock sell-off yesterday attests, the rest of the world is wishing China wouldn't choose now to slow down the only solid economic force on the planet.

The Aussie dollar had already taken a tumble yesterday as well. This was because while the RBA did raise its cash rate, such a move was already half priced in, and no one had anticipated the RBA's hint that tightening was over for now. Add in last night's flight to quality and it all adds up to an Aussie down 2% to US$0.9082.

The SPI Overnight shed 102 points or 2.2%.

While the situation in Europe looks bleak, I refer readers to last week's article Greece And What We'd Not Like To Contemplate in which Danske Bank economists expressed their views and fears. Danske suggests a “good” scenario, in which the EU and ECB do manage to pull Europe back together, would still be predicated by further weakness in the euro, with a target of US$1.25. In other words, things have to get quite bad before they will get better. We have 2008 as evidence of what not to do.

Note that Westpac ((WBC)) releases its interim profit result today.

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