The Overnight Report: Europe De-Rates

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By Greg Peel

The Dow closed down 39 points or 0.4% while the S&P fell 0.1% to 1187 and the Nasdaq lost 0.4%.

Disappointment over weaker than expected Black Friday sales in the US gave way to relief when it was revealed internet sales were very robust. These numbers are released on the Monday after the Thanksgiving weekend which is thus known as Cyber Monday. Shares in Amazon, for example, were strong last night, as were shares in Amazon's carrier FedEx.

There was also further good news on the regional manufacturing front, with the Dallas Fed index rising to 16.2 in November from 2.6 in October. We have had strong results from all of Philadelphia, Richmond and Dallas this month with only one shocker in the form of New York State.

Such news meant little on the open of Wall Street, however, when the Dow plunged 162 points. Wall Street was following the European bourses, which saw falls of around 2.5% in each of the UK, France and Germany, and following the flow of funds out of the euro and into the US dollar. More de-risking.

When Greece was saved with an individual EU-IMF bail-out earlier in the year the relief was temporary, but when the EU-IMF subsequently set up an emergency fund of around US$1 trillion to ease concerns of contagion the markets finally managed to recover and retrace to April highs. The intention of the fund was to ensure that no peripheral European country could ever default, albeit the fund's intention was more psychological than practical. The assumption was it would never have to be used because knowing it was there, bond traders would stop selling Euro-debt and allow the struggling PIIGS to refinance at cheaper levels.

Therein lies the problem. It's all well and good for the PIIGS and others (ie UK) to introduce strict austerity measures, budget cuts, tax hikes and so forth, but the reality is each nation still has to roll over its bonds used to finance its budget deficit before such time as that deficit can be reduced to more comfortable levels. If the cost of those bonds rises (credit spreads rise) then the cost of financing the budget becomes prohibitive anyway. A point of no return is passed. (The rule of thumb is a 4% spread over the German bund is that point of no return).

The euro may have rallied strongly in the interim but the reality is the Euro-debt problem never really went away. And so it is that Ireland has now had to be bailed out to the tune of E85bn. One might have thought that the Irish bail-out would once again relieve the markets, but then attention turned to the Iberian peninsula, as Portugal and Spain became again the next ducks to be lined up by the bond markets. We know the EU-IMF emergency fund is still there. What's the problem?

Well for starters, it was hoped the emergency fund would never have to be used but now it has been. And thus the question arises as to whether the fund could go as far as saving the big economy of Spain having bailed out Portugal on the way, with Italy lining up as the next down the track, and the UK hardly out of the woods yet. But the real problem is that Germany has since changed the rules on the fund.

Originally the intention was that the fund would mean, emphatically, that no European country would have to default on its debt. The markets were not so easily convinced by what was effectively spin however, and so bond yields did not return to more comfortable levels. The assumption was that at least someone would need to restructure its debt. And with Germany being the biggest contributor to the fund, meaning effectively the hardworking German taxpayer was bailing out the profligate, tax-avoiding Mediterraneans, Angel Merkel saw the potential for political suicide. And so Merkel has insisted that Germany will play the game until 2013. Thereafter, the bondholders of any European sovereign which is still technically insolvent will simply have to take a “haircut”, as would happen in the commercial world. (Instead of retrieving 100 cents in the dollar on maturity, holders would only see, say, 90 cents or less).

Investment is all about discounted cash flows and risk premiums. Bondholders will not be sitting back with fingers crossed hoping they get past 2013 without incident. They will immediately apply a risk premium to their sovereign bond valuations and thus reduce the value of those bonds on their books. They will de-rate those bonds. The biggest holders of Euro-debt are Euro-banks and insurance companies. They also represent large proportions of stock indices.

So there you have it – Europe is being de-rated. Is this a calamity? Well some people are up in arms – Germans are never popular at the best of times – but realistically one would have to think the end result is a good one – orderly re-pricing with plenty of time to respond. At the end of the day, investing in Euro-debt was not a good decision. Investors who make bad decisions lose money. That's the way the capitalist system works. As long as sudden announcements don't send markets crashing, longer term planning means orderly re-pricing of risk.

What the haircuts mean is that were, say, Portugal to hit 2014 with a big rollover required and a bond spread that would send it broke, it simply rolls to a “cheaper” cost of debt by not paying out all of the 100 cents in the dollar owed. And no one can whinge if it's been coming for three years.

It does not nevertheless detract from the fact that the PIIGS are rolling over debt right now. Last night Italy received lacklustre support for a sovereign auction and Portugal and Spain both have auctions this week. The euro fell another 1.2% last night to just over US$1.31, sending the US dollar index up 0.5% to 80.80. The dollar index was higher earlier, and indeed the Dow recovered from its steep loss to be down only 39 points on the close.

The Aussie was looking at a 95 “handle” as they say, but is back to where it was on Friday night at US$0.9632. Gold was little moved at US$1366.40/oz and base metals were steady enough, albeit lead fell 4% and zinc 2%.

Oil, on the other hand, is currently ignoring the dollar and de-risking and doing its own thing. It jumped US$1.97 to US$85.73/bbl last night on what traders described as technical trading.

The SPI Overnight was up 5 points.

Today in Australia sees private sector credit data, building approvals and a house price index. Once upon a time all of these numbers would have been closely watched by a “finely balanced” RBA – the same RBA that two months ago suggested it couldn't wait forever to see if Europe was going to blow up again. The numbers are now academic as we're unlikely to see another RBA rate rise until perhaps the second half of next year. Tomorrow's third quarter GDP could well be negative. Glenn Stevens is no doubt looking for a big hole he can crawl into.

There are certain truisms in life such as, for example, one should never have that last drink and one should never have just one more run down a ski slope. Another is that a central bank will always make one policy move too far.

Today also sees interim earnings results from Metcash ((MTS)) and Campbell Bros ((CPB)).

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