While eurozone secession risks have risen, secession is still not our central case. The short-term costs for debtors and creditors alike would be very high. But to prevent this, market access has to be restored on sustainable terms for Italy and Spain. This will necessitate credible performance on fiscal adjustment plans – plans that are now in place – and the ECB stepping up its bond purchase programme, together with use of the EFSF, to buy time while fiscal adjustment takes place.
To be successful in the longer term would also require additional moves in the direction of closer fiscal integration, together with mechanisms to penalise potential fiscal miscreants.
In this respect, the timing of S&P’s move is controversial, coming ahead of a meeting of eurozone policy makers in Brussels today and tomorrow which is intended to reassure on a new fiscal framework and enforcement measures which are now increasingly seen as a precursor to a more robust ECB securities purchase programme.
S&P is no stranger to controversy, having downgraded the US from its AAA rating in August in a move that the US government argued was based on incorrect data. On balance we regarded that as the correct decision and also believe it to be the case this time around. As a minimum, it will intensify pressure on eurozone policy makers, in the periphery and the core, to step up to the challenge.
These downgrades are a further reflection of a process of broad deterioration in developed world debt metrics, including peripheral and parts of core Europe. By contrast, the debt metrics in much of the emerging world continue to improve. In other words, relative sovereign credit quality has diverged and the rating agencies and markets are still playing catch-up, downgrading the developed world and, on balance, continuing to upgrade the emerging world.
Market impact
The move should not be regarded as a major surprise and neither should the distinction drawn for long-term ratings between countries like Germany and the Netherlands on one level, France on a second and Spain and Italy on a third.
The negative outlook on the whole eurozone was probably more of a surprise but points out the bigger picture risks to the bloc as a whole. The good news is that a number of pieces of a potential solution are already in place, including more credible austerity packages for Italy and Greece and, together with the comfort markets have taken from concerted central bank action to provide liquidity to the banking system, this has limited the immediate market reaction.
Investment implications
At the time of writing, French government bonds had sold off most in Europe on the news but over time the decision is likely to put upward pressure on German government bond yields as well. German government bonds have been the asset of choice in the safe haven trade in Europe.
As investors have sold risk assets and government bonds from the peripheral European countries they moved into bunds which have outperformed other AAA eurozone countries as a result. However, the importance of S&P’s move in this regard is that it emphasises the extent to which what they referred to as ‘systemic stresses’ in the eurozone have risen, putting downward pressure on the credit standing of the bloc as a whole. Interestingly, ten-year Italian bond yields have continued to contract and are now below 5.8% in yield.
