Goldman's Roadmap For Europe - The Next Steps

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Three of the smartest strategists at Goldman, Huw Pill, Francesco Garzarelli, and Peter Oppenheimer, have released what one could tentatively call a white paper on the "next steps" for Europe. Far from being the traditional permabullish sellside drivel, this is a must read note, as it cleanly lays out the risks for the Eurozone from this point. The note focuses on three key aces: 1) fiscal consolidation and the ongoing role of the ECB in the future of a Eurozone which still has no fiscal cohesion (which makes sense: just like in the US, the Fed is aggressively putting the ball in Congress' court, as neither the monetary nor fiscal apparatus has any interest in being blamed for ongoing economic deterioration, so in Europe the ECB wants a federal union, complete with Eurobond issuance powers, so it is not in the cross hairs: alas, European politicians realize this is career suicide and the question remains: when push comes to shove, and saving the Euro requires career harakiri from politicians, will they step up to the plate?); 2) Italy, of course, as the country under the spotlight now and going forward; and 3) what the above two mean for BTPs and thus the European (and Global) equity markets. The sense we get from the Goldman trio is that while the company which has just spawned Europe's latest central banking head, while cautiously neutral is pushing for a downside case: after all what better way to unlock the Heidelberger Druckmaschinen true potential, than with a full blown crisis...

From Goldman Sachs

1. Fiscal consolidation is a precondition for further support

Over the past week, the pace of events in the European crisis has again picked up, amidst increasing sovereign bond market tensions, particularly in the case of Italy. After a week of drama, we are likely to see the formation of a government of national unity in Greece, mandated to approve and oversee the financial adjustment package agreed with the EU ahead of national elections next Spring. Meanwhile, a routine vote on last year’s public accounts to be held this Tuesday in the Italian Lower House will be a test of how much support the government can still rely upon and may lead to political change there too. Finally, the much anticipated Cannes G-20 summit – which was flagged as a key moment in the resolution process – has come and gone with little in terms of concrete measures announced.

Against this background, the ECB Governing Council surprised both us and financial markets by lowering its repo rate by 25bp to 1.25% at last Thursday’s meeting. While the timing of this move was unexpected, it remained consistent with our medium-term view, which foresees rates being lowered to 1% in the coming months and held there through the end of 2012 – as the market now also fully discounts. We forecast a mild recession in the Euro area this quarter and next, also involving the ‘core’ countries.

Of more immediate significance may be President Draghi’s remarks on the ECB’s asset purchases in the context of its securities markets programme (SMP).  Since the start of August, the ECB has bought roughly EUR 100bn of Italian and Spanish government bonds (BTPs and Bonos, respectively), equivalent to roughly 9-months worth of the combined Italian and Spanish budget deficits. Purchases accelerated over the past week, following the Greek Prime Minister’s abortive announcement of a referendum on the bailout package agreed at the October euro summit, which led to contagion into the Italian market.

These purchases have accommodated the net sale of these securities by non-domestic investors, forestalling large price discontinuities. From this perspective, the ECB’s SMP purchases resemble operations conducted by the Fed in relation to Agency debt in 2008-09.  A key difference between the two schemes, however, is that the ECB has not pre-announced a transparent framework within which the purchases will take place. At last week’s press conference, President Draghi stated that the limit on ECB asset purchases would only be revealed ex post each week, when the central bank discloses its security holdings. As in the past, no ex ante information on the magnitude, country composition, price or maturity structure of purchases would be announced.

More generally, in discussing the SMP, President Draghi demonstrated a high degree of continuity with the views of his predecessor. In particular, he emphasised that, as part of the ECB’s armoury of non-standard measures, SMP purchases of sovereign debt are: (i) (by their nature) temporary in duration; (ii) limited in scope; (iii) focused on the maintenance of monetary policy transmission; and (iv) (owing to the ECB’s separation principle) distinct from the monetary policy stance as reflected in the level of the repo rate.

We have consistently argued that the ECB will continue with SMP purchases in order to prevent a seizing up of sovereign markets, and the emergence of a disorderly situation in European markets more generally. At the same time, we have been sceptical that a President Draghi-led ECB would shift away from the ‘passive’ approach adopted by the Eurosystem thus far in the conduct of these purchases. Despite the calls of many observers for the ECB to adopt a larger, more ambitious and pro-active scheme for bond purchases, we doubt that the ECB will pursue such a strategy anytime soon. President Draghi’s remarks on Thursday appear to support our stance: he emphasised that the acting as a lender-of-last-resort for governments was not ‘really within the remit of the ECB’.

With the ECB apparently unwilling to pre-announce and engage in substantial and sustained purchases of peripheral sovereign debt and/or to establish and enforce ceilings for peripheral sovereign yields, the main responsibility for addressing the intensifying tensions in government bond markets lies with the issuing governments. Assigning responsibility to governments appears to be exactly the intention of the ECB: Governing Council members have been increasingly strident in pointing to the conditionality of SMP purchases on the implementation of agreed fiscal consolidation and structural reform.

Over the past week, the pace of events in the European crisis has again picked up, amidst increasing sovereign bond market tensions, particularly in the case of Italy. After a week of drama, we are likely to see the formation of a government of national unity in Greece, mandated to approve and oversee the financial adjustment package agreed with the EU ahead of national elections next Spring. Meanwhile, a routine vote on last year’s public accounts to be held this Tuesday in the Italian Lower House will be a test of how much support the government can still rely upon and may lead to political change there too. Finally, the much anticipated Cannes G-20 summit – which was flagged as a key moment in the resolution process – has come and gone with little in terms of concrete measures announced.

Against this background, the ECB Governing Council surprised both us and financial markets by lowering its repo rate by 25bp to 1.25% at last Thursday’s meeting. While the timing of this move was unexpected, it remained consistent with our medium-term view, which foresees rates being lowered to 1% in the coming months and held there through the end of 2012 – as the market now also fully discounts. We forecast a mild recession in the Euro area this quarter and next, also involving the ‘core’ countries.

Of more immediate significance may be President Draghi’s remarks on the ECB’s asset purchases in the context of its securities markets programme (SMP). Since the start of August, the ECB has bought roughly EUR 100bn of Italian and Spanish government bonds (BTPs and Bonos, respectively), equivalent to roughly 9-months worth of the combined Italian and Spanish budget deficits. Purchases accelerated over the past week, following the Greek Prime Minister’s abortive announcement of a referendum on the bailout package agreed at the October euro summit, which led to contagion into the Italian market.

These purchases have accommodated the net sale of these securities by non-domestic investors, forestalling large price discontinuities. From this perspective, the ECB’s SMP purchases resemble operations conducted by the Fed in relation to Agency debt in 2008-09. A key difference between the two schemes, however, is that the ECB has not pre-announced a transparent framework within which the purchases will take place. At last week’s press conference, President Draghi stated that the limit on ECB asset purchases would only be revealed ex post each week, when the central bank discloses its security holdings. As in the past, no ex ante information on the magnitude, country composition, price or maturity structure of purchases would be announced.

More generally, in discussing the SMP, President Draghi demonstrated a high degree of continuity with the views of his predecessor. In particular, he emphasised that, as part of the ECB’s armoury of non-standard measures, SMP purchases of sovereign debt are: (i) (by their nature) temporary in duration; (ii) limited in scope; (iii) focused on the maintenance of monetary policy transmission; and (iv) (owing to the ECB’s separation principle) distinct from the monetary policy stance as reflected in the level of the repo rate.

We have consistently argued that the ECB will continue with SMP purchases in order to prevent a seizing up of sovereign markets, and the emergence of a disorderly situation in European markets more generally. At the same time, we have been sceptical that a President Draghi-led ECB would shift away from the ‘passive’ approach adopted by the Eurosystem thus far in the conduct of these purchases. Despite the calls of many observers for the ECB to adopt a larger, more ambitious and pro-active scheme for bond purchases, we doubt that the ECB will pursue such a strategy anytime soon. President Draghi’s remarks on Thursday appear to support our stance: he emphasised that the acting as a lender-of-last-resort for governments was not ‘really within the remit of the ECB’.

With the ECB apparently unwilling to pre-announce and engage in substantial and sustained purchases of peripheral sovereign debt and/or to establish and enforce ceilings for peripheral sovereign yields, the main responsibility for addressing the intensifying tensions in government bond markets lies with the issuing governments. Assigning responsibility to governments appears to be exactly the intention of the ECB: Governing Council members have been increasingly strident in pointing to the conditionality of SMP purchases on the implementation of agreed fiscal consolidation and structural reform.

2. Italy under the Spotlight

Given the size of the BTP government bond market – the second-largest in the Euro area, after Germany’s – and the large exposure to these securities in the other core Euro area countries, the focus of the European sovereign and banking crises has moved squarely to Italy.

In the first half of 2011, BTPs were priced at levels broadly consistent with Italy’s relative macro fundamentals, say at yields around 200-250bp over German Bunds at the 10-year maturity (see our European Views from August 7, 2011 ‘Europe Should Say that BTPs are Cheap’ for a discussion). But since Germany demanded substantial ‘private sector involvement’ in the restructuring of Greek debt in June, the pressure on Italian sovereign yields has been relentless (outside a brief period immediately after the ECB commenced BTP purchases in early August).

In this context, any doubts in the market over whether the Italian authorities have the resolve to carry out fiscal and structural reforms are very damaging. Plans to force commercial banks to raise buffer capital against the risk of a (small) impairment of peripheral bonds, including those of Italy and Spain, has all but amplified investors disaffection towards this issuer. Although we concur with the Bank of Italy that Italy can sustain higher levels of funding costs, the ongoing self-fulfilling pessimistic dynamics may ultimately restrict the sovereign’s ability to roll-over its liabilities and thus bring its sustainability into question. And while yields are elevated and confidence is at a low ebb, these conditions weigh on the real economy, which appears to be entering a deep recession.

If the Italian government can re-establish its credibility and thereby re-access the market at spreads closer to the ones suggested by our credit analysis, a virtuous cycle of increased confidence, growth and sustainability can emerge both in Italy and, indirectly, in the Euro area as a whole. Re-establishing such credibility and confidence, however, is easier said than done. The measures put forth so far are in line with those announced in previous medium-term reform plans. Strong resistance from interest groups has in the past obstructed their implementation. Domestic political tensions and the frailty of the governing coalition only add to the difficulty of formulating and agreeing on the necessary changes to the social contract, including to inter-generational transfers, which are required for any fiscal programme to be credible. In this context, the quarterly IMF review that Italy has agreed to – and which will be initiated on November 15 – raises the stakes. But it may also provide a credible signal to the market if progress is made (and facilitate the task of transferring international financial resources without a strict ex ante conditionality should unwarranted pressures persist).

3. Implications for BTPs and the European Equity Market

In the shorter term, we anticipate that Italy will continue to pursue its announced reform agenda. Votes of confidence have been attached to the legislative passage of a number of key elements of the reform programme, the first of which is scheduled in the week of November 14. Ahead of this, the main focus will be on a vote in the Lower House this Tuesday on the approval of last year’s audited budget accounts. This otherwise routine ballot is expected to reveal how much parliamentary support the centre-right government can still rely upon after several MP defections in recent weeks. Should the government fail, possible scenarios include a reshuffle; an interim government of national unity, like the one that is under formation in Greece; or general elections.

Given fragile market sentiment and the perceived lack of delivery by the Italian authorities thus far, tensions in the BTP market are likely to persist. In the short term, these will continue to be contained by the ECB. As said above, we strongly doubt the ECB will force yields down pro-actively, but rather continue preventing discontinuities in the price formation from occurring. That said, the central bank will also likely attempt keeping the 10-yr yield spread between on Italy/Spain and AAA-rated EMU sovereigns below 450bp (for reference, Italy closed on Friday at 400bp over and Spain at 320bp, underscoring the strong pressures on the former). This is roughly the threshold that would trigger higher margin calls in the private sector and thus a shift in the stock of Italian and Spanish debt onto the ECB balance sheet as commercial banks look to fund an increasing share of their government bond portfolio with the central bank.

This strategy of ‘passive containment’ by the ECB will probably last until there is commitment by the national fiscal authorities to undertake urgent fiscal adjustments. But domestic politics are still evolving. Examples include the institutional mechanics surrounding a broadening of the parliamentary coalition supporting the government in Italy (a process that Greece is currently undergoing). All of this will buy time for the Italian authorities to re-establish the confidence of the financial markets. Our modal scenario remains that the Italian authorities will exploit this final window of opportunity to meet the formidable challenges facing them.

Once the framework for the EFSF is defined more clearly by the Eurogroup and made operational, further support for Italy may come from EFSF purchases of BTPs and/or EFSF guarantees of new Italian sovereign issuance (which we discussed in recent Global Markets Dailies). The Italian government may even make recourse to a precautionary credit line from the IMF, notwithstanding its unwillingness to accept the IMF’s help at the Cannes G-20 meeting, presumably on the grounds that subordination of outstanding debt to new IMF loans may further destabilise the secondary market for BTPs.

Our central scenario is characterized by high volatility in local assets, but probably also a reduction in broader systemic risk (we have seen indications of this in the price action last week). Should positive breakthroughs eventually occur (e.g., an ambitious fiscal package in Italy supported by a larger majority), we suspect that the reduction in fiscal risk premium in government bonds will be partly offset by investors’ attempt to reduce exposures in the rally, particularly in intermediate to longer-dated maturities where the price discount is currently large.

A different, more problematic scenario would instead be the one in which the Italian government proves recalcitrant (or politically incapable) to seize the initiative, notwithstanding increased pressures from the markets, peer EMU countries and the IMF. This could result in unilateral decisions by the authorities to nationalize banks, and/or restrict market activity in government securities. Under these circumstances, which we judge as very unlikely given current information but by no means impossible, the ECB would likely interrupt the SMP and retreat to refunding of depository institutions. This would leave the fiscal authorities (the IMF, the EFSF) to deal with the adverse primary and secondary market implications. Clearly, such a low probability outcome would be an extremely costly one, both for BTPs, equities, and for systemic risk more generally.

Balancing these different outcomes, we see BTP yields close to their highs against AAA-rated peers as the ECB contrasts market pressures. If, after a period of political turmoil, the Italian government takes more decisive action and this is accompanied by fiscal transfers (by the ECB and the EFSF) as in our central case, we see scope for the Italian spread curve to narrow and steepen from the front-end. This will not result in a rally to our measures of historical ‘fair value’, particularly heading into the less liquid year-end. But it should re-establish a more two-way market and, most importantly, result in a gradual ‘de-coupling’ of European sovereign concerns from broader market developments, as cross-asset correlations have already started to suggest.

From an equity market perspective, we think the near-term outlook is likely to remain volatile, with the market continuing to trade the implied risks (in either direction) of the evolving news flow. In the event of market pressures forcing the authorities to nationalize banks or restrict the market in secondary government securities, equities could be vulnerable to a setback towards their August lows. A more likely move towards re-establishing market confidence through convincing commitments by Italy to undertake structural reforms would likely result in a reasonable rally. A squeeze higher, however, would not be a reflection of the underlying macro fundamentals: we expect no growth in the Euro zone next year and forecast a fall in EPS of 10% across the SXXP (against a bottom-up consensus of +10%). Rather, it would be more a reflection of the possibility of some progress on Italy and a realisation that the European situation is more ‘containable’ than many have feared at each political twist and turn. This would allow the risk premium to moderate (we calculate the European ERP to be 7.8, and the level consistent with our macro forecasts’ 6.9%), pushing the SXXP towards 255 (our current 3-month target).

Given the prospects for more equity index volatility in the short term, we continue to have more conviction on relative trades within the market. Specifically, we continue to focus on relative growth prospects via a long position on European companies with high exposure to BRICS versus those with pure domestic exposure (GSSTBRIC v GSSTDOME) and, along a similar dimension, we focus on long core European exposure relative to periphery exposure (GSSTCORE v GSSTPEMU), as discussed in Strategy in Style, November 4, 2011. Both of these, however, reflect the desire to capture the prospects of undervalued stocks who’s end markets are less likely to be constrained by the ongoing deleveraging of European economies.