From Peter Tchir of TF Market Advisors
Harry Potter, Twilight, And The EU
Neither Harry Porter nor the Twilight series felt that one movie could bring proper closure, so both did the “final movie” in 2 parts. The EU has adopted that tradition and is already pushing the focus to the next Summit in March which really will be the grand finale. They also seem to have stolen from the Twilight series and only work in the middle of the night and have to hold press conferences before the sun comes up. They haven’t yet taken to calling us muggles, but they themselves certainly seem to believe in magic words like IMF while shorts live in fear of the “bazooka” with many names.
With the Summit having reached a conclusion, we now wait on a few final scenes to play out. The plot started falling apart on Thursday with Draghi’s testimony, but by forming a circle, holding hands, and chanting IMF and G-20 over and over, the market was placated, at least for a day.
Draghi and the ECB
On Thursday, Draghi disappointed the market by taking unlimited sovereign bond purchases off the table. Unlimited lending to banks, yes, but no unlimited bond purchases. The market is trying to digest what unlimited lending really means, and since the ECB has never seemed to refuse to lend to a bank, if it is anything that new.
Investors, and American ones in particular, retained the firm belief that Draghi was just saying that to placate the Germans, but would immediately reverse course once a new treaty (or compact) was reached. Well, on Friday, Draghi stated that the Summit results were as expected, and that those expectations had been included when they made their decision on Thursday morning. The market somehow continues to believe that he is going to change his mind. That somehow, he will relent and announce unlimited sovereign bond purchases. He won’t. Certainly not yet, and possibly never. It is not only the German’s who disagree with QE. There are other Europeans who do not see QE as a way to end this crisis. Not even every American is as willing to believe that QE has been a massive success. While Geithner and Bernanke remain wedded to the idea that QE has been great, more and more people question whether the perversions of QE aren’t responsible for a sluggish economy. QE has done more for the stock market than the real economy and has probably allowed the government to act irresponsibly for longer. The ECB is a long way from deciding to pursue US style QE and may never get there.
In the meantime, the market is thin enough that €10 to €20 billion of allegedly mostly sterilized bond purchases could support the market. I believe that as the realization that full scale printing is a long way off in Europe, the market will once again put pressure on the Spanish and Italian yields. The ECB will care about that, but at this point they are more concerned with seeing real, sustainable change, in Italy and Spain than about helping them trick the market every single day.
Treaty Change and Austerity
We should expect to hear more countries discuss the treaty changes. Some countries really need to implement these changes. Germany and France need to be first to show leadership. Italy and Spain need to implement the rules to show that they deserve more bailouts. I don’t think even these 4 countries will have such an easy time. There will be opposition in each country – potentially for different reasons. Italy has a technocrat who was imposed on the country, who couldn’t get his countryman to ease up on printing. That could impact his credibility. Spain at least has an elected government, but will everyone be so willing to cede so much sovereignty, especially when the rewards are so vague?
Even more importantly, when will they target meeting the budget constraints? I expect that “balanced budget” amendments will not be slated to occur prior to 2015, or maybe longer. They cannot get to a balanced budget anytime sooner (and maybe not even then) for many of the EU countries. Maybe they will start carving things like “interest expense” out of the “balanced budget” language. So yes, we will have a “balanced budget” if you don’t include interest expense. I highly doubt that any “balanced budget” act will resemble what a normal human would think of as being a “balanced budget”.
What about the punishments for breaking the budgets? Will they be a slap on the wrist, in which case no one will care, or will they be more onerous? How onerous can they be? A country that is running a 4% deficit because it is facing economic hardship may just take the fines or costs and add them to the budget deficit. Debtor’s prison didn’t work and I suspect these fines or punishments won’t work either. Countries that feel the need to run a deficit are unlikely to be deterred by having to run a bigger deficit to cover the punishment costs. Maybe the punishments will be to stop receiving ECB support or to be kicked out of the EU? I’m laughing as I type that. We have seen time and again the EU cave at the thought of real defaults or real change. Does anyone seriously believe that this group would follow through on those threats? Especially when more space was devoted to how punishments could be waived rather than to the punishments themselves. The EU could threaten countries that break the rule, that they won’t get any more summit invites. Since that would hit the leader and finance minister directly, that could have the most impact (I think I’m joking).
What about the smaller countries. I have this feeling that by 4 in the morning some were just told to sign up and not make an issue of it. Did they want to be the ones to cause global panic? No, so they signed up, but now have to go home and think about it, and try and get it passed. I believe some smaller countries will seriously consider leaving the Euro. They are losing more control, and it is not clear, at least to me, what some of these small countries gain. Finland might be in the best shape. Most of its Nordic neighbors don’t use the Euro. It has a very high credit rating. It has some natural resources and some production. Slovenia is AA- on the credit side. Maybe it benefits a lot from using the Euro, but maybe they would like to take a step back and remain in the Eurozone, but not use the Euro? Tiny Estonia has worked very hard to be debt free, and it is on watch because of what is going on with the bigger countries. Do they need that hassle? This group of countries that is being pushed off to the kiddies table may not follow through with the treaty agreements which would make investors question the overall deal.
ESM, EFSF, IMF
How much money will these entities get and where will it come from. The ESM is not all “paid-in capital” in spite of the headlines. Though, even if it was all “paid-in capital” where would the money come from? It is the same problem as so many of the other programs that have been announced. The money has to come from somewhere, and it is unclear who can support it. The IMF is likely getting some money from individual central banks. Okay, that is good, but wasn’t someone relying on that money? Wasn’t some investor saying, I will lend to XYZ, because their central bank has all these reserves? When those reserves flow out of good countries, that has to impact them. In some ways it will “average out” the cost of funds for the countries, but that average will not be Germany’s or even France’s current average cost. There will be pressure on yields of those countries as their wealth gets transferred.
The IMF needs to come up with some new donations. The US is reluctant. The changes in Russia don’t bode well for that. Brazil is experiencing some problems and their neighbor (Argentina) has a stock market that is down 30% YTD and is experiencing 25% inflation. That may put a dent on their ability to increase IMF support. China is weakening, and depending on who you listen to, may need a lot more of their reserves for China sooner than people expect.
I am not expecting new money for the IMF. They will make these loans and will use up their existing unallocated commitments, but will not be able to go much beyond that. They may even experience some difficulty getting the funds as many countries that have pledged money, will be happy to come up with the cash at this time.
So the IMF is likely to say a few things, that although priced in, may still provide a small spark, but nothing radical, and with no new G-20 support and some perceived problems of getting the already committed money, we will see disappointment.
Unlimited cheap loans. ECB support. Awesome! But at what cost? I find it hard to believe that the EU politicians will allow the banks to receive all of this without some form of payback. Whether it is forced capital raising, transaction taxes, or something, the banks will have to pay for all this free money. It is just too politically unacceptable for the politicians not to be seen to be doing something. They are too scared to do much now, but there is likely more in the background. The frustration some politicians have over the PSI will come back to haunt the banks. The banks continue to think short term and seem to extract as much value in the short term. That may not be the right decision. Anyways, we will see, but I remain cautious on European banks, because it feels like there is too much ill will against them and all these benefits they are currently getting will come at a cost.
S&P and the Downgrades
I expect we will see news out of S&P early this week. I am assuming they will be somewhat disappointed by the compact as there is so little detail. They won’t be as pessimistic as I am (they have more to lose politically by saying what they think), so will want to give some benefit of the doubt. The central bank/IMF scheme will offer some support to the weakest countries, which they will take into account, but they will also take into account the cost to the higher quality countries of doing this. The ESM will be treated similarly by them. They will also compare their ratings to those of Moody’s and use this as a chance to get them in line (it’s how they work). They will take the ECB comments at face value and assume no wholesale QE.
So here is what I think happens:
Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg were all highlighted as only being at risk of a 1 notch downgrade. I believe that they will all be left on negative watch as the rating agencies wait to see if each government in the treaty can agree to the plan. I suspect that Belgium, if anyone, may actually get downgraded 1 notch, but that may be based on my personal aversion to the Dexia bailout. If anyone was taken off watch at this stage, I expect it would be Finland as they continue to seem to fight to do what they view as prudent. Germany will contribute the most to the bailouts, but they are so strong, and relatively little has been implemented, so I doubt they get downgraded.
The UK wasn’t on S&P’s original list, but I suspect that they will get put on watch as their will now be “heightened uncertainty” about their role in Europe or some other noise.
I think the small countries will be left alone. I think it is too early to take them off watch, but since they had just been generically added in, they might be released and put back to stable, or moved from watch to outlook.
I think Spain gets hit with 1 notch and left on outlook or watch pending implementation. Moody’s has them A1 already versus AA- at S&P, so taking them down 1 notch gets them to A+ and in line. The positive comments would be additional IMF support but that would be against less than hoped for ECB support and uncertainty over their ability to implement treaty decisions.
I think Italy may get left alone for now, though it may get one notch like Spain. The reasons to treat Italy a bit better would be based on Monti’s commitment, a new budget passed last week, and that Moody’s has them at A2 already which is the equivalent of A, so they are already ahead of the curve (of course that latter reason wouldn’t be published). Also, Spain at A+ and Italy at A seems as good as any other relation between these two countries. They will be left on watch until the support materializes and the treaty concerns and existing budget are implemented and demonstrated to be working.
So that leaves France. I think they downgrade France 1 notch, to AA+ (same as the US) and shift them from watch to outlook. That France was in the potential 2 notch group is an important distinction from Germany. They are cleared viewed as a weaker credit. More than Germany, France has to put in its own budget plans. It has more risk of failing in that respect than Germany. At the same time, the contributions it is making to the cause are similar to Germany’s. They are putting money and guarantees up everywhere, and even got dragged into Dexia which Germany was able to avoid. I think the costs of the bailout will be the primary reason for a 1 notch downgrade. It would also be consistent with saying that it was all the additional support from other EU countries is the reason to be optimistic for Spain and Italy.
Downgrading France 1 notch would be a huge step for S&P. It could have severe repercussions for their business model, yet it would be consistent with their methodology and rationale. It would de-rail the EFSF and ESM or at least force ESM to move to a fully capitalized model. The fear of the problems it would cause may hold back the rating agency, but logically they have to do it. They already highlighted their view that France is weaker than Germany with the 2 notch threat. France is at risk from being able to implement its own balanced budget deal. France doesn’t benefit from the new IMF facility or ESM, it is actually a cost to France. Their willingness to leverage and guarantee money at every point is worrisome as a creditor (France is involved in Dexia and pushed hardest for all forms of leveraged EFSF and ESM). Not downgrading France would be solely out of the fear of the damage that downgrading them would cause. That and the fact that the new head of S&P only became the head of S&P when his predecessor was fired for doing what he thought was right.
It is hard, as I believe that with close to 100% agreement, S&P will view France as deserving a downgrade, but the political pressure and fear may force them to keep it unchanged for now.