Summary
- S&P asserts downgrades were the result of inadequate steps taken by euro-zone leaders to manage Europe’s debt crisis.
- The market impact should be limited because the downgrades were widely expected, and largely reflected in market valuations. Also, most sovereign bonds remain investment grade, and sovereign bonds remain eligible sources of collateral for the European Central Bank (ECB).
- We view the downgrades as lagging indicators, so we are more concerned about the “watering down” of the planned European Union (EU) fiscal compact and a potential failure to reach an agreement on Greece’s sovereign debt restructuring.
- We remain moderately constructive on the development of European Monetary Union (EMU) periphery bonds. However, the risk of unforeseen and unpredictable events remains significant.
What happened?
On Jan. 13, 2012, S&P downgraded the ratings of nine EMU sovereigns by one notch or more, leading to the following changes:
- France and Austria lost their AAA ratings, which were reduced to AA+.
- Slovenia, Slovakia and Malta saw their ratings lowered by one notch; Malta was reduced to A- from A; Slovenia and Slovakia were downgraded to A from A+
- The ratings of Italy, Spain, Portugal and Cyprus were reduced by two notches, with Portugal and Cyprus no longer investment grade.
- Germany is the only euro-zone country with a fully-intact AAA rating and a stable outlook; indeed, the long-term rating outlook for all but two sovereigns, Germany and Slovakia, is now negative.
S&P said that its downgrades were the result of what it believes to be inadequate steps taken by euro-zone leaders to solve the region’s debt crisis following the last EU summit at the end of 2011. Developments since the December summit have not, in the ratings agency’s opinion, been sufficient to solve the ongoing crisis, with significant stresses and substantial downside risks remaining in place.
What was the impetus behind the S&P downgrades?
The downgrades were a response to a confluence of factors: tight credit conditions, widening spreads and a simultaneous increase in efforts to save money and reduce debt in both private and public sectors. This led to a lower growth outlook for the EMU and ongoing policy disputes on how to solve the debt crisis.
S&P emphasized, in particular, the fact that conclusions and policies drawn up at the final European Union Summit of 2011 were, in its view, insufficient to solve the euro-zone debt crisis, with too much focus put on fiscal austerity and too little on improving conditions to boost competitiveness and drive fresh economic growth. The risk that the decisions taken in December may not be implemented also remains in place in the view of S&P.
What is your view on S&P’s rationale for the downgrades?
At Allianz Global Investors, we agree that fiscal austerity alone is insufficient to solve the crisis. It is equally important that weaker euro-zone countries undertake fundamental economic reform and develop a long-term strategy to boost structural growth. However, in that respect, and in contrast to S&P, we believe that some initial progress has already been made. Several countries, notably Ireland and Spain, have managed to bring down unit labor costs during the past two years. In Italy, structural reforms have become a priority for the technical government under Mario Monti, with initial reforms already in place. In addition, several steps have been taken to reduce future economic imbalances within the region. There is also growing awareness among EMU politicians that they need to develop long-term growth strategies. The next EU summit at the end of January will therefore focus on economic growth and labor markets.
On balance, our interpretation of the Dec. 9, 2011 results is more constructive than the one assumed by S&P though, admittedly, more has to be done with respect to structural reforms in the EMU periphery. In addition, there remains a risk that the decisions made in December will either not be sufficiently applied or will not be implemented at all.
How will the downgrades impact capital markets?
Markets had already weakened based on the rumors circulating before the announcement of the downgrades. In particular, the euro weakened versus the U.S. dollar, with EMU sovereign bond spreads widening and equity markets falling. Since then, however, markets have rebounded and going forward we believe that the market impact should be limited for the following reasons:
- The downgrades, particularly France, were widely expected and have not come as a surprise to investors.
- Consequently, market prices were already reflecting the downgrades; indeed, according to our numbers, sovereign bonds are already pricing in unrealistically high default rates and yields of European Financial Stability Facility (EFSF) bonds have also been rising accordingly; in the EUR/USD market, we are seeing extreme levels of short-term positioning by investors.
- The downgrades do not affect the status of sovereign bonds as eligible collateral for the ECB.
- With the exception of Portugal and Cyprus, all sovereign bonds remain investment grade.
- In the past, rating downgrades have not had a major impact on actual bond yields, exceptfor in the very short term; this has been true for Japan and the U.S. since the summer of 2011. Nevertheless, there are two aspects that are different compared to recent U.S. and Japan history. No EMU member country can rely on its own central bank to finance its debt; hence the default risk of any EMU member country is higher than that of the U.S. and Japan. One could argue, though, that the U.S. and Japan are more likely to devalue their debts through inflation.
- The downgrade of France and Austria has already triggered a subsequent downgrade of EFSF bonds by one notch from AAA to AA+, making it more difficult for other EMU member states to bridge-finance EMU sovereigns via the EFSF. So far, markets have disregarded this downgrade but it could, nevertheless, mean that a greater burden to finance the EFSF in the future could be placed upon Germany and the other remaining AAA rated euro-zone countries. Overall, however, we think that the impact on EMU sovereign financing costs is likely to remain moderate.
Are recent downgrades the most important issue for EMU sovereign bonds at this juncture?
As we regard the recent downgrades as lagging indicators, we are currently more concerned by two other developments that unfolded last week.
Weakening of Fiscal Discipline
The first concern is the ECB’s Joerg Asmussen’s criticism of the potential “watering down” of the planned EU-26—all EU countries except Britain—fiscal compact by euro-zone members as they finalize the current draft. According to the current draft, the structural deficit limit of 0.5% of gross domestic product may be permitted to be higher under certain circumstances. The introduction of debt brakes in national constitutions—as well as semi-automatic sanctions of countries—are crucial to win back investors’ confidence. Any watering down of the initial proposals will most likely be interpreted negatively by the capital markets meaning that the outperformance of EMU periphery bonds, seen since Dec. 9, could quickly come to an end.
We would expect this topic to be high on the “Market Insights: S&P Credit Ratings Downgrade in Europe 2” agenda at any current and future meetings taking place between Angela Merkel, Nicholas Sarkozy and Mario Monti. We still believe that a weakening of fiscal policies is unlikely, as Germany continues to strongly back strict fiscal discipline among euro-zone members.
Potential Failure To Reach Agreement on Greece’s Sovereign Debt
We continue to hope and expect that a voluntary agreement on restructuring Greece’s sovereign debt will be reached between Greece and its creditors, as the consequences of a disorderly default are likely to be both expensive and unpredictable.
In conclusion, we remain—for the time being—moderately constructive on the development of EMU periphery bonds. However, the risk of unforeseen and unpredictable events remains significant.
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