If the skies looked dreadfully dark throughout August and September then the investment weather has turned decidedly brighter this month. As Friday’s stronger-than-expected US retail sales figures showed, the US economy is not heading into recession any time soon. Major central banks are bending over themselves to create the right financial conditions through either conventional or unconventional means. European policy-makers (and the IMF for that matter) understand the urgency of recapitalising Europe’s major banks; for now at least the exact details on how this is going to be achieved can be left for another day.
Plus it now appears that Europe will probably allow Greece to default on most of its debt (see below), which is sensible because Greece has no realistic prospect of paying the money back anyway. Finally, risk managers are shutting down their books as calendar year-end approaches. In response, risk appetite strengthened further on the final day of the week, with European equities up 1%, the Aussie up above 1.03, oil up two dollars and the euro near 1.39.
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Bond yields soared – the French 10yr yield jumped 17bp at one stage to 3.11% – while the US 10yr yield is now 2.25%, up 50bp in just five trading sessions. Evident on Friday were some further asset allocation switches, out of bonds and fixed income into equities. This is not surprising given that the equity risk premium on offer recently has been at historically high levels, making equities exceedingly attractive in relative terms.
Commentary
A substantial Greek debt restructuring now looks inevitable. Finally, European leaders appear to have accepted the futility of defending the indefensible, namely allowing Greece to default on a sizeable portion of its government debt. With the economy in freefall and debt-to-GDP set to reach 190% very soon, plus interest rates at astronomical levels, Greece’s ability to service such a debt mountain was destroyed long ago. Now under serious discussion is a much more substantive haircut for Greek bondholders, possibly as high as 60% (July’s agreement only required bondholders to accept a derisory 21%). After incredible resistance to significant private sector involvement over a sustained period – especially from the ECB – it now appears that nearly all parties view a significant default by Greece as both inevitable and desirable. What is making the scenario much more palatable now is that policy-makers in Europe understand that large debt haircuts can only be implemented once there is a simultaneous commitment to meaningful bank recapitalisation. Before endorsing the need for a 60% haircut, policy-makers need to resolve numerous issues, such as what to do with those Greek banks that would see their capital essentially wiped out by a large default, and whether contagion to other fiscal miscreants such as Portugal, Ireland, Spain and Italy would be triggered. The latter issue is an especially tricky one; Ireland, for instance, has made incredible strides to improve its competitiveness and meet its debt obligations and so may be justifiably outraged should Greece be allowed to default. Spain is back in the crosshairs again after Friday’s S&P downgrade and the raising of fresh doubts over the effectiveness of its fiscal deficit reduction plan. So, while allowing Greece to default on a significant part of its debt is sensible, and with significant banking recapitalisation now appearing inevitable, there are still many unresolved challenges for European leaders.
The pain of Spain. The market appears to be increasingly immune to the downgrades of sovereign nations, the latest being Spain’s downgrade by S&P to AA-. Still, the last downgrade was some 18 months ago and a lot of water has flowed under the bridge since that time. Back then, Spanish bonds were trading only 80bp over Germany, whereas now they are just over 300bp above Bund yields. But what appears to be of more concern to S&P is the growth outlook combined with the potential hit from the banking sector and further asset write-downs. On paper, Spain’s position looks far more comfortable than that of Italy, with the debt/GDP ratio at 60% last year – half the level of Italy at that time. But it’s the balance sheet of the banks and private sector that are of more concern in terms of the credit outlook. Spain is still running a current account deficit, one which has narrowed substantially from the 10% of GDP seen in 2007, but nevertheless still requires it to seek capital from abroad to cover it. The one piece of good news is that Spanish banks’ borrowing from the ECB did ease slightly in September, down to EUR 79.1bln from EUR 81.2bln. But Spain remains on life-support and this is why the course of the bank recapitalisation plan currently being discussed remains so critical for its ability to escape the eye of the current sovereign storm gripping Europe.
Lower Chinese inflation on the way. Although headline inflation in China last month was little changed from August, nevertheless there are enough signs that some moderation in price pressures can be expected over coming months. For the year to September, growth in consumer prices was 6.1%, down only slightly on the 6.2% recorded previously. Food prices are proving to be rather sticky, up 13.4% YoY last month. However, the sharp decline in the prices of various major agricultural goods over the past couple of months augurs well for some relief from high food prices in the near term. Also, producer prices are coming down – the 6.5% YoY increase last month was down markedly from the 7.3% rise recorded in August. Separately, there are signs that the economy is moderating. Export growth dipped last month, hardly a surprise for an economy which is so geared to global growth. House prices also fell in September, for the first time in quite a while, as the policy of raising rates and increasing reserve requirements starts to impact. On Thursday the IMF warned that Asia was at serious risk of being dragged down by Europe’s sovereign debt and banking crisis, although it also stated that “overheating pressures remain high” in China. It is too early to start speculating about an interest rate cut in China as policy-makers remain justifiably concerned about the potential for inflation to remain elevated. Also, should inflation start to head come down in coming months, the first move in terms of easing financial conditions may be to reduce bank reserve requirements which have been raised substantially over the past year.
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