Waddell & Reed Advisors Market Perspectives – December 2011
In some of his first remarks as Spain’s incoming Prime Minister, Mariano Rajoy sounded not like a man swept into office in a landslide, but someone preparing to face the daunting challenges facing his country.
“Hard times lie ahead,” Rajoy told supporters gathered outside his party’s headquarters on Nov. 20. “We are going to govern in the most delicate situation Spain has faced in 30 years.”
The pressure was immediately evident. Although Rajoy won by the biggest majority in a Spanish election in nearly three decades, there was no honeymoon period. Calls for him to unveil both his cabinet and a plan to reduce his country’s deficit — among the eurozone’s largest — began immediately.
Recognizing the likely pressure, Rajoy asked the markets to give him “more than half an hour” to address the crisis. He didn’t get it.
Traders instead turned up the pressure on Spain with Spanish borrowing costs increasing as 10-year bonds rose 20 basis points to above 6.5 percent in the aftermath of the election. The risk premium, which measures the spread between the Spanish 10-year and the benchmark German bund, rose 28 basis points to 466. The market action may be a reflection of a top criticism of Rajoy and his Popular Party — their apparent unwillingness to share details of their plans with the public.
Still, the victory by Rajoy is seen by many as good news for both his country and the evolving European crisis.
“This is a long-term positive,” Jeff Surles, fixed income analyst for Waddell & Reed, says. “The conservative party in Spain has a pretty good grasp of what’s going on and they are likely to implement needed austerity measures within Spain.”
The changing of the guard
Rajoy’s victory, and his party’s capture of 186 of the Spanish Parliament’s 360 seats, marks the third European government to change in as many weeks as the crisis has continued to escalate. Only days earlier, Mario Monti assumed office as Prime Minister of Italy and Lucas Papademos took over as Prime Minister of Greece on Nov. 11. Similar events unfolded in Portugal in June and in Ireland in February.
While Rajoy is not expected to take office until Dec. 21, both Monti and Papademos are leading what are known as technocratic governments. Instead of career politicians, Monti, who was Italy’s representative to the European Commission, has built a cabinet of people from banking, finance and academics. Papademos, meanwhile, is a former vice chairman of the European Central Bank.
“These governments are going to have broad mandates to implement additional austerity packages through their Parliaments,” Surles says. “And once they’ve passed through their Parliaments, they will also have to implement them into their fiscal plans and make sure that the adjustments happen throughout their economy.”
That will likely take time. Surles says it looks like Greece, where the crisis formed two years ago, has a three- or four-month mandate. That might feel like a lot of time for some other European leaders.
In Italy, Monti said in mid-November that the future of the euro depends partly “on what Italy does in the next few weeks” as that country battles to address a $2.6 trillion debt that is believed too large for other Euopean countries to rescue. Meanwhile, the Italian 10-year-bond dances around 7 percent — a level that Surles says “will bury them” if Italy tries to fund itself. And in Spain, Rajoy has said he hopes Spain won’t need a bailout before he takes office next month. To accomplish that, Spain, which also has the highest jobless rate in the eurozone at more than 20 percent, will need to get the yield on its 10-year bond to move lower.
Beat the clock
Time is of the essence throughout the entire region. A rise in French bond yields led Moody’s Investor Services to warn that rising borrowing costs and an uncertain economic outlook could result in a loss of the coveted AAA rating.
“Elevated borrowing costs persisting for an extended period would amplify the fiscal challenge the French government faces amid a deteriorating growth outlook, with negative credit implications,” Moody’s said in a Nov. 21 note. Investors saw the report as a sign of contagion into countries previously viewed as safe. In the days prior to the Moody’s report, yield spreads between 10-year French bonds and comparable German bunds rose to more than 200 basis points. Although the spreads tightened about 50 points after the Moody’s report, they are still well above their historical average of 40 to 60 basis points. The spread is being influenced on both sides as an investor flight to quality means money is moving away from the perceived higher-risk bonds of some nations, thereby pushing yields on those bonds higher, and into the relative safety of Germany, where the increased demand drives yields lower.
France, as the second-largest eurozone economy, is critical to the entire continent. Surles says if France loses the AAA rating, the European Financial Stability Facility’s (EFSF) euro zone bailout mechanism may not function. However, there is technically some question about what a cut by Moody’s would mean if the other rating agencies don’t follow suit with a downgrade.
“In many cases they require two of the three rating agencies to downgrade the country before they’ll actually recognize that it’s not AAA anymore,” says Mark Beischel, co-portfolio manager of the Waddell & Reed Advisors Global Bond Fund and global director of fixed income. “So, if S&P downgrades them and Moody’s and Fitch still have them AAA, they might still be considered AAA. But, at that point, the writing will probably be on the wall.”
A week after its warnings to France, Moody’s issued an even stronger warning for the region, publishing a report that said the crisis could lead multiple countries to default on their debts or exit the euro — a threat to the credit standing of all 17 countries that use the currency. Moody’s also said that because politicians have been slow to act — taking steps only “after a series of shocks” — some countries may be shut out of credit markets “for a sustained period.”
“The probability of multiple defaults by euro-area countries is no longer negligible” Moody’s said in its Nov. 28 report.
Meanwhile, on the same day the Organization for Economic Cooperation and Development (OECD) issued its own report on the crisis, saying the events in Europe are a key risk to the global economy. The OECD, which also slashed its 2012 growth outlook for the region by nearly one-third, said it fears that some European leaders do not grasp the urgency of the situation.
The interconnectedness of the region was illustrated yet again on Nov. 25 when Standard & Poor’s lowered its long-term rating for Belgian debt from AA+ to AA . The country, which has its own internal political turmoil, has one of the EU’s highest debt levels compared with the size of its economy, reaching nearly 100 percent of gross domestic product, and is heavily reliant on its trade partners.
“With exports of over 80 percent of GDP, Belgium is one of the most open economies in the eurozone and is therefore … highly susceptible to any weakening of external demand,” S&P said.
There were signs, however, that some progress had been made. On Nov. 27, France, Germany and Italy indicated that they were willing to agree on new rules that would encourage increased policy coordination and spending discipline on all 17 nations. German officials have said they hope to see the necessary treaty changes by the end of 2012. However, France and Germany are reportedly also engaged in preparing contingency plans if the treaty negotiations fail that could tighten spending oversight in the region. French officials say that a commitment to reduce fiscal debt could allow the European Central Bank (ECB) to take on a greater role in stabilizing markets.
Meanwhile, calls for additional support for the EFSF have continued to mount. Finland, Germany and the Netherlands have all called on the International Monetary Fund to play a bigger role in the EFSF to act as a firewall against market panic.
European union?
When European leaders created the European Central Bank a decade ago it was thought that different interest rates could not emerge within the zone of a united currency. That viewpoint, however, did not recognize what now appears to be a potentially critical weakness of a monetary pact without a related fiscal union. While there is one central bank, there is no centralized budget control. The disconnect can create profound problems when individual countries take on too much debt against too little growth and not enough capital.
After a failed attempt at an early-November G-20 meeting to find outside help, pressure has continue to mount on the ECB to take action. So far, the central bank has resisted the type of intervention that the Federal Reserve has done in the U.S.
Mario Draghi, who took over as the president of the European Central Bank on Nov. 1, has instead pushed back on the governments to implement reforms to rescue their economies.
In his first public speech Draghi said the ECB would not start printing money and that the bank would stick to its core mission of controlling inflation. Moving away from that goal, he said, would risk the ECB’s credibility.
“Gaining credibility is a long and laborious process,” Draghi said. “But losing credibility can happen quickly — and history shows that regaining it has huge economic and social costs.”
The ECB did cut its key interest rate by 25 basis points on Nov. 3 and Surles says it is highly likely that the ECB will cut another 25 basis points when it meets again on Dec. 8.
These cuts, however, simply reverse what Surles says were previous policy mistakes by the ECB: 25 basis-point rate hikes in the spring and summer that “really hurt and stalled out European economies.” Both of the previous cuts were made under the leadership of Draghi’s predecessor at the ECB, Jean-Claude Trichet.
Amid the current calls for ECB action are those who want the ECB to reconsider its mission. Unlike the Federal Reserve, which is charged with price stability and maximum employment, the ECB is responsible solely for maintaining price stability.
Some ECB officials, especially the Germans who dominate the central bank, have been particularly vocal about any changes to the mandate. However, Ewalt Nowotny, a member of the ECB’s governing council and the head of the Austrian National Bank has said that officials need to discuss the role of the ECB “in these difficult times.”
Surles says that at some point, the crisis becomes one of price stability.
“If they continue to let yields do this in Italy, they are not going to have price stability in the eurozone,” he says. “And at the end of the day that is the sole mandate that they need to adhere to.”
The European Union has already lowered its growth forecast for next year. In a Nov. 10 report the European Commission said that the European economy is struggling with weak confidence, financial turmoil, government austerity and a slowdown by European trading partners. As a result, the Commission now projects that EU gross domestic product will grow a mere 0.6 percent adjusted for inflation — one third of the 1.8 percent growth it previously projected.
Some analysts have suggested that comments from German Chancellor Angela Merkel, who has opposed the idea of euro bonds out of a belief they discourage fiscal responsibility by individual countries, signal that the breakup of the eurozone may be the eventual outcome.
“It’s entirely possible that you might see one or more countries leave,” says Dan Vrabac, co-portfolio manager of the Waddell and Reed Advisors Global Bond Fund. “They key is whether it is in a structured fashion or a panic mode and nobody knows which it is going to be. This type of uncertainty has a real negative psychological impact on the markets.”
At the end of November, however, EU officials and the world’s key central bankers were working together in a bid to prevent that from happening, although critics said the steps were not substantial enough. On Nov. 30 eurozone ministers agreed to provide Greece with an 8 billion euro ($10.7 billion U.S.) rescue loan to help that nation address its immediate cash crisis.
While EU officials said the move showed “important progress” the markets sent a clear signal that it was not nearly enough to quell fears with the cost for European banks to fund in dollars immediately rising to their highest levels in three years.
In response, the Federal Reserve, in an effort coordinated with the EU and other key world central banks, cut the cost of emergency dollar funding for European banks. The swap arrangements were initially launched during the 2007 crisis and closed in early 2010. They were revived three months later as conditions worsened in Europe.
“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and … help foster economic activity,” the central banks said in the Nov. 30 joint statement.
Looking ahead
In the coming weeks there are several scheduled key events in Europe. The Waddell & Reed investment team continues monitoring the course of events and meets daily to discuss the issues.
- Dec. 08 ECB interest rate decision and press conference
- Dec. 09 EU leaders summit
- Dec. 13 First meeting of new Spanish Parliament
- Dec. 21 Date by wish new Spanish Prime Minister expected to take office
- Dec. 31 Date by which Greek Parliament votes on 2012 budget
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