Sunday, July 24, 2011

LONDON SESSION: Debt concerns pan across the Atlantic

The EU Summit delivered more than the market was expecting. Firstly, it showed the EU, the ECB and the private sector working together. The markets had low expectations that a solution could be found, so the final programme has been warmly welcomed by the markets. Although we think there are still issues outstanding (such as enhancing the size of the EFSF fund and the potential for further haircuts on Greek debt) there is at least a structure in place to deal with the financial problems blighting the currency bloc.

This is more of a plaster cast than a Band-Aid, and while problems could still flare up later this year, for the next few months at least we think market fears of an imminent collapse of the Eurozone, or withdrawal from the currency bloc by Greece et al has been averted.

Now the hard work begins. The EU authorities need to see some progress from Athens on reducing its fiscal deficit and reforming public sector spending and tax collection in the coming months. Greece has not been able to do this up until now, so there is a weight of expectation for them to come up with the goods in the coming months.

Markets staged a stunning rally yesterday; however, it hasn’t extended into today, in fact, although stocks are slightly higher the euro has ground to a bit of a halt. This suggests a few things to us: 1, malaise as we reach the end of the week, 2, markets are starting to ponder the limitations of the EU summit deal and whether it will truly solve the problem of contagion (unlikely in our view) and 3, fears starting to gather pace about the potential slowdown in the currency bloc. Yesterday’s PMI data was extremely disappointing. The composite PMI fell to 50.8 from 53.3 in June, which is only just above contraction territory.

The markets have been very selective over what they concentrate on of late. Signs of economic weakness from China and Europe have been brushed off as markets have been cheered by some good corporate earnings and the EU debt deal. This is potent mix, but there are clouds on the horizon.

The US is running out of time to raise its debt ceiling, the deadline is August 2. Debt issues are panning across the Atlantic right now. The focus is shifting to the US; especially after credit rating agency S&P said there was a 50% chance of a US downgrade in the next three months. The impasse on a debt deal in Washington is weighing on business confidence and has already hurt consumer confidence. Markets have been fairly resilient; however they might not be if the US fails to come to an agreement in time sparking a US “default” in a matter of days.

If there is a resolution in the coming days then this would add to positive sentiment in the markets and signal risk-on for the next couple of weeks. It’s difficult to know exactly how the dollar would react. One could imagine it would get a boost after an announcement on a debt deal, however, typically during risk-on events the dollar weakens, so it might be better for the traditional risky assets like stocks, commodities, the euro, the pound, the Aussie, the Kiwi and the Cad, along with emerging market assets.

We are in a bit of a sweet spot for the markets, but how long will it last? There is still significant uncertainty about the outlook for global growth, also we haven’t heard from all of the credit rating agencies regarding Europe’s new deal for Greece. Since it is an essential default (Greek bond holders will have to take on average a 21% haircut on their debt holdings) credit rating agencies should react.

Although the EU leaders’ said in their statement last night that they would rely less on credit rating agencies in future, the markets’ may take a different tack. Although they have been prepped on a default for Greece, confirmation of it from any of the major rating agencies may cause a set-back in risk appetite. Fitch has already come out and said that Greece faces “restricted default” after the debt pact. The markets haven’t really digested what this means, and the euro remains fairly well supported. But it appears that for Fitch the debt deal is positive and will mean a rating upgrade for Greece from junk to low-grade speculative status.

Ironically, as the EU has finally agreed to allow a member state to default the costs to insure Greek debt have fallen. Greek CDS’s have fallen 500 basis points. As we have been saying, an “orderly” default would be welcomed by the markets since investors could then price in the risk of not getting their money back. For most of the past year, investors have panicked because they didn’t know the chance of default and what to price in, this certainty should help calm credit markets.

The debt deal has certainly placated credit markets, Italian 10-year bond yields have fallen nearly 80 basis points to 5.2 per cent, while Spanish debt has also retreated to 5.6 per cent. Both countries still face high yields compared to financing costs they paid in the past, but at least they are moving in the right direction and are crucially moving away from the key 7 per cent level that usually signals a bailout is imminent.

German IFO data for July moderated slightly to 112.9 from 114.5 in June. The expectations index also fell to 105.0 from 106.2 in June. This was to be expected since PMI data has suggested that manufacturing activity is coming off its peaks. We would expect further moderation in the IFO manufacturing sentiment indicator in the coming months. Ahead today, Canadian CPI data is the only release of note, and after a hectic week it could be a quiet afternoon leading to the weekend.

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