European debt: Downgrades point toward persistent risk

On Jan. 13, 2012, the ratings agency Standard & Poor's issued a one-notch downgrade to France's credit rating, kicking off a series of sovereign debt downgrades that would eventually implicate all members of the euro zone (and — perhaps more ominously — the European bailout fund itself).

Generally speaking, the downgrades did not come as a big surprise; sovereign debt was already trading at yields that factored in the likelihood of a downgrade, particularly after the warnings issued by Standard & Poor's in early December. But the reality of the downgrade puts a cold light on the fact that sovereign debt issued by much of developed Europe — not just “peripheral” Europe — will likely be on shaky footing for some time.

We believe that, on balance, European markets will entail downside risks for much of 2012, with pressure coming in several forms. Keep in mind, for instance, that the euro zone economy seems very likely to contract in the first half of 2012, with peripheral countries contracting more deeply than the German and French economies. However, if there is a disorderly recession (involving a sovereign debt default or the eventual break-up of Europe's monetary union), the economic contraction could be much worse. In our view, it is also unlikely that European governments (nor those of other developed economies or the foreign-reserve-rich countries in the emerging markets) will introduce new rounds of stimulus. We believe that economic contraction in Europe could therefore be prolonged.

What's more, banks within the euro area will need to recapitalize more than 100 billion euros in debt by the middle of 2012 (this is according to estimates published by the Euro Banking Association, though many analysts believe the amount could realistically be as high as 300 billion euros). If banks choose to deleverage rather than recapitalize, the amount could likely climb further, reaching somewhere between 0.5 and 3.0 trillion euros. At the same time, the funding needs of euro-area governments could possibly climb north of 1 trillion euros for the year, while banks may see their funding needs climb to somewhere between 600 and 700 billion euros. (Funding estimates are based on sources that include the Euro Banking Association, Bloomberg, and Thomson Reuters). We believe these funding needs, together with challenging economic conditions, put the balance of risks in Europe to the downside.

By Ned Gray

January 2012

On Friday, Jan. 13, 2012, the ratings agency Standard & Poor's (S&P) downgraded nine euro zone countries. The agency stated that "the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone."

The full impact of the recent credit-rating downgrades is still unfolding and may create an additional level of uncertainty and volatility in the markets. When a country's credit rating is downgraded, the effect can be higher lending rates, stricter lending standards, and reduced access to capital.

S&P cut France's and Austria's top ratings of AAA by one level, to AA+. S&P also downgraded Spain's high grade (AA-) credit rating two levels, to an A rating (medium grade), and Italy's upper-medium A rating to a lower-medium BBB+. Other downgrades were made to Portugal, Cyprus, Malta, Slovenia, and Slovakia. Germany, the Netherlands, Finland, Ireland, Belgium, and Estonia were not downgraded. Germany is now the only top-rated (AAA) backer of Europe's bailout fund (the European Financial Stability Facility, or EFSF1) for troubled economies.

We believe investors have been expecting the French downgrade since S&P announced in December 2011 that a cut could occur. On Monday, Jan. 16, France sold 8.6 billion euros of short-term debt securities at yields that were only slightly lower than in the previous auction. Market reaction thus far seems subdued. The euro zone rescue fund (EFSF) was also just downgraded from its prime AAA rating to AA+ on Monday, yet it easily sold 1.5 billion euros of debt on Tuesday. Spain also had a successful debt auction on Monday and sold 4.88 billion euros' worth of bills.

The ratings agency Moody's Investors Service said Monday that "the stable outlook on France's AAA credit rating remains under pressure, with risks arising from the growing level of government debt and adverse developments in the euro zone." There are also concerns that France may have to provide support to its banks or to other euro-zone countries. Moody's is expected to announce its ratings during the first quarter of 2012. If a second ratings agency, such as Moody's Investors Service or Fitch Ratings, initiates a downgrade, it could possibly have a more negative effect.

Our international and global portfolios are underweight financials, with exposure that is much less pronounced versus peers.

The views expressed in each outlook represent the Manager's assessment of the market environment as of January 2012, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the manager's current views.


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