France next in the firing line; stocks, EUR should also feel the pain.
Berlusconi or not, Italy looks in dire straits. The immediate focus is on blowing out bond spreads as the remaining liquidity in BTP’s evaporates, sending 10-year yields jumping through the 7.0% level (the 4.75% Sep 2021 bond trading 7.23% as we type). Recent buying from the ECB has just provided investors with liquidity to exit rather than helping shore up confidence in the market.
But even before these death throes, the picture for Italy was bleak; confidence measures have been in freefall for months, and the decline in the purchasing managers’ indices has signaled recession since the summer. Average growth of barely 0.6% since 2000 highlights the fragility of the situation: recessions having the potential to wreck havoc on finely balanced debt dynamics.
Whether the immediate crisis is one of solvency or confidence is academic now (although those in Berlin, Paris and Brussels still probably don’t see it that way). It looks increasingly probable that Italy will be frozen out of debt markets, certainly at levels that are needed to fulfill its financing needs without blowing a huge hole in the budget, and in turn triggering greater pressure from core governments and markets to enact aggressive austerity.
Such steps would exacerbate growth pressures, of course, and one only has to glance towards Greece and Portugal to see how this would eventually play out. The Treasury needs to roll over a further EUR 37 billion debt by year-end, which by the looks of it the ECB will find itself reluctantly on the hook for, and for 2012 rollovers alone are just shy of EUR 307 billion. It’s no wonder that the EFSF (ratified at EUR 440 billion, plans to leverage it to EUR 1 trillion are not really workable without pledges of more capital from the core) already looks like a relic.
There had been hope that the removal of Berlusconi would provide some breathing room, but politics is fractured in Italy, meaning the prospect of a strong government emerging out of the turmoil is slim, especially given the usual core/ECB prescription of ever more demanding austerity measures in return for aid/support. The IMF – whose arrival looks imminent - would have similar demands.
We struggle to see what could really stabilize the situation now; to us it looks as if eurozone politicians have past the point of no return, Italy (and the world’s third largest bond market) was too big to fail, and the consequences will be pronounced and lasting.
BTPs are likely to remain untradable as this all plays out, but there still looks to be good opportunities elsewhere, in particular in French sovereign paper, contagion leaving its treasured AAA rating ever more exposed and with it the creditworthiness of the whole bailout mechanism. While Sarkozy announced a raft of new budget measures totaling EUR 65 billion over five years on Monday to shore up confidence, which should pull the deficit back to the 3% of GDP Maastricht threshold by 2013.
Given the perilous state of the French banking sector (which has nearly EUR 500 billion exposure to Italy, BIS Q2 stats) pressures won’t abate. We still like spread wideners vs. bunds to capitalize on this noting that 12-months ago Italian spreads were not too dissimilar to where French spreads vs. Germany lie today. From current levels of 146bps, a push towards 200bps (bunds steady and OATs continuing to retrace back to the March/April yield highs) is a reasonable first objective. There is clearly more room for a significant spike higher if the crisis continues to snowball than for conditions to normalize.
Outside of bonds, European markets have sold off for the past two sessions but overall have been rather resilient to this crisis specifically. The rally we saw in the region’s stock indices throughout October the most notable peculiarity, although euro strength is not that far behind. Indeed, just based on macro trends and the probability of recession in the region, we continue to expect that stocks will trade at much lower levels, favoring our sell rallies call, and the single currency itself needs adjust back to a price that would fit more closely with a broader rebalancing, certainly sub EUR/USD 1.20, and probably closer to parity.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
