Position: Long Germany (EWG); Short Euro (FXE), Short Italy (EWI)
Today European leaders announced at their two day summit in Brussels that a permanent debt-crisis mechanism will replace the current temporary package of €750 Billion that expires in mid-2013.
Importantly for German Chancellor Angela Merkel, who largely has the support of French President Nicolas Sarkozy, the EU’s constitutional Lisbon Treaty was amended to meet her demand that lending to fiscally “troubled” nations come only as a last resort. The two words added to the treaty to pacify Merkel were “if indispensable” in the clause:
“The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality.”
Our read-through is that the clause accomplishes very little, given the very near to intermediate term sovereign debt risk for such countries at Portugal, Spain, and Italy. While it importantly recognizes the necessity of a “debt-crisis mechanism” for the future of this union of countries, much confusion still surrounds who will determine when financial assistance is “indispensable”, how it will be funded, and how much will be allocated, especially given the uncertainty surrounding bank liabilities throughout the region.
It’s also worth note what was NOT decided on at the summit. In particular, Luxembourg PM Jean-Claude Juncker had pressed for a joint Eurozone bond and ECB President Jean-Claude Trichet voiced support for adding additional funding to the €750 Billion fund going into the meeting. Neither were formally agreed or disagreed on.
To the former point, it’s our guess that states such as Germany and France won’t agree to take on the risk of a collective Euro area debt obligation – there’s no benefit to them, but rather downside risk to their own credit standards. To the latter point, we believe we’re likely to see further monies thrown at the Eurozone’s sovereign debt crisis before the temporary package expires.
In Europe we’re concerned about the bank liabilities in the peripheral countries that are not largely understood/quantified and the market implications should members of the “PIIGS” come up short in meeting their targeted deficit and debt reduction levels over the next three years, the probability of which we think is high. Weaker growth prospects will put pressure on incoming tax receipts, while governments continue to get pushback (strikes) over austerity to issue spending cuts. This is a dangerous equation when trying to reduce a budget.
Further, deficit reduction plans are lofty: Greece is attempting to cut from -15.4% of GDP in 2009 to -9.4% in 2010 and Portugal from -9.3% in 2009 to -4.6% in 2010. Equally, we think there’s a fair probability that any one of the PIIGS end up revealing that their previous numbers were fudged, a case we’ve already seen with Greece revising up both its debt and deficit figures for 2009. On this score, Italy could be contender.
Certainly such scenarios could require additional bailout monies over the intermediate term to arrest a plunge in a country’s capital markets. In any case, we expect government bond yields to reflect this risk. As the chart below shows, despite bailouts in Greece (May) and Ireland (December), yields across peripheral countries have remained elevated, and most recently are breaking out.
While the region ratcheted up “emergency” measures in the form of a decision yesterday by the ECB to increase its capital base by €5 Billion to €10.7 Billion over three years beginning on December 29th, the reality remains that the union of unequal states (Eurozone) will continue to be plagued by divided opinion on policy, including who’s funding its crisis. We expect underperformance from Europe’s peripheral countries that should also weigh to the downside on the Euro versus major currencies.
Today, European equity markets closed in negative territory with underperformance from the peripheral markets. Equally, the EUR-USD is taking a beating today and flirting with our TRADE line of support at $1.31. We see TREND resistance up at $1.34 (see chart below).
We sold our position in Spain (EWP) today with the immediate term TRADE oversold. We remain bearish on the intermediate term TREND.
Keep your risk management pants on,