Positions in Europe: Long Germany (EWG); Short Italy (EWI); Short EUR-USD (FXE)
Bearish Enough? We’re getting incrementally more bearish on European sovereign debt contagion, which we’ve expressed by being short Italy and the EUR-USD in the Hedgeye Virtual Portfolio, as the focus turns closer to the heart of Europe: Italy and Spain. Here are our updated risk factors weighing on our outlook for Italy and the broader Eurozone over the last week:
1. Yields and CDS Spreads—The Italian 10YR government bond yield is now flirting with the 6% level, having crossed it early last week (before coming in slightly into week-end) and again jumping around the line today. As we show in the government yield and cds charts below, the 6% level or ~ 525bps CDS line have proven critical breakout lines for Greece, Portugal, and Ireland that shortly after violation necessitated bailout packages. An Italian breach of this 6% yield line could prove particularly damaging for not only the yield demanded at future sovereign bond auctions, but given Italy’s elevated debt exposures the Eurozone’s current temporary EFSF bailout facility of €250 Billion is far underfunded to handle an Italian rescue package. We’d expect headline risk to continue to power both yields and CDS spreads higher over the near and intermediate term, especially as the European community is undecided on how to handle contagion (more below).
2. “Sizing” Market Sentiment – With Italy’s economy 3X the size of the combined economies of Greece, Portugal, and Ireland, and with some €1.9 Trillion of debt, or 120% of GDP, which ranks Italy second behind Greece with the largest debt as a % of GDP in the Eurozone [Greece = 144%], market sentiment could turn violently, especially as we learn more about the country’s banking exposures across the region.
3. Austerity’s Timing – While both houses of the Italian Parliament approved a €47 Billion austerity package late last week, essentially €40 Billion in tax hikes and public sector spending and wage cuts are back loaded to 2013/14. In our opinion, this back loading is at odds with a market that is looking for clear-cut signals that Italy has a firm grip on reducing its debt and deficit loads over the near term. The continued erosion in PM Berlusconi’s credibility, including a recent scandal with his Finance Minister, adds only further downside risk. While the case can be made that Italy is in a “better” fiscal spot than a Greece or Portugal with a 4.5% budget deficit (compared to 10.5% and 9.1%, respectively), Italy is heading up against some significant debt maturity repayments in the coming months.
4. Looming Debt Schedule—As the chart below shows, Italy must make debt maturity payments (principal + interest) of ~ €201Billion into year-end, with payments in the months of August and September particularly steep. For reference, Greece, Portugal, and Ireland have combined debt payments of €62 Billion for the remainder of the year. Weaker demand for future debt issuance and higher interest rates could well snowball and further roil investors.
5. EU Stress Tests, Part II Disappoint- As Josh Steiner and our Financials Team noted in a post on 7/14 titled “Lunacy: Previewing Tomorrow’s EU Stress Tests”, the tests revealed nothing about the current state of banking exposures as both the balance sheet data and risk assumptions reflected data as of December 31st, 2010. Critically, the tests did not consider assumptions on sovereign defaults, change in ratings, and valuation haircuts were only applied to held-for-trading bonds for each bank, that is, those that are already marked-to-market. We see more downside to Italian bank stocks as more layers of the onion are pulled back.
Broader Notes on from the Eurozone:
In short, we continue to see gargantuan politicking efforts by Eurocrats to deflect the pressing risks across the region. Over the weekend Trichet told the FT Deutschland that again he’s not working under the assumption that a Eurozone country defaults, a stance that prevents him from having to address the real (and possibly near) concern that a ratings agency rates a peripheral country’s credit in default. A rating of default throws a wrench in ECB collateral requirement rules and debated bank restructuring of peripheral debt.
The next calendar catalyst of note is this Thursday’s emergency EU summit to address a new rescue plan for Greece, pegged around €115 Billion. Over the weekend Germany Chancellor Angela Merkel told the FT that she will only attend “if there is going to be an agreement on a new rescue plan for Greece”, while recent discourse suggested a plan would come in mid-September. Merkel said “she wished to avoid any Greek debt rescheduling, but underlined that the key to a deal would be substantial voluntary involvement of private creditors in easing the Greek debt burden.”
We’re sticking to our bearish outlook on the EUR-USD. Our immediate term TRADE levels are $1.39 to 1.42, with the intermediate term TREND line clearly broken at $1.43.
European Financials CDS Monitor
Not surprisingly, bank swaps in Europe were mostly wider last week. 37 of the 38 swaps were wider and 1 tightened. ISDA ruled that the Bank of Ireland experienced a credit event (restructuring), triggering a settlement on the credit default swaps. Accordingly, swaps are not trading this week for Bank of Ireland.
Stay tuned as this volatile soap opera charges on.