Saturday, January 14, 2012

National parochialism.

No surprises . The S&P downgrade of the credit ratings of France and other Eurozone countries has finally come through . On the positive side it wasn't as bad as it might have been . France was only cut by one notch, not the two that some observers had thought possible. S&P takes the view that the policy measures taken so far to address the crisis remain insufficient . Put more succinctly Europes politicians have been unable to rise to the challenges facing them. Parochialism rules.

Markets are unlikely to be unsettled by the S&P decision. More importantly, they will now be determining whether Moodys and Fitch will follow suit. We would expect Moodys to join their colleagues at S&P with a raft of downgrades possibly at the start of Q2. ( They have said they will review their rating of France at the end of Q1 ).A second rating downgrade may lead to institutional selling flows out of France and into the remaining triple A's. A textbook flight to quality . It would have been much easier for France and Italy if Germany had also been downgraded. Then the whole AAA benchmark would have been rendered moot. Once forced selling begins a second downgrade of France is possible as money flows from there into Germany. This is when the trouble starts.

Over the next month the key implications of this widely heralded move are likely to be political. Trying to get anyhting meaningful agreed in Europe ahead of the French Presidential elections has suddenly become much more difficult.Yet without political help for Spain and Italy the chances of the current techocratic government surviving decreases. By the same standards the chances for the election of populist governments increases. Hungary may be the tenplate of what lies in store for much of Europe.

1) The UK
Any remaining hope that Britain might sign up to the Europact agreed at the December summit has evaporated . The perception has grown amongst the British public that the Eurozone experiment has failed. A parliamentary majority for further harmonization is unlikely if not downright impossible. A Europe of 26 + 1 is now a de facto certainty. In the near term Sterling and gilts may continue to perform well. By mid year markets may begin to look at the falling value of the European collateral that the UK banks hold against their $2 trillion + of debt. Expect UK rates to be at a 3% level by year end.

2) France
The embarassment for the French government of losing their triple A rating while Germany and Britain retain theirs is tangible. The French government is now under strong pressure to give up more of its fiscal sovereignity and impose tighter austerity. This is something it has been loathe to do. President Sarkozy must now, quickly, decide whether to implement additional fiscal reforms or hang tough with the markets. Imposing spending cuts before an election is something he is against. Fighting the markets is something he cannot win. French banks are already set fo further downgrades, a process that can only sharpen if Greece were to default. Expect further Germanization of French policy.

The danger is that in the run-up to the May Presidential election , calls for France to leave the Euro or to renegotiate the European rescue accord are likely to grow. Things for France can only get worse. Germanys economic dominance of Europe is plain to the French electorate. France speaks of parity with its colleagues across the Rhine. The reality is clear.

3) Germany and Greece
Within Germany support for the Euro is showing the first tangible signs of waning. There are those within Chancellor Merkels own party who take the view that a Greek exit could be managed. We would expect a little more time to be bought for Greece at this weeks Troika negotiations. However, with an economy that has declined in size by 15% since 2008 the chances of repaying its debts become ever more distant and illusory. The real question is whether Greece can stay in the Euro while simultaneously defaulting . Removal of German political and funding support makes default more probable.This is something that we thought unlikely as recently as the start of the year.

4) Italy and Spain
It is only a matter of time before the austerity imposed on Greece, and soon to impact Italy, Spain and Portugal, causes popular resentment . Further election box driven changes to governments within the Eurozone will keep this crisis protracted.
Germany seems to have decided that it wants its Eurozone partners to sign up to a radical fiscal pact . This discipline must be enshrined in the forthcoming treaty and only when the ink is dry will more radical solutions ( ie unlimited ECB bond buying ) be considered . Short term this may work . In the mid to longer term it is building up resentment and nationalism.

The European recession is now underway . Watch out for slowing economic output, downgrades by Moodys,further devaluation of the € ( a trading range of 1.15-1.20 to the $ seems reasonable ) and further pressure on the markets. At some stage, following a Moodys downgrade of France , Germany may decide to pull the plug on Greece and try to weather the resulting storm . Portugal would be next in line for a downgrade. Then ?. Sad, because none of this need ever have happened . And Americans think their politicians are bad .

Barring a political accident the probability is that by early next year the ECB will be forced into firing up the printing presses. As early as next week they may provide a further $700 billion of LTRO liquidity to the banking sector . If I'm right H1 2012 will be disinflationary and the latter part of H2 reflationary. That's when gold powers back through to the $2000 level and the S&P touches 1350 .In the meantime this drama will play and play and play . I'm still of the opinion that the crisis will come not in 2012 but in 2013 when austerity measures really take hold in Spain and Italy and when the new French administration understands the nature of the cuts it will have to employ. After the technocrats the populists.

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