Investors Back Draghi-Merkel
Tuesday, 07 February 2012 | 00:00
Investors are buying what Mario Draghi and Angela Merkel are selling.Bloomberg indexes of Europe’s banks and financial conditions are the highest since August, and money-market lending rates and bond yields from Italy to Spain are sliding. Such signs of improvement reflect mounting bets that the euro will last and the two-year debt crisis won’t, as emergency loans from European Central Bank President Draghi take hold and leaders including German Chancellor Merkel pivot from crafting tougher fiscal rules to considering bigger bailout funds.
“People ended last year thinking everything that could go wrong would go wrong, and it hasn’t,” said Jim O’Neill, chairman of Goldman Sachs Asset Management in London. “There is still an inbuilt skepticism about the euro project, but there’s a shift away from the dire mood.”
Whether respite extends to recovery isn’t guaranteed. Greece is trying to fend off insolvency and questions about its membership in the euro as it seeks another bailout, just as bondholders question Portugal’s ability to dodge default with 10-year yields topping 17 percent last month. A possible region- wide recession could be deepened by a credit crunch or budget cuts, while potential political land mines include Greek and French elections.
The euro slid the most in a week against the dollar amid political wrangling in Greece over austerity measures needed to secure a second bailout. The currency fell as much as 1 percent to $1.3030 and was at $1.3045 as of 10:54 a.m. in London.
“I haven’t heard any convincing arguments that Europe will solve its problems,” said Nobel laureate Joseph Stiglitz.
Investors are starting to signal otherwise, as “a virtuous cycle is beginning to develop,” said Klaus Baader, co-chief European economist at Societe Generale SA in London. Bets made at Intrade.com implied a 39 percent probability on Feb. 3 of a country leaving the 17-nation currency bloc by the end of 2013, down from 56.8 percent Jan. 19.
The Bloomberg Europe Banks and Financial Services Index, which includes Deutsche Bank AG (DBK) and UniCredit SpA (UCG), has gained 18 percent so far this year. The spread between three-month Euribor and the overnight indexed swap rate -- a barometer of European banks’ willingness to lend to one another -- narrowed to 76 basis points last week from about 100 basis points on Dec. 8.
Meanwhile, the Bloomberg European Financial Conditions Index has risen to minus 2.9 from about minus five in early December. The Euro Stoxx 50 has climbed about 9 percent this year, and Germany’s benchmark DAX Index (DAX) is up 14.7 percent, more than double the Standard & Poor’s 500’s 6.9 percent advance.
Government bonds also are attracting buyers. Italy’s 10- year yield fell last week to the lowest since October, ending at 5.7 percent compared with more than 7 percent at the start of the year. Spain’s equivalent yield, at 4.988 percent, fell last week to the lowest since November 2010.
A Bank of America Merrill Lynch index shows euro-region government debt returned 4 percent in December, the most since the euro started trading in 1999. The currency is up 3.9 percent against the dollar since Jan. 16, when it closed at the lowest since August 2010.
“Tensions have eased noticeably,” even though “the euro crisis is far from over,” said Holger Schmieding, chief economist at Berenberg Bank in London. “Turning away from the prior panic mode, markets have drawn a clear distinction between Italy, Spain and Ireland on one side and Greece and Portugal on the other side.”
Investors are handing credit to Draghi, who took the helm of the ECB Nov. 1 and almost immediately returned its benchmark interest rate to a record low of 1 percent, eased collateral rules and loaned banks an unprecedented 489 billion euros ($642 billion) for three years at the benchmark rate.
Such initiatives buoyed the ECB’s balance sheet by 15 percent since late October. The loans also enabled banks to bolster their own accounts, lend to customers or buy higher- returning assets, helping to avert what Draghi said Jan. 27 was a “major credit crunch.”
Banks will have a second chance later this month to borrow cheap cash until 2015, with analysts saying they may snap up even more than the original program’s 489 billion euros. The stigma of using the facility is fading, and the list of assets that banks can use as collateral will be broadened. The ECB’s Governing Council meets Feb. 9 in Frankfurt.
The three-year loans “had a huge impact across several asset classes,” said Huw Van Steenis, a banking analyst in London at Morgan Stanley. “We’ve gone from a period where the risk of a collapse was material to a situation where the systemic risk is coming down.”
All this has given governments time to step up efforts to repel speculators. Leaders last week agreed to accelerate to July -- a year ahead of schedule -- the introduction of a 500 billion-euro bailout fund. At the same time, Germany, Europe’s largest economy, may be open to the idea of combining that plan with the current temporary fund, which still has about 250 billion euros.
Euro-area members also are dispatching 150 billion euros to the International Monetary Fund, which is trying to boost its coffers by $500 billion. The result could be a combined cash pile of more than 1 trillion euros and likely more if planned leverage boosts Europe’s totals even higher.
“The only way Europe’s going to be successful in holding this together, making monetary union work, is to build a stronger firewall,” U.S. Treasury Secretary Timothy F. Geithner said Jan. 27.
Political will also may be paying off. Seeking to restore fiscal credibility, governments last week inked a German- inspired treaty that requires countries to legislate for balanced-budget rules and speeds sanctions on nations with bloated deficits.
Italian Prime Minister Mario Monti’s standing in opinion polls rose last month, even after he pushed through 20 billion euros in tax increases and spending cuts, along with a plan to liberalize the economy.
Merkel used her Jan. 25 speech to the World Economic Forum in Davos, Switzerland, to underline her commitment to the euro, saying officials must “dare” to pursue even more European integration to tackle “a very clear erosion of confidence” internationally.
Signs of Resilience
Recent data indicate the region may be showing more resilience than previously predicted. European services and factory output expanded in January for the first time since August, led by growth in Germany and France, London-based Markit Economics said Feb. 3.
Economists at Goldman Sachs Group Inc. said last week they now anticipate the euro-area economy will contract 0.4 percent this year, compared with December’s prediction of 0.8 percent shrinkage.
The “breathing space” Draghi’s ECB has provided is “important for Europe certainly, but it has also been very important for emerging economies, because he has contributed to the stabilization of currencies and the revival of capital inflows,” Subir Gokarn, deputy governor of the Reserve Bank of India, said in a Feb. 2 interview. Still, “it’s not the substitute for a structural solution, which is needed.”
The ECB’s bank loans have failed to deal with pockets of insolvency, said Stuart Thomson, a portfolio manager at Ignis Asset Management in Glasgow. Greece, for example, is struggling to cut its debt to 120 percent of gross domestic product by 2020 from 144.9 percent in December and is in a protracted recession.
“Draghi has done the right thing in a very difficult situation, but he hasn’t solved problems,” said Thomson, who helps to manage about $121 billion. “Liquidity doesn’t work when there is a solvency crisis.”
Nobel laureate Paul Krugman predicts Greece will default and probably be forced from the euro area.
“The Greek situation is essentially impossible,” he said Feb. 2 at a conference in Moscow.
Greek officials spent the weekend in talks aimed at concluding a debt swap with private-sector creditors and winning a second international bailout as the country faces a 14.5 billion-euro bond payment on March 20.
It could default and still remain a member of the euro as long as it can balance its budget, billionaire investor George Soros told reporters in Davos, Switzerland, on Jan. 25.
While eight U.S. states and the territory of Florida defaulted on their debt in the early 1840s, “there was never an issue about the default being a catalyst for leaving,” because the underlying economic strength and political rationale for the union were still there, said Bart Mosley, chief investment officer in New York at Alprion Capital Management.
Even as European leaders say a Greek restructuring is unique, Portugal is striving to persuade investors it won’t renege on its debt. Investors have been paying the most ever to insure the debt against default amid speculation Portugal won’t be able to auction bonds next year before funds from its 78 billion-euro bailout run out.
BNP Paribas SA estimated Jan. 27 that the Portuguese economy will shrink 5 percent this year and face a 9 billion- euro funding shortfall at the end of 2013 unless it can sell the debt. GDP contracted 1.6 percent last year, according to the median estimate of economists surveyed by Bloomberg News.
Italy also must refinance debt equivalent to half of its annual GDP between now and 2014, even as its borrowing costs ease, according to Julien Seetharamdoo, an investment strategist at Coutts & Co in London. And Spain faces an uphill battle to cut its budget deficit to a target of 4.4 percent of GDP this year from 8 percent last year.
Lenders also may keep retrenching, with Draghi himself acknowledging it isn’t clear if the ECB’s cash injections are finding their way into the economy. Central-bank data last week suggested a net 31 percent of banks tightened lending standards in the last three months of 2011 and a net 24 percent are likely to do so in the current quarter, according to calculations by Citigroup Inc. economist Guillaume Menuet.
Banks also face regulatory calls to raise an additional 114.7 billion euros of core capital by June.
“Reduced credit availability will dampen economic activity throughout the first half and push the region into recession,” Menuet said.
Governments also are cutting back. JPMorgan Chase & Co. economists estimate budget cuts will subtract about 1.3 percentage points from growth this year, double the U.S. rate. With unemployment as high as 22.9 percent in Spain and 10.4 percent in the euro area, the most since the currency began trading, the risk is even weaker expansion and higher debts.
Laurence Boone, chief European economist at BofA Merrill Lynch, predicts France, Italy and Spain all will join Greece in recession.
“The most important need is economic growth,” said Barry Eichengreen, author of a 2006 history of the euro area and a professor at the University of California, Berkeley. “Europe doesn’t hold together politically without it.”
The austerity threat is prompting Francois Hollande, the front-runner in France’s presidential race, to say he will call for the renegotiation of Europe’s budget treaty if he wins the May election. Greece’s feuding political parties also will seek parliamentary power at some point soon, while Ireland may hold a referendum on the fiscal pact.
The risks mean officials will need to do more, said Stephen King, chief economist at HSBC Holdings Plc. He predicts the ECB will cut its key rate to 0.5 percent and ramp up its bond purchases, while Germany will bow to greater fiscal ties. The ECB already is under pressure to take losses or tap profits on its holdings of Greek bonds to help provide debt relief.
“The financial news has been OK but, all in all, the euro zone is still facing considerable difficulties,” King said.