Fisher Investments Editorial Staff
Geopolitics, Developed Markets

Fisher Investments Outlook: The Plot Thinnens?

By, 07/12/2011

The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff. The article constitutes the general views of Fisher Investments as of July 2011 and should not be regarded as personal investment advice. No assurances are made Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration.

Story Highlights:

  • Moody’s downgrade of Portugal this week—while hardly surprising—seems at first glance to have narrowed European officials’ options in addressing eurozone debt issues.
  • But the reality is Europe needn’t necessarily rely on credit ratings agencies in assessing the creditworthiness of various sovereignties’ debt.
  • Adding to the economic complexity is multi-speed growth, which the ECB addressed this week with an interest rate increase.
  • The challenges are many, but the reality is the eurozone still has options available to avoid a larger debt crisis or contagion.

As we discussed here on Fisher Investments MarketMinder last Thursday, Moody’s downgrade of Portugal this week wasn’t much of a surprise—markets and investors have known about Portuguese debt issues for months now. But with ratings agencies’ decision to call anything involving debt restructuring a default and European officials potentially backed into a bit of a corner with fewer options available, the plot’s seemingly thinnened.

This may well turn into a battle between ratings agencies and the so-called Troika—the IMF, the ECB and the European Commission. German Chancellor Angela Merkel’s already indicated the Troika’s view of eurozone debt issues is likely more reliable than that of ratings agencies—and she may be right. If not more reliable, at least timelier. And ECB President Jean-Claude Trichet’s already essentially acted on a similar assertion in agreeing to continue lending against debt issued or guaranteed by Portugal’s government, despite Moody’s downgrade.

However, Trichet’s also indicated the ECB will in no way compromise when it comes to triggering any sort of perceived default—selective or otherwise. Well, that seems to be that, right? If ratings agencies are indicating any sort of debt rollover—private or otherwise—will be considered an essential default (whether they actually call it that or not), and the ECB’s determined not to accept default-rated debt as collateral for lending, isn’t their goose cooked?

Actually, no. For one thing, there’s no law saying the ECB has to base their collateral rules on ratings agencies’ proclamations about sovereign debt creditworthiness. Remember: The ratings agency oligopoly exists in essence because the US government created it. In the 1970s, as financial institutions requested softer capital and liquidity requirements than those initially handed down by the SEC, the government sought a way to ensure the funds institutions did hold were creditworthy. So they subjected Fitch, S&P and Moody’s—the primary ratings agencies at the time—to heightened regulation and scrutiny and declared their ratings officially acceptable in determining whether financial institutions’ holdings passed muster. In essence, they declared the ratings agencies would never be wrong again. But that’s simply not true—did any of the ratings agencies warn of impending Irish debt troubles? No. Iceland? No. Did they help much during 2008? Not really, resulting in Dodd-Frank regulations aimed at actually breaking up the oligopoly—which led to the ironic scenario of S&P threatening to downgrade Moody’s last year.

Not to mention this all pertains primarily to US financial institutions. No one’s mandated the ECB must accept the same ratings or run their capital and liquidity requirements in the same way—if they want to change the rules, they certainly can.

And they have before—just last year when Greece was initially facing debt problems, Trichet reversed course and agreed to accept low-rated debt as collateral for Greek loans. And in extending the same courtesy to Portugal this week, he’s seemingly again signaled a willingness to cooperate with struggling peripheral countries to ease their current debt dilemmas. Now, they run the risk US institutions may look askance at all this disregarding of credit ratings. And US investors may feel this degrades the risk profile of those banks that accept junk-rated collateral. But that’s a risk Trichet et al likely understand and are willing to take.

In the wake of the ratings agencies’ latest announcements regarding the various plans and whether they’d be considered default, Germany further stirred the pot, resurrecting proposals previously considered basically dead in the water. The discussion primarily surrounds the size of the burden borne by private investors versus governments. Germany’s proposal would in essence place a larger burden on private investors, allowing eurozone governments to bail out Greece for a lesser amount—but it would also most definitely be considered a default.

As if eurozone debt issues and debates weren’t enough, the ECB faces the continued challenge of maintaining monetary policy consistent with multi-speed growth across the eurozone. Considering countries like Germany and France are generally growing while Greece, Portugal and Ireland struggle and Italy and Spain muddle along, it’s a pretty tall order, to say the least. The most recent decision was to raise interest rates 25 basis points Thursday, which likely makes things a bit more difficult for the periphery. As their economies continue to lag and they face the prospect of rolling over their debt, an increase in key benchmark rates is certainly an added consideration and potential hurdle. Yet with inflation continuing to tick up and above their target rate of 2%, in the ECB’s eyes, there was little choice to but to ensure the economically strong eurozone members are sufficiently supported.

And there are additional challenges—like recent volatility in Spanish and Italian stock and bond markets, mostly tied to Italian political tension and concerns Spanish and Italian banks may not pass upcoming stress tests. Given Spain and Italy’s relatively larger size, the impact of more turmoil there would likely be felt by markets more significantly than issues in the smaller PIIGS. With Spanish region Castilla La Mancha’s announcement they have significantly more debt than previously thought, that Spanish bond rates are moving up isn’t too surprising but could indicate yet rougher waters ahead.Still, these two nations aren’t on the same fiscal footing as those bailed out, and gyrations there aren’t necessarily new.

Then there’s the fact some European banks have sold off their Greek debt holdings, despite promises to the contrary. Which only makes private participation—voluntary or involuntary—more difficult (to put it mildly). And Greek bank deposits seem to be leaving the country. Greek banks seem well capitalized for now, but money outflows certainly won’t help if they continue. And then spin back to the aforementioned issues involving what constitutes default, how many agencies have to agree it’s a default before that country’s debt is no longer accepted, and so on.

The long and short of it is there are still many open questions when it comes to the eurozone’s debt situation and possible solutions. But at the end of the day, there are undoubtedly still solutions that avoid a wider eurozone contagion or break up. And it could spell the end of ratings agencies as we know them, but as we’ve said, that’s not necessarily a bad thing. There are other avenues for assessing the creditworthiness of institutions and nations—and the fact some are more market-based and less tied to governments’ regulatory whims strikes Fisher Investments as an overall positive. For now, we’d cautiously applaud Europe’s general willingness to stand up to the ratings agencies and deal with their debt issues as they see fit—we’d agree they’re likely better informed. And they’ve certainly been more timely in their assessments of troubled nations. So thinning or thickening—the plot certainly continues to unfold in Europe.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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