Following almost two years of “kicking the can down the road” through a series of actions that have proved to be both too little and too late, the member states of the European Union, and particularly those of the single currency Eurozone, reached agreement in the early hours of Thursday, October 27 on a comprehensive package of measures. They are designed to prevent the European debt crisis from deteriorating further and tipping the Eurozone economies into prolonged recession. The stakes were extremely high, since an outcome that fell significantly short of what was considered to be necessary would have had serious negative implications for European, and indeed global, economic prosperity. That tail risk event has now been removed.
The package necessarily addresses three interrelated problems:
1. The bailout of Greece had to be revisited, since Greece’s economic and fiscal situation has worsened. The 21% haircut on Greek government debt included in the July agreement with private banks clearly had to be increased. Bondholders understandably opposed this and demanded increased commitments from the Greek government to carry out further reforms. At the end, it took a late-night meeting of the Greek bondholders with French President Sarkozy, German Chancellor Merkel, and Luxemburg President Junker, during which the European leaders made clear that the alternative to accepting a 50% haircut would be a failed summit and a likely loss of 100% on that debt. The bondholders then agreed to the 50%, with details still to be worked out. It is believed that this “voluntary” agreement will not be considered to be a credit event that would trigger credit default swaps. Officials projected that, with this haircut, the debt-to-GDP ratio for Greece should decline to 120 by 2020, as compared with the estimate of 152 in the absence of the increased haircut.
2. European banks require additional capital. They now have to reach a core tier 1 capital ratio of 9% by the end of June 2012. Major French and German banks indicated that this will not be difficult for them to do without official help. However, banks in weaker economies will need, and be able to obtain, capital injections from their governments. In cases where the governments need assistance to finance these injections, the EFSF (European Financial Stability Fund) will provide the finance. The total new capital for European banks is estimated to be 106 billion euros. There is a concern that the higher capital requirement will lead some banks to shrink their balance sheets and restrict credit markets in Europe. The European Banking Authority (EBA) in cooperation with the European Central Bank (ECB) and the European Investment Bank (EIB) will “explore options” on how best to restart the term unsecured funding market and support credit creation.
3. The “firepower” of the EFSF rescue fund is to be increased by “several-fold” to roughly 1 trillion euros ($1.4 trillion) through leveraging. Two approaches will be used. The first will be a guarantee scheme under which the EFSF will insure the first tranche of new debt issued by a sovereign of a peripheral country. The second is creation of a special purpose vehicle designed to attract institutional and sovereign wealth fund investors (and possibly the IMF) and provide funds to Eurozone sovereigns. The details for both of these approaches are still to be worked out.
In addition the ECB has signaled its intent to continue its purchases of European sovereign bonds in the secondary markets.
In sum, while there are many details to be filled in and there surely will be difficult negotiations on some of these, the overall package should give considerable assurance to markets. Europe will be able to avoid a Lehman-type event. Europe’s banking system will not suffer a crisis. Greece’s debt restructuring will be orderly. The euro will not collapse and will continue to be an important reserve currency. Europe’s underlying institutional problems still need to be fixed, and the international competitiveness of the weaker economies needs to be strengthened, but the threat of imminent disaster has been taken off the table.
Markets around the world have reacted positively, with the previously depressed Eurozone equity markets rebounding sharply. While it is to some extent a “relief rally,” we expect this global rally to “have legs” and continue for some time. In addition to the good news from Europe, investors have further data – the 2.5% GDP growth in the third quarter, the strength of consumer demand – to show that the US economy is not entering a second (“double-dip”) recession. Also, China’s economy appears clearly to be headed for a “soft” landing, and Chinese authorities are moving towards easier macroeconomic policies. While the global economy is still expected to grow at a relatively moderate pace, a less risk-adverse environment is likely to lead to renewed outperformance on the part of emerging markets and those of commodity exporters such as Australia and Canada.
At Cumberland Advisors we believed that the Europeans did not have a death wish, and in the slow way their parliamentary systems work, they eventually would do what had to be done to save their financial system and the euro. At the same time, we remain concerned about the growth prospects for the European economies, including Germany and France. They face a lot of headwinds, including the various austerity programs and restricted availability of credit. Accordingly, our international and global multi-asset class ETF portfolios are fully invested but remain underweight with respect to the Eurozone markets.