Unraveling This Week’s Euro Drama

Thu, May 10, 2012 - 3:15pm

There has been a lot of talk about French and Greek elections, Spanish Banks, and austerity versus growth in the headlines this week. It really might have been too much for you to filter on your own, so here I wanted to summarize some of the macro drivers that steered the markets. Many of these topics will be discussed on the radio show this weekend. As we slip away from the earnings season, attention will again turn towards the macro picture in steering the markets.

Election Time Means Promise Time

On Monday, the market opened down responding to the French and Greek elections. In France, Hollande had defeated Sarkozy 51.9% to 48.1% based on his left-wing socialistic policies. Those policies were being feared in the credit markets, because the removal of austerity could cause the country’s credit rating to drop, which would cause bond yields to rise as a result. However, since last week there continues to be a shift in the political landscape to begin talking about growth and ways to stimulate a recovery. Some of those ideas came about last week in a €200B proposal using some of the funds from the European Financial Stability facility (EFSF). Since Hollande, rhetoric continues to shift towards growth, but more on that in just a bit. Later in the week, credit agencies verified no change in France’s credit rating due solely to the election of Hollande as President.

Greek elections were a big source of paranoia on Monday and throughout the week. As many had feared, the country’s major parties that supported the EU/IMF bailout suffered at the polls. Because not one party garnered much control, a coalition will need to be made of the parties that have the closest ideals. That was the New Democracy and PASOK, which combined would be two deputies short of the 151 seats needed for a majority in the 300-seat chamber according to Bloomberg on Thursday. The back and forth between the variety of views each party has over Greece created headlines that moved the markets. The Syriza party leader Alexis Tsipras declared on Tuesday that the Greeks should completely renege on the recent EU/IMF bailout and separate from the EU.

Because of the difficulty in forming a majority, there will likely be a June election. The Greeks said they have enough funds to see their government continue to run on through July if there aren’t any tax revenue hiccups. Sources on Wednesday said the EFSF was expected to give a €4.2B tranche to Greece and the remaining €1B in June. Mind you, the market is going to be very interested in the €436M bond redemption on the 15th next week.

Despite all of the talk about leaving the EU and the euro, the euro held up rather well this week, dropping only 1% from last week’s close as of this Thursday. Additionally, a financial stress index compiled by Bloomberg is holding steady despite the weakness in equities stemming from weak economic data in March and April.

European Financial Stress Index

Bancos De España

There were rumors last week that the Spanish were considering the formation of a “bad bank” to consolidate toxic debt. Those rumors got some attention on Monday when Prime Minister Mariano Rajoy announced that Madrid would detail measures for the banking industry on this Friday. In addition, the Bank of Spain and Economy Ministry said they were finishing up the details on capitalization plans for Bankia through convertible bonds.

On Wednesday, there was a Dow Jones article that spooked the market on Spain. The article said that Spain was going to require banks to ramp up provisions against performing developer loans to 30% from the current 7%. This calls into question the credit worthiness of loans currently labeled as performing on Spanish bank balance sheets as well as earnings. This alone heightened the systemic credit risk of the Spanish banks this week and recouples the solvency issues the market had psychologically repaired by the ECB’s LTRO program (1% loans for 3 years) that it offered to EU banks.

After that announcement, on Wednesday night, the Spanish government’s stake in Bankia rose to 45% as a result of a conversion of its preferred equity stake in BFA. The government adamantly stated that the bank is solvent and thus far, we haven’t seen any news of any bank runs there. The two institutions have the largest property exposure than any other financial institution in Spain.

So tomorrow we should hear from the Spanish government details on the Spanish banking industry. There’s been talk in the papers that Spain would get leniency in its deficit target from 3% to 4%. In addition, there’s been talk that the EFSF may be tapped to assist in recapitalizing the banks. We’re learn more tomorrow.

Austerity Ballot: Yes/No

With the election development in France and Greece, it is crystal clear that the populace can only take so much cutting. Promises have been made by the electorate. Concerning Hollande, it remains to be seen just how serious his promises were. During his campaign, he said he wanted to shift the focus from austerity to growth. The political culture is shifting and that could be the final catalyst Europe needs to turn their economy around.

If you recall in December, I adamantly pounded the table that the ECB’s LTRO was the big bazooka the credit markets needed to shore up confidence. With the favorable response to the first auction late December, that appeared to be the case. Yields fell across the board; however, that changed in March when Europe’s manufacturing began to dip again after a short rally. Before the Spanish bank issues in the past two weeks, concerns have shifted from solvency late last year, towards growth. On that note, here were some of the statements made this week in that regard:

  • Germany Factory Orders were up 2.2 versus 0.5 expected.
  • Germany’s Lars Feld said the ESM isn’t large enough.
    • Klaus Regling, head of the EFSF, said they have enough for a year.
  • FT article late Friday last week: “Olli Rehn will call for increased spending on large scale infrastructure projects and will also hint at a willingness to soften existing fiscal targets.”
  • The European Commission will release new economic forecasts and will wind up lowering estimates for several countries on Friday (May 11).
  • Germany’s Bundesbank head Weidmann, suggested Germany may have to soften its strict insistence on austerity. “Germany could in the future have an inflation rate somewhat above the average within the European monetary union (to help spur growth in periphery).”
  • China’s CIC says it has stopped buying Eurozone sovereign debt due to crisis concerns – Bloomberg.
  • Reuters had an article about Germany’s SPD raising an attack against Merkel’s austerity push in Europe, accusing her of boosting the far-right in Greece.
  • Germany’s finance ministry is pushing for higher wages for German workers to boost consumption demand.
  • IMF changes austerity rhetoric. CNBC said Lagarde acknowledged that austerity measures hold back growth.
  • Reuters stated that Merkel rejects the notion that Europe is on the cusp of a major policy shift and said the region should press ahead with austerity measures. Merkel and Hollande will meet for the first time on the 16th.

So, as you can see, despite Merkel’s feelings policy is beginning to shift by the heads of state and those heads in the Troika (EU, IMF, ECB). It appears there might be a compromise between the two, but it will remain to been seen just how much a decentralized system like the EU would be able to promote such growth in ways other than inflating through the LTRO and ECB’s bond purchase program (SMP). The one option that is quite obvious is easing debt requirements.

It’s going to be a very interesting time for the markets and political landscape for Europe in the two months ahead. It seems that the Euro debt monster is rearing its head once again, steering the volatility of the financial markets by every headline.

I still hold that the equity market wants to put in a short-term bottom here. Many of the divergences I discussed on Tuesday still hold, while a few more have formed. There is now a divergence in momentum from the hourly bottom on Tuesday and on Wednesday for the S&P 500. In addition, the Russell 2000 and the Dow Jones Industrial Average are still holding major support levels despite the breakdown in the S&P 500 under 1358 and the NASDAQ composite under 2945.

Right now I’m looking at near-term resistance at 1364, but the short-term downtrend appears to have been broken today. I believe a break above 1364 would signal a rally is in the cards.

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