S&P threatens eurozone with widespread downgrades

By Daniel U. Alvarez

PEREIRA (MercadAnalytic)– Standard & Poor’s (S&P) ratings services last night threatened to downgrade the status of 15 of the 17 European Economic and Monetary Union (EMU or eurozone) members, adding pressure to get their sovereign debt problems fixed.

The risk-rating agency believes that “systematic stresses in the eurozone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the eurozone as a whole”.  The following “five interrelated” concerns are cited by the agency as contributing factors to the potential downgrade:

1)      Tightening credit conditions across the eurozone;

2)     Markedly higher risk premiums on a growing number of eurozone sovereigns, including some that are currently rated as ‘AAA’;

3)     Continuing disagreement among European policy makers on how to tackle the immediate market confidence crises and, long term, how to ensure greater economic, financial, fiscal convergence among eurozone members’

4)     High levels of government and household indebtedness across a large area of the eurozone; and

5)     The rising risk of economic recession in the eurozone as a whole in 2012.  Currently, we expect output to decline next year in countries such as Spain, Portugal and Greece, but we now assign a 40% probability of a fall in output for the eurozone as a whole.

Interestingly, the potential downgrade announcement came hard on the heels of: 1) Franco-German initiative announced early Monday by President Nicholas Sarkozy and Chancellor Angela Merkel to enforce budget discipline and 2) Italian Prime Minister, Mario Monti’s, government austerity plan to cut $30 euros from its budget.  

Market reaction on Monday before the S&P announcement was well-received.  Late Monday, however, the markets began to give-up some the gains. 

Sarkozy, Merkel and Monti have a very difficult challenge ahead of them.  One of the measures proposed by the Franco-German initiative is to agree on “mandatory limits on budget deficits that eurozone members would have to adhere to, or risk possible sanctions”.  Monti’s austerity plan was approved by his cabinet on Sunday but still needs senate approval. Trade unions oppose the austerity measures and planned for protests later in the month.

Amazingly, the markets initially responded positively to the proposals, but nothing has been approved yet. 

Assessment

We believe ratification of the Franco-German proposal and the Italian austerity plan is going to be a major challenge to ratify.  In the end, pressure from the S&P and the United States may still not be enough for passage.  

Accordingly, we expect a higher U.S. dollar opening and equities to pull-back.  We still hold the following positions: $DOG, $RWM, $SDOW, and $FAZ.  On Tuesday and Wednesday we will be looking for exit points.