Eurozone Policymakers Deliver Long-Anticipated Debt Crisis Plan
By Mark Dixon, Chief Investment Officer and Jim Baird, Chief Investment Strategist
Plante Moran Financial Advisors
Executive Summary
- There was a rising tide in risk assets on Thursday, October 27, after a deal emerged from the Eurozone summit which addressed several of the key concerns that have plagued the region. The plan included a European bank recapitalization program, a framework for Greece to restructure its sovereign debt, and an enhanced financial backstop.
- Specifically, a 50% voluntary haircut was applied to financial sector bond holders of Greek government bonds to avoid a more disorderly restructuring. Meanwhile, the bank recapitalization program will require Eurozone banks to meet a Tier 1 capital ratio of 9% by the end of June 2012.
- While the bold plan to address the crisis assuaged near-term fears of greater contagion, we believe both the Eurozone area and the U.S. economy remain in a fragile state as consumer deleveraging continues.
- We believe heightened volatility may likely persist in the months ahead, given the prospects for slower growth, the persistently poor employment situation, the increasing focus on the debt “super committee” report, and 2012 election.
Based on the tendency for European policymakers to over promise and under deliver, the bar for a meaningful policy response coming out of the recent Eurozone summit was low. As such, we were pleasantly surprised to wake up on Thursday morning to find that European leaders were able to reach agreement on a plan to take the first step to address the European debt crisis. By no means are we – or anyone else – saying that Europe’s issues have been solved, as this will be a process that takes years to fix. However, it is encouraging to see policymakers step up and deliver a comprehensive plan that begins to address the Eurozone debt crisis, especially considering the relatively weak economic backdrop and the fragile state of confidence. The initial market response
to the measures has been very positive as well, with both domestic and international equities rallying and bond spreads in peripheral Eurozone countries falling.
The plan produced at the summit contained several key elements, including a bank recapitalization program, a framework to allow Greece to move to a more sustainable debt level, and an enhanced financial backstop. While the core portion of the plan has been drafted, many of the technical issues needed to put the plan into action have yet to be finalized. Thus, much work remains to be completed and implementation risk looms large as there may be various unintended consequences.
The bank recapitalization program requires Eurozone banks to meet a Tier 1 capital ratio of 9% by the end of June 2012. To achieve this targeted capital ratio, banks must first tap the private sector, then national governments, and then the European Financial Stability Facility (EFSF) if the national government lacks fiscal capacity. Since banks may want to avoid the increased scrutiny and regulations that go along with raising capital via national governments and the EFSF, they may primarily reduce leverage via the private sector. That could be accomplished by raising new capital (perhaps by issuing common stock) or by selling assets, reducing lending, or some combination of the two. With shares currently trading at distressed levels, banks may prefer to sell assets or reduce lending rather than dilute existing shareholders and place further pressure on their shares. In order to address this implementation risk, policymakers have asked the European Banking Authority (EBA) to explore options to support credit creation in the real economy.
Policymakers agreed to impose a larger haircut on Greek government bonds to reduce the country’s overall debt level to a more sustainable level. The 50% voluntary haircut applies to bonds held by the financial sector and is anticipated to avoid a hard and potentially disorderly restructuring by triggering credit default swaps (CDS) on Greek debt. In addition, the International Monetary Fund (IMF) stated that they planned to recommend the disbursement of the sixth tranche of financial aid to Greece. While this is a clear positive for Greece, some interesting questions have been brought to light. Particularly, will this set a precedent for other beleaguered peripheral European countries to ask for debt relief as well? Additionally, what type of insurance does a CDS contract on a sovereign really offer? If CDS protection wouldn’t apply in this form of restructuring, how might that impact demand and pricing for other sovereign debt considered to be at an elevated risk of restructuring?
Specific details around the proposed enhancement of the EFSF are the least clear at the moment. We do know that the EFSF will be leveraged up by insuring a portion of new debt issued by peripheral sovereign countries. While details of the extent and cost of the insurance will be announced later, it appears that a leveraging of four to five times the EFSF is in the works. In addition to the leverage scheme, the creation of a special purpose vehicle (SPV) that will run parallel to the EFSF was announced. The SPV will allow institutional investors and sovereign wealth funds to invest in Eurozone sovereigns. While no concrete details were provided, this too was an encouraging sign.
While we are pleased that European leaders have finally taken bold steps to address the crisis, we believe that this is only the beginning of what must be done, both within Europe and the United States. We may well still be closer to the beginning of this story than we are to the end. Government policy will continue to remain a focus for financial markets for the foreseeable future. On the domestic front, the debt “super committee” will propose steps to address our budget deficit next month, setting the stage for the general election battles to be waged over the next year. Given the vitriol and the sharply divided philosophical differences between (and to a lesser degree even within) the two parties, it is difficult to foresee a bipartisan “grand bargain” emerging from that group that would garner sufficient support from both sides of the aisle to pass both houses. Financial market volatility is likely to remain elevated in this environment as the range of potential outcomes is very wide and both attention on the matter and rhetoric will likely become heightened as the deadline draws near.
We are very pleased that progress has been made in Europe, and that there have been some positive reports recently regarding the U.S. economy. Because the market tends to move based on results relative to expectations, these developments have caused the market to rebound sharply, which may boost consumer confidence in the coming months, an improvement that would also be welcomed by the markets. However, leading economic indicators continue to point to a further slowdown in the global economy, specifically in Europe and the United States. As we have discussed in past writings, a slow growth economy is not surprising, as we remain in a secular debt deleveraging cycle of the consumer sector. Debt deleveraging tends to be characterized by subpar trend growth. When growth is below trend, the economy is naturally more prone to recessions, and thereby any slowdown in the economy would imply a heightened recessionary risk.
Recessions in and of themselves should not be feared, as they are a natural part of the business cycle. However, when recessions occur, policymakers usually step in to pick up the slack, through fiscal stimulus and central bank easing. Whether or not significant stimulus will be an option for policymakers during the next recession, whenever that may happen, remains an open question. The issue of greater importance, in our opinion, is the need for the fiscal authorities to take any action necessary to avoid systemic shocks to the financial system. In that regard, yesterday’s events are a very welcome development, even though they may do little to revive the global economy in the near term.
We continue to expect a high degree of volatility in the months ahead, as the issues needing to be addressed by the debt “super committee,” the ongoing unemployment situation, and the 2012 election will all cause apprehension at different points in time. Despite these relatively short-term issues, we continue to believe that in the long run, the global economy will grow and investors will be rewarded by owning risk-oriented assets. As always, we will continue to closely monitor economic developments and refine investment positioning within our disciplined investment approach.
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