Main takeaways from the EU summit: The worst was averted, banks will be safer, but this is not a full ‘risk-on’ trigger
This hard won deal is positive along several dimensions, notably for the stability of the banking system and the reform of the governance of the euro area. But it is not a convincing trigger to switch to ´risk-on´ in our view. Inasmuch as the markets were pricing the possibility of no deal at all and thus of an imminent disorderly Greek default, a post-summit short term rally in risk assets makes sense. But soon the market will re-assess the macro outlook of the euro area, put its fingers on the long list of unknowns left, and take a more sober view. In Europe at least, a lasting rally is unlikely until the ECB really steps in and fully plays its role of de facto lender of last resort. Times are not yet ripe for that to happen. Let’s look at the details of the agreement reached last night at 4am. There were four separate although intertwined chapters: Greece, banks, EFSF, governance.Greece: positive agreement for Greece but could trigger CDS
The deal is positive for Greece (substantial debt relief, including an unspecified €30bn relief package by ‘member states’, a new loan package of €100bn covering budget shortfalls until 2014) but the country is not out of the woods. Until a critical mass of structural reforms initiates a virtuous circle based on investment (not consumption) and -this is critical- foreign direct investment, Greece will not recover and projections up to 2020 will remain highly hypothetical. We are far from there.
Elsewhere, the arm-twisting game with creditors represented by the IIF may eventually trigger CDS. Either most of private bond holders opt out during the negotiation, betting on a default against which they are insured, or officials increase even more their pressure in which case this would be a ´coercive´ deal, i.e. a credit event for the ISDA credit committee. There is probably a fine line between these two polar cases, but it remains to be found. IIF representatives had to capitulate last night, but the negotiation is only starting. The deadline is the end of this year but we will know much earlier if this works or not.
Banks: a bitter pill to swallow, with welcome sweeteners
The Greek deal, with 50% loss on Greek Government Bonds and no guarantee for the 30Y bond “offered” in exchange of 35% of the initial face value investment (on top of a 15% cash payment), was harsh for creditors in general and banks in particular. Banks will have to beef up their capital base in order to reach a 9% core tier 1 ratio by mid 2012. The European Banking Authority (EBA, which is starting to deserve the last letter of its acronym) will disclose its final estimates on recapitalisation needs later on. We think that it will be higher than the €106bn mentioned in press releases, because this number is based on end-of-June accounts while the final one will be based on end-of September accounts, which were much more stressed for Italian and Spanish government bonds. Our own estimate is already higher, at 116bn. On the other hand, banks got interesting sweeteners: guarantees from governments to issue unsecured debt, under the umbrella of the European Investment Bank. In contrast with 2008, this support will be coordinated, which will make it both more effective and consistent with a level playing field approach. Since ECB will start buying covered bonds soon, banks will have robust support for their two main sources of medium term refinancing: unsecured debt and covered bonds. Overall, the banking side of the twin sovereign and banking confidence crisis that caused the market turmoil in August has been reasonably addressed, we think.
EFSF: 1Tn euros headline but no details
On our estimates, the actual EFSF firing power is between €175bn and €200bn, once commitments to Ireland/Portugal and guarantees from weaker countries (Italy and Spain) deducted (again, see Manolis Davradakis research note). A insurance scheme alone could insure at best a 20% first loss on sovereign bonds, in order to reach the 1Tn notional amount. This would not be enough to restore confidence, we think. Hence the second concept of a special purpose vehicle (SPV) funded by third parties, now officially endorsed by EU leaders. Good enough, but not yet sold to third parties (China, Japan, IMF … individually or via IMF?). This may well work in the end, since third parties will make up their mind based on their political judgment on the real commitment of euro area countries to tackle their problems. Note however that potential investors in the SVP are not charities. They will want a quid-pro-quo. For instance, is the EU ready to weaken its bargaining power in trade negotiations with China by granting it the ´market economy´ status? We do not know. What is sure is that markets will soon ask for the full picture, not only the headline and that the ramifications of the SPV deal may be more complex than generally assumed.
Governance: small but significant and positive steps
This is probably the most positive part of the deal. All euro area leaders have accepted to harden their fiscal credibility by i) taking complementary fiscal measures designed to reach budget balance targets in 2012 (this is pro-cyclical but this is the price tag for credibility in the short term); ii) adopting budgetary rules (so called golden rule, inspired by the German ´debt-brake´ law) by the end of 2012; iii) setting up independent fiscal committees which would provide governments with realistic GDP and tax revenue assumptions. These were all requests from Germany, which has constantly strengthened its bargaining position all throughout the crisis. From a market perspective, a deal with a German flavour is positive
Overall, the worse -a systemic accident- has been averted, European banks have to swallow a bitter pill (losses on Greece and recapitalization) but they are now potentially safer. Yet, we are still far from a long term sustainable governance of the euro area. In my view, the main risk associated with the EFSF 3.0 (insurance + SPV) is that is confirms that, in most euro area economies, the financial system will be deprived from the risk free asset that is needed to take investment decisions and this for a significant period of time. The most credible way to re-create a deep and liquid risk-free asset while harnessing market discipline to tame big spenders is the joint issuance of Eurobonds (senior) and national debt (junior). The word Eurobond was not even evoked last night, it seems.
Short term macro and market conclusions:
We are not changing our baseline macro forecasts for the euro area: winter recession and zero growth on average next year. Last night deal has confirmed that fiscal policies will be very much pro-cyclical (see Italian and French fiscal reactions), i.e. will depress demand even more. The agreement on Greece and the high bar on capital ratio for banks will worsen the credit crunch. Hence risks to growth are tilted to the downside over the next 6/9 months. Only the ECB will be able to block this downward spiral by buying bonds to lower long term interest rates, i.e. moving from pure interest rate easing to quantitative easing.
Turning to assets, the deal should prove positive for the banking sector, especially for unsecured bank debt. Overall, we remain overweight IG credit.
A relief rally on weaker euro sovereign bonds makes sense, all the more so that ECB chairman Mario Draghi made a smart statement during the summit. He said in substance: “the ECB will continue to buy government bonds if it wants”. Smart because this has made clear that the EFSF will not substitute to the ECB (a widely held view which we did not share but it’s better to hear it from the man in charge) and also that the ECB will remain fiercely independent in its decisions, let’s translate, will continue to link bond purchases to reforms. However, we remain cautious on peripheral sovereign bonds, given all the unknowns left by the EU summit regarding the EFSF.
Last, on equities, we believe that the rally will be short lived: once markets have re-assessed on the downside the risk of a systemic meltdown, the macro outlook will prevail again and it won’t be pretty for earnings. If the ECB moves to outright quantitative easing (our assumption) and when it does (mid 2012, maybe earlier?), the macro outlook will brighten and risk assets will be the first beneficiary.
