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Debt fears temper Europe euphoria

Posted on June 29, 2012

As rallies go, this was impressive. Friday’s rebound in European equity markets marked the biggest one-day gains this year for blue-chip stocks. Investors pumped money into equities, peripheral eurozone bonds and the euro as they gave their initial blessing to an EU summit outcome that delivered more than hoped.

In short, investors welcomed plans to give the European Central Bank direct supervision of eurozone banks, the activation of crisis support for Spain and Italy through the eurozone rescue funds buying bonds and the move to waive preferred creditor status for these funds in holding Spanish debt.

    Click to enlarge

    Investors also applauded allowing a direct capital market injection for Spain’s banks via the European Stability Mechanism, the permanent, successor bailout fund to the European Financial Stability Facility – a positive step, say many, that should act as a circuit breaker between banks and sovereigns.

    Set against that, though, were concerns over the time it might take to create the single supervisory mechanism for the banks, involving the ECB. There were question marks over whether seniority would be waived for Italian bonds.

    And, despite the strongest daily rally of the year for many markets, there remained nagging doubts that the proposals, hatched in the early hours of Friday, really amounted to anything resembling a “silver bullet” to resolve the debt crisis.

    Alan Wilde, head of fixed income and currency at Barings, says: “Will the rally last a day, a week or be more permanent? The plans were the right first step, but there is a lack of detail that could start to worry the market.”

    Didier Duret, chief investment officer at ABN Amro Private Banking, says: “This is a political milestone. The decisions are good and laying a road map. I am particularly impressed with the way they want to recapitalise the banks.

    “This has the potential to bridge the confidence gap between the markets and the EU leaders. But it is too early to decide whether to increase exposure to the peripheral markets.”

    Arif Husain, director of European fixed income at AllianceBernstein, is more blunt. “I am optimistic, but not optimistic enough to increase my exposure to the periphery.”

    Critically, expectations had been lowered substantially prior to the summit, which goes some way to explaining the strength of the rallies in European equities, Italian and Spanish bonds and the euro-dollar exchange rate, say investors.

    The decisions caught some market participants on the hop, particularly those who had increased positions in haven assets, such as German Bunds and UK gilts, before the two-day summit started.

    “It’s the right thing to do but it is only likely to come into force in 2013, because getting the ESM to inject directly in to the banks is only feasible once the single bank supervisor is in place, which will take time,” says Philippe Bodereau, head of European credit research at Pimco.

    Mr Bodereau welcomes the decision to use the ECB as a single regulator, as the central bank has in the past proven to be averse to imposing haircuts on private bond investors “because the ECB has a lot of skin in the game lending to banks”.

    While many of the details of the plan are still to be fleshed out, some investors say it is significant that the EU has listened to concerns of investors and decided not to make money channelled to Spanish banks via the ESM rank as senior to that of private bondholders. However, they point out that the move at the moment only appears to apply to debt lent to Spanish banks via the ESM.

    One investor says the fact that “the remaining stigma and conditionality” of accepting money from the EU has been taken away is “extremely powerful”.

    However, investors say the measures announced seem to offer more to bank investors than sovereign bond investors. Private bondholders say they are wary of listening too much to the political rhetoric, pointing out this is only one step towards solving eurozone woes.

    Many investors remain uneasy as a result of the private sector involvement agreement signed with Greece earlier this year, which forced them to accept heavy “haircuts”, or losses, on their debt and left them subordinated to European bodies such as the ECB.

    Marie-Anne Allier of Amundi says the moves announced by European leaders were positive but cautions about reading too much into the rally, pointing out that trading volumes have been thin and yields on Spanish and Italian debt have recovered to end of May levels only. “The bigger winners today were Ireland and Portugal, where yields are now back to levels not seen in the last six to 12 months.”

    Mr Bodereau says: “The only way the market rally is sustainable is if they [eurozone leaders] can come back with more concrete detail of how it is going to work.

    “I don’t think this is anywhere close to a permanent solution but it’s a better short-term fix than we had expected.”

    Christopher Drennen of BNP Paribas says: “We have a paper that on the surface shows leaders had a good discussion and arrived at a consensus on some of the complex issues but the proof will be in the pudding. There is much detail to be fleshed out as well as the definition of time scale … but it is a step in the right direction and a public acknowledgment that eurozone leaders understand the issues and have laid a down a clear statement of aspiration.”