Last week, S&P appeared to downgrade France from triple-A on its website – a change later confirmed as erroneous following a ‘computer glitch’. Error or not, the agency’s actions have nevertheless raised eyebrows among investors.
- France has vulnerabilities: its economy is slowing, it has the highest debt levels amongst triple-A eurozone nations and it has significant fiscal work to do on its balance sheet. It also has several large banks exposed to eurozone debts, which appear to be ‘too big to save’.
- The risk is that a widening spread between French and German yields poses a threat to the integrity of Europe’s core, and to already strained French and German relations, which are vital for the survival of the single currency project
- Not so long ago, Italy was thought to be ‘safe’ from peripheral concerns, but now Italy is suffering – its latest €3bn auction of five-year paper was a success, but it came at the cost of a massive 6.29% yield.
France’s triple-A rating is important
- France’s triple-A sovereign debt rating enables it to manage its public debt (due to peak at above 87% of GDP next year) and a downgrade would directly impact the European Financial Stabilisation Facility (EFSF), Europe’s €440bn bailout fund
- If France loses it triple-A status, it would put the EFSF’s own triple-A rating at risk – indebted eurozone members rely on the EFSF to access funding at much lower triple-A rates and France is the second-largest contributor
- Recent third quarter GDP results for France and Germany revealed that the eurozone core is still supporting modest eurozone growth, but fears of a looming eurozone recession remain, as the latest leading PMIs have dropped into contraction territory (see chart right)
- Its not just France’s rating that is being questioned – yields on Austrian and Dutch triple-A government bonds have also risen over downgrade concerns, leaving few safe havens for investors and the prospect of a shrinking eurozone core that comprises of only Germany.
Investors will need to take a pragmatic, strategic approach to the way they manage their European equity and bond exposures
- Managing peripheral exposure will be vital, and certain financials may still have large exposures to these troubled regions – despite the promise of unlimited liquidity from the ECB, interbank lending and funding costs could cause further pain for banks
- Within equities, recessionary concerns may negatively affect the performance of cyclical stocks by a greater magnitude than defensive names, so it makes sense for investors to take a more defensive stance during these uncertain times; especially for higher-yielding companies with reliable earnings streams who are growing their dividends
- The key is to remain flexible and not forget the importance of income-producing assets in this low growth environment – bond investors would be wise to adopt a strategic approach to their investments, while equity investors should consider high-quality stocks with healthy dividend yields as a source of future total returns.
“A lack of real economic growth is a problem for over-indebted economies that remain reluctant to engage in serious debt restructuring. Investors remain highly sensitive to the political events unfolding in Europe as EU leaders try to restore confidence. The key is to remain diversified and in particular, not to be over concentrated in financials. Financials remain the largest source of volatility in the market since their abilities to operate are threatened by the risk of a eurozone sovereign debt fallout.“
Ian Spreadbury, Portfolio Manager, Fixed Income
“Savers needing income should look at equity markets. Even if equity markets are showing volatility in growth, equity funds can provide a good alternative source of income. For the last 20 years, investors have bought equity markets for capital growth, but now is the time to buy equities for income.”
Dominic Rossi, Global CIO, Equities
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