- S&P cited weakening economic growth, a fragile economy and political differences for the downgrade.
- The news comes as Italy’s debt auction last week was met with tepid demand.
- S&P had not placed Italy on review for a downgrade and now rates Italy three-notches below Moody’s (which was widely expected to be the next mover on Italian debt) .
- The reaction from markets today has been muted – indeed equities have rallied.
What are markets really worried about?
Italy’s downgrade is not a game-changer. The key issue remains the extent of contagion from a disorderly Greek default which could spread to Italian and Spanish government bonds – these have been heavily bought by French and German banks. The worst-case scenario is a new credit crisis if banks stop lending and money markets freeze.
Stresses are now appearing in Europe’s interbank market – the Euribor-OIS (a key gauge of unsecured interbank lending that measures the difference between the three-month euro interbank offered rate and overnight index swaps which banks use to lend to each other) has widened materially. It shows European banks are less willing to lend to each other.
France’s largest banks are heavily exposed to peripheral debt. Siemens has reportedly withdrawn its deposits from Société Générale in favour of the ECB. However, France is unlikely to let its largest banks fail.
Policy Response – Building towards orderly default?
Five central banks, including the ECB, US Fed and Bank of England have teamed together to provide extra US dollar liquidity using three-month loans – this is on top of an already existent US dollar swap facility offered by the ECB. European banks use dollars for much of their everyday business, rather than euros. Eurozone authorities appear to be building up the financial infrastructure to contain the contagion that would arise from a Greek default. We can expect more of this in the coming weeks and the success or otherwise of this endeavour will be key.
So what should investors do right now?
1. Stay diversified and remain flexible – it might sound obvious, but if you are a fixed income investor, the best way to achieve this is to adopt a strategic approach to bond investing. If you are an equity investor, look beyond your domestic allocation, tilt yourself to more defensive sectors and search for value (but avoid value traps).
2. Think about total returns – yields on equities have become increasingly attractive, tempting investors away from looking at equities for simple capital gains. Compounding dividends could yield attractive future returns for patient long-term investors.
3. Don’t forget we are in a two-speed world – emerging markets are likely to be the long-term engines of growth for the global economy as they continue to rapidly develop their economies.
“The eurozone debt crisis continues to rage. Over the weekend, the EcoFin meeting in Poland ended in disappointment as European finance ministers failed to offer any concrete plan to halt the region’s debt crisis. The central banks may have won the liquidity battle with their US dollar funding program last week, but the solvency risk is far from over. One thing to look out for is the Fed’s next two-day meeting this week. At the moment I continue to monitor the situation very closely. I’m maintaining a high level of liquidity in the Euro Bond portfolios, avoiding losses and tactically taking advantage of potential market dislocations. I expect the high level of uncertainty to persist in the next few weeks.”
David Simner, European Fixed Income, Fidelity Worldwide Investment
“While the downgrade has brought Italy into focus, I still believe that this is not a single country issue but a Europe-wide issue. Thus, this serves as another alarm bell to European politicians and the European Central Bank to understand the urgency of finding a path towards halting its debt issues and the resulting market contagion. It is important to recognise that the markets have been anticipating this downgrade and today's news is already largely priced in. Therefore, I do not expect any major short-term impact as a result of today's announcement.”
Alberto Chiandetti, Italian equities, Fidelity Worldwide Investment
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