Key financial market driver 1 - Eurozone crisis
Key questions
e What is the way forward for Eurozone banks?
e What is the most likely course of events in Spain, Italy and Portugal? ¢ In what direction will the economy and the ECB go?
ClO View (Probability: 65%*) Austerity and weak growth ¢ Support for the banking sector is a major political agenda item, and the request for external support for Spanish banks can be seen as the starting point for greater European support and oversight for banks, to be discussed at the upcoming European Council.
¢ Greece's debt remains unsustainable, but the risk of a euro exit over the next six months has diminished after the 17 June elections, which have produced a viable government coalition. The Troika may only accept moderate adjustments to the second Greek package. Portugal is likely to receive an increased bailout package and is unlikely to default in 2012. Progress on reforms and consolidation in Spain and Italy is most crucial for the near-term development of the crisis. Risk premiums would rise strongly on any failure to meet deficit targets; we expect bond risk premiums to remain elevated for Spain and Italy over the next six months.
¢ Following stagnation in 1Q 2012, economic surveys are commensurate with a quarterly GDP contraction of around 0.3% at present. Business survey evidence points to a general wait and see mode. The risk to the outlook for a stabilization of economic growth in the second half of 2012 is skewed to the downside. The ECB remains on hold, but the bar to support the economy and markets has been lowered substantially. We see a significant probability of policy action in early July, including the possibility of a rate reduction. Despite all the talk about political measures to support growth and increased tolerance for budget slippages, there is practically no leeway for fiscal stimuli. The near-term growth impact of any fiscal measure will at best be marginal, in our view.
A Positive scenario (Probability: 15%*)
¢ Bond yields are contained, as peripheral countries' budgets stay on track and economic activity recovers faster than expected. Greece fully complies with the austerity plans and receives further support. Market confidence is restored, and economic growth stagnates in 2012.
& Negative scenario (Probability: 20%*) Major shock ¢ Major shocks could include Spain being pushed into a full IMF/EU program, possibly by a rating cut to junk, enhancing pressure also on Italy; serious political disagreement in core countries (for instance after Dutch elections, etc.); a possible Portuguese default; a Greek euro exit; or a major external growth shock.
Return to macro stability
Key dates
5 July ECB press conference
9-10 July Eurogroup/ECOFIN-Meeting
24 July Eurozone purchasing manager indices (PMI), July estimates
36 UBS
Bottoming in Eurozone leading indicators (PMI) in June?
65 60 55 50 45 40 35
30
06 07 08 09 10 11 12 —Manufacturing —Services —Composite
Source: Bloomberg, UBS CIO, as of 21 June 2012 (estimates)
Yield of Spanish and Italian 10-year bonds over German Bunds (in bps)
600 500 400
300
01/2011
04/2011
07/2011 10/2011. 01/2012: 04/2012 —ltaly Spain
Source: UBS CIO, Bloomberg, as of 18 June 2012
Note: Past performance is not an indication of future returns.
* Scenario probabilities are based on qualitative assessment.
For further information please contact CIO analyst Thomas Wacker, thomas.wacker@ubs.com and ClO economist Ricardo Garcia, ricardo-za.garcia@ubs.com
Please see important disclaimer and disclosures at the end of the document.
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