Eye on the Market July 25, 2011
J.P Morgan
Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks and rising corporate profits are patiently waiting for both of them to end
What the EU gave: an easing of lending conditions, and an expanded role for the EU lending facility (EFSF)
* Another 109 bn for Greece, allowing the country to continue to pay off maturing debt (to those not participating in the exchanges)
* Rate on new EU loans to Greece, Portugal and Ireland cut to 3.5%, maturities on new & old loans extended from 7.5 to 15-30 years * 10 year grace period on interest on new EU loans to Greece; the unpaid interest accumulates
* EU loan facility has the ability to buy sovereign debt in the secondary markets, including a plan to purchase 40 bn of Greek debt (most likely including much of the Greek debt purchased by the ECB)
* EU loan facility has the ability to lend to countries (even those not in an IMF program) to recapitalize their banks
* Language (with no specifics) regarding the use of EU structural funds to boost growth in Greece
What the EU gets: more austerity, Maastricht with teeth (?) and private sector involvement in Greek debt rollover
* Legally binding national fiscal framework to be developed by end of 2012; fiscal deficits brought to 3% by 2013 at the latest
* Private sector involvement in Greek debt rollover, committed in principle by 30 financial institutions listed in the document released by the Institute of International Finance; target participation rate of 90%; exchange appears to result in Selective Default credit rating * Voluntary participation options include exchanging existing debt into 15 or 30 year bond with AAA-guarantees of principal. Bonds exchanged at par will carry low coupons (4.25% effective), while bonds with higher coupons will be exchanged at a 20% discount Source: Eurozone draft proposal July 21, 2011, IIF press release July 21, 2011
In addition to execution risk in Greece, we are left with 3 other concerns. First, while there’s enough in the EU- IMF lending facility* to deal with problems in Greece, Portugal and Ireland, if you include Spain, it gets tight (note: the chart excludes costs to recapitalize banks). If Italy or Belgium entered Europe’s Liquidity Hospital, a lot more money might be needed from European parliaments
Limited capacity at the European Liquidity Hospital Official sector lending capacity vs sovereign funding needs (including deficits) through 2013 - Billions, EUR
1,800
1,600 1,400 1,200 1,000
800
Greece package
(in one worst-case scenario, Alliance Bernstein estimates that the EU lending facility would have to increase from 440 bn to 1.7 trillion Euros, mostly from Germany). Italy
es EFSM
600 400 200
faces a multi-notch downgrade from Moody’s, which is not going to help. As we discussed two weeks ago, Italy has been a model citizen in terms of running low budget deficits for 20 years, but still cannot escape the confines of its very large existing debt stock (120% of GDP).
Greece, Portugal, Ireland
Total lending capacity
Plus Spain Plus Italy and
Belgium
; Possible sovereign borrowing needs from official sources Source: AllianceBernstein, Public Filings.
Second, as shown below, Europe is now a two-speed economy, with the periphery stuck in neutral (industrial production is one proxy for this; there are others, such as unemployment, consumption, export shares, etc). Ifthe idea behind the EU/IMF effort is that austerity will boost growth and lead these countries back to the public markets, there is very little momentum in this direction. If the status quo in the periphery does not change, all the EU package does is allow the current approach
more time to fail.
Industrial production Index, 100 = January 2007 110
105 100 95 90 85 80
15 2007 2009 2010 2011 Source: INE, CSO, ISTAT, NSS, Eurostat, Bundesbank, J.P. Morgan Securities LLC, J.P. Morgan Private Bank. Periphery = Portugal, Ireland, Italy, Greece, Spain.
2008
* The current EFSF lending capacity is Eur 255 bn, but we anticipate that as agreed, national parliaments will expand it to 440 bn.
Unemployment rates - core vs. periphery Percent, Peripheral rates weighted by population 18% 16% 14% 12% 10% 8% 6% 4% 2% 0%
1970 1980 1985 1990 1995 2000 2005 2010
Source: J.P. Morgan Private Bank, Bankof Spain, Bank of Portugal, OECD, CSO, NSS, Bundesbank.
Greece, Ireland, Spain & Portugal
Germany
1975
3
HOUSE_OVERSIGHT_025223