Good news! German chancellor Angela Merkel and French president Nicolas Sarkozy had a chat in Berlin over the weekend. They now have a cunning plan to save the eurozone.
Markets headed higher and the euro strengthened. All is well with the world once again.
What’s that you say? What was this magnificent plan that has so cheered investors?
Well… they haven’t told anyone yet. But they’ll definitely announce a “comprehensive package” at the next G20 meeting at the start of November. And they are determined “to do whatever is necessary for the recapitalisation of our banks”, as Ms Merkel put it.
Forgive our scepticism, but every single other time that European leaders have announced a solution to the eurozone debt crisis, markets have ended up being disappointed.
Chances are, it’s about to happen again…
We have a cunning plan – but we won’t tell you what it is
While Merkel and Sarkozy were stalling for time, the credit ratings agencies spent most of last week making their lives much more difficult.
Moody’s, Fitch and Standard & Poor’s were the villains of the sub-prime crisis. Their AAA stamps of approval were one of the main reasons that dodgy US mortgages managed to hollow out the global banking system.
Now they seem to be trying to atone for past sins by taking a more proactive approach to Europe, home of sub-prime part II. Ratings across the region were slashed on Friday.
Being honest won’t make the ratings agencies any more popular. And they’re not telling us anything we don’t know already. But by forcing investors to acknowledge that the emperor really is naked, they could bring this crisis to a head more quickly than any of the protagonists would like.
As usual, it all boils down to the banks again. First, there was Moody’s downgrading of 12 banks and building societies in the UK. There’s no need to panic on this score. The downgrade isn’t down to any big change in the conditions in the British financial sector.
It “merely acknowledges the government’s reduced support for UK lenders post-crisis”, notes Lex in the FT. The banks “cannot now assume automatic taxpayer support in a crisis”. Just keep your savings per person per bank below the insured £85,000, as we’ve been saying for years now.
More concerning was Fitch’s downgrade of both Italy and Spain. The Spanish downgrade in particular was due to the state increasing its exposure to the banking sector. The Spanish government took over another four regional banks last week.
Why France’s AAA rating is crucial – for now
And now we have Belgium nationalising troubled Franco-Belgian bank Dexia, buying its retail banking arm for €4bn. That’s not going to help Belgium’s credit rating, which has been put on ‘negative’ watch by Moody’s. The country had a debt-to-GDP ratio of 96.2% last year, the third worst in the eurozone (behind Greece and Italy).
But the fact is that Belgium’s not the important one in this particular relationship. As one City source put it, “be under no illusions – the rudderless Belgians are being forced to take one for France here.”
Why? Because France can’t afford to lose its AAA-credit rating. Or to be more precise, Europe can’t afford for France to lose its AAA rating. Why not? Because for now, the great hope for the eurozone is that the European Financial Stability Facility (EFSF) can be turned into a ‘bazooka’ bail-out fund.
But if France loses its AAA rating, then the EFSF won’t be AAA either, unless other countries inject a lot of cash into it, which they can’t afford. That would drive up the EFSF’s cost of borrowing.
But more importantly, Germany isn’t happy about the idea of giving its backing to a bail-out fund that has less than a AAA rating. German voters are already none-too-pleased about the idea of paying to save the rest of Europe. It will become an even harder sell if they are told they are standing guarantor behind Europe’s equivalent of a sub-prime CDO (colateralised debt obligation).
As always, there are ways and means around all these things. There has been no solution to the eurozone crisis yet. But equally, every time we seem to be approaching a catastrophic ‘no way back’ event, some new option for weaseling out of disaster lands on the table. So even if France gets downgraded, it won’t necessarily be game over right away.
However, it all points to a lot more volatility ahead. The potential for nasty shocks just keeps growing. The risk, as Forex.com’s Kathleen Brooks puts it, is that “now the ratings agencies are scrutinising sovereign balance sheets, it won’t be long before France and the UK get downgraded, which could set off another bout of market volatility”.
So what should you do? Stick with the high quality defensive stocks we’ve been tipping regularly. And it’s probably still safe to expect the dollar’s rally to continue – you can find out how to profit from that in a piece my colleague David Stevenson wrote a couple of months back: Will the US dollar rise from the dead?
Also, in the next issue of MoneyWeek magazine (out on Friday), James Ferguson will be looking at the global banking sector, and its progress in dealing with the bad debts from the financial crisis. He’ll be giving his analysis on which banks are most vulnerable – and which could be heading for a miraculous comeback. If you’re not already a subscriber, subscribe to MoneyWeek magazine.
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