European Market Insight: S&P Downgrades Shock the Market

AMSTERDAM—Economic data, statements by politicians, as well as the rating agencies rocked European markets last week.

Eurozone industrial production came in better than expected for the month of November, but is still contracting. The real disappointment came again from Germany, which saw industrial production decline 0.6 percent in November from October, instead of the 0.5 percent decline expected by analysts. Germany was one of the few countries still growing in the eurozone and these declining figures do not bode well for the continent.

Spanish Unemployment Rises Dramatically

Mariano Rajoy called the figure “astronomical.” Unemployment for Q4 2011, which will be officially released on Jan. 27, rose to 5.4 million, according to the Spanish prime minister, bringing the rate up by 2 percent to 23.3 percent, a percentage that cannot be perceived or easily explained in a normal economy. In a private meeting, however, a renowned economist of a large Wall Street bank called the Spanish labor market the “most dysfunctional in the world” and said that excessive employment protection for the old generation equates to “stealing” from the younger generation, preventing them from getting jobs.

The European Central Bank (ECB) did not move its main refinancing rate, akin to the federal funds rate, and kept it steady at 1 percent. Mario Draghi, the bank’s chairman, said that the committee did not discuss further rate cuts and also warned that underlying economic data remained weak and that the outlook faces “substantial downside” risks. This meeting was practically a nonevent, as most economists expected the rates to be kept steady and Draghi did not comment on unconventional monetary measures.

Spain and Italy Successfully Issue Debt

Despite the bad economic data out of Spain (unemployment up and a 7 percent decline in industrial production year over year in November), the country managed to auction off roughly 10 billion euros ($12.7 billion) in debt, mostly shorter term maturities, last Thursday. This represents 12 percent of its 2012 funding needs and was greeted by the market with enthusiasm. Italy also saw two auctions of shorter term maturities succeed last Wednesday and Thursday. For both, the yield was significantly lower than during previous auctions.

Many economists attribute the success of the shorter term paper to the ECB’s provision of three-year refinancing at a 1 percent rate. This way, banks can borrow money at the ECB and invest it in higher yielding government securities without any so-called maturity risk. In addition, speaking at a conference to investors in Amsterdam on Friday, Citigroup Chief Economist Willem Buiter said that governments will increasingly influence “insolvent” banks to buy sovereign debt, similar to the financial repression that happened in the 1970s where governments exercised significant control over the banking sector.

As a result, the euro currency rose to a high of $1.2870 on Thursday morning, as did equities—the EuroStoxx had hit a high of 2,384 a bit earlier last Thursday—mainly driven by these positive auction results.

Friday Provided for Rude Awakening

Last Friday morning, however, the optimism was gone and a rumor of large-scale sovereign downgrades made the rounds. According to desk chatter, the ECB was heavily buying Italian debt that morning, as spreads to German bund yields widened and another auction of 3- and 5-year paper came in decidedly weaker than the day before.

Sure enough, equities and the euro sold off and Spanish and Italian 10-year yields widened. Equities fell to a low of 2,307 for the EuroStoxx on Friday afternoon before recovering to close the week at 2,338. But the almost 2 percent plunge in the euro versus the dollar in a few short hours to $1.2623 scared even the most seasoned traders and investors. It recovered to close at 1.2678, but the damage was already done.

Rumor Becomes Fact as S&P Downgrades Hit

Standard & Poor’s rating agency late Friday confirmed what the market was expecting. Italy got a two-notch downgrade from A- to BBB+, Spain also got a two-notch downgrade from AA- to A. Both Austria and France lost their AAA rating; being downgraded one level to AA+ but with a negative outlook.

As a rationale, S&P cited that the European Union summit last December was largely disappointing and not enough to stem the crisis: “The agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. According to our assessment, the political agreement reached at the summit did not contain significant new initiatives to address the near-term funding challenges that have engulfed the eurozone.”

The Week Ahead

Economic data will be light this week, but there is a big trilateral meeting in Rome on Friday. Angela Merkel, Nicolas Sarkozy, and Mario Monti will meet to discuss the ongoing issues and developments.

It will be interesting to see whether they will discuss the Spanish bond auction, which will take place on Thursday, as well as a French debt issuance to the tune of 10 billion euros ($12.7 billion) on the same day.