INSIGHTS

On January 17, 2012

European Nations Stripped of Credit Rating

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Late on Friday, Standard and Poor’s announced they were cutting the credit rating of nine European countries and stripping Austria and France of their AAA credit rating.  Reminiscent of the removing of the AAA status from the United States nearly six months ago, all eyes are on what will happen to their debt markets and ultimately their currency.


As we remarked last year, the markets had long expected some sort of credit rating warning or downgrade with regard to the United States.  So too is the reaction from the European downgrades on Friday.  Consider what has occurred in the debt markets over in Europe and you can then compare it to the United States movement.

France, Italy & Spain Two Year Government Yields



Source: Bloomberg


The movement has been decidedly lower since the market’s perception that recognition of the breadth of the issue has been partially recognized by European leaders.  This movement has been amplified by what the European Central Bank’s (ECB) President Mario Draghi has done and said since taking over in October 2011.  Recognizing what the ECB has done and has said it will do, regarding price stability in a deflationary environment and indirectly increasing quantitative easing, should not be discounted.  To further the potential resolution to the European situation, Chancellor Angela Merkel said of the downgrade: “We are now challenged to implement the fiscal compact even quicker and to do it resolutely, not to try to soften it.”


As you are aware, we believe that one of the most overlooked and discounted tools in forecasting is the analysis of the shape and movement of the yield curve.  Consider the various yield curve spreads:

European & United States Yield Curve



Source: Bloomberg


A steep yield curve traditionally has translated into growth expectations and higher rates of inflation expectations.  You could also interpret that the steepness is related to the perception of higher risk and the need for higher returns to justify taking maturity risk of debt obligations.  If this were the case, one would also see the shorter maturities yielding closer to longer-term maturities, however a Yield curve spread of over 500 bps for Spain and Italy and 355 bps spread for France don’t show this profound fear represented by actual investors' money.


The markets are already displaying the downgrade so we direct our attention to the exposure (again) of U.S. financial institutions exposure to the more troubling European sovereign debt.  According to Moody’s, net exposure to the PIIGS (Portugal, Italy, Ireland and Spain) as far as percentage of Tier 1 Common Equity shows roughly 14% for Citigroup, 12.4% for JP Morgan, 11% for Bank of America and 6.8% for Morgan Stanley.  When a comprehensive resolution does arrive in Europe, some of the American financial institutions could see significant tail winds.  Morgan Stanley appears to be very well positioned with a Tier 1 Common Equity ratio of 13.20 and Total Risk based capital ratio of 16.40.  Coincidentally, Citigroup is trading down on after net income dropped on declining trading.


As witnessed by the market’s reaction to the United States’ credit downgrade six months ago, we see the downgrade by Standard and Poor’s toward nine European sovereign debt ratings as priced in and most questioning why it took so long.


 

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