Mario Draghi proclaimed that the European Central Bank (ECB) would be ready to intervene in capital markets to support financial stability in the Eurozone… with conditions. Specifically, Draghi stated that the ECB stands ready to intervene by purchasing short term sovereign debt in order to ensure that its intended monetary policy transmission mechanism remains effective. He gave “necessary but not sufficient” criteria for the ECB actions, namely that a country must request aid from the bailout facilities—and therefore follow a road of conditionality—in order for the ECB to consider debt purchases. In addition, he soothed investor concerns by indicating that the seniority issue—the idea that the ECB is treated more favorably in the credit queue—would be resolved. So far, sovereign debt markets in peripheral countries, namely Spain and Italy, have reacted quite favorably. Has the solution been found? No. But the ECB has given us another round of tail risk removal, and this is worth something positive for non-European assets.
No Good Economic Outcome for Europe
Regardless of ECB actions, economic growth is likely to remain very slow and often negative across several member nations. Debt loads are high, and, I believe, for several years debt to GDP ratios will appear to worsen before heading lower. Necessary fiscal reforms should ultimately bear positive results, but unemployment is likely to rise and banks continue to de-lever during this painful process. It is difficult to imagine a sustained rally in European risk assets such as currencies and cyclical stocks that are tied to economic growth.
Removal of Tail Risk Could Support Financial Markets
However, the removal of even marginal tail risk is important for the rest of the world’s asset prices. The market has been living with several scary questions with growing probabilities of terrifying answers: Will the euro survive? Will a sovereign (other than Greece) default? Are the policymakers really willing to tackle this crisis?
The powers that be are determined for the euro to survive. Both the ECB and Germany have been pretty consistent on this front. Investors often doubt the intentions of these two powerful players, but so far the ECB and Germany are unanimous in their support of the euro’s future. And it appears that Italy and Spain, the countries most at risk of default, are willing to play ball, albeit at a snail’s pace, in order to change their debt dynamics. While default probabilities are definitely positive, they’re not alarmingly high.
Are policymakers willing to do what’s necessary to put out the fire? I believe, only when they see the actual flames; smelling the smoke is not enough. Last week’s ECB statement and press conference represented a small but significant step toward defining the institution’s role as fireman. Draghi has removed some of the speculation and internal disputes as to whether the ECB would be involved at all; the ECB does have unlimited firepower and, in my opinion, will ultimately react in an attempt to calm dysfunctional markets, IF the countries do their part. And there appears finally to be some form of pact between the ECB and the German central bank, so there should be more consistency about the method of central bank intervention. This inspires some confidence for once that the ECB will do whatever it takes to keep markets functioning.
That leaves us with the governments, and smoke versus fire. Sovereign debt yield curves are the equivalent measures of how smoky/blazing the fires are burning. The closest flames—the sub-two-year part of the curves—seem to have been subdued for the moment. But yield curves remain steep, as we all know of the glowing red embers that can spark at any time. What we need is true action, defined in this case by a formal understanding between the Spanish and Italian governments, and the European Financial Stability Facility. The Italian and Spanish governments need to have a binding agreement to reforms—no matter how painful and no matter who is in charge—that should ensure that debt sustainability remains on track. While we are not out of the danger zone yet, we now know the ECB will hold governments’ and investors’ hands should government officials play by the rules. I’m guessing the Spanish government will need to see the flames once again before they grasp for that hand. Until we have this assurance, markets are likely to fluctuate and worry about sovereign default.
Emerging Markets Are Likely to Benefit
In the midterm, however, this incremental removal of tail risk helps. After a thousand feathers are placed on a scale, the next feather can truly tip the balance. One of these policy measures should effectively tip the scales enough that the rest of the world can get on with the business of growth. The countries that are most ready to rebound are likely the emerging markets, given their relatively low debt loads, policy flexibility and favorable demographics. Therefore, as more tail risk is removed, we can expect emerging market assets to continue to show their resilience and potential for outperformance.