On Fitch and Italians trying to be Germans
Late on Friday, Fitch downgraded Italy to BBB+, in line with S&P but still ahead of Moody’s Baa2. Luckily for Italy, DBRS still rate them AL (that stands for “Single A low” for those not acquainted with Dominion’s nomenclature) which means therefore that no ECB haircuts have yet to be applied. Are the agencies ahead of the curve, behind it or is there really no curve at all?
I suppose this is where one invokes Keynes again with his priceless observation that, in the long run, we are all dead. Markets are still driven by the assurances which St Mario, the patron saint of single currencies, gave us last year that he would defend the euro with “whatever it takes”. Looking back to July last year, although applauding Sr Draghi’s determination, I had immediately wondered how long that piece of string might have to be and who would provide it. “Whatever it takes” is not a free option and he neither put a cost on it nor did he suggest who might have to pay for it.
Alan Greenspan was the master of verbal tightening and easing in an era of a surplus of unwanted Kremlin watchers – practised in determining what policy was going to be based on who was standing where on the Kremlin wall for the May 1st parade – who subsequently appear to have switched their focus to watching Greenspan’s sphinx-like demeanour and attempting to read his mind. Despite his many other failings, he did have an uncanny ability to have global markets hanging on his every word.
The problems arise – an old bugbear of mine – when other people begin to believe that by being tied into the currency union with Germany, they get an automatic right to live the same lifestyle
Draghi did something similar in that, in a single speech, he completely change the eurozone risk game. Sure, he changed the superstructure but did he also change the base? Is the Fitch downgrade a case of trying to jump on a train which has already departed or is it a stark warning to all of us that simply because one train has just left, it doesn’t mean that the next one is just about to pull in?
Risks within the eurozone might appear to have flattened at the sovereign level - still steep but flatter than they were, that is – but as you drill down into the respective domestic economies, the asymetricity of risk increases again. Let me explain:
There is a simple reason why Germany is better off than other counties. Its people work harder and are more productive. They might not enjoy life in quite the same way – I distinguish very clearly between quality of life from standard of living – but they make better stuff more effectively. There is nothing wrong with that. The problems arise – an old bugbear of mine – when other people begin to believe that by being tied into the currency union with Germany, they get an automatic right to live the same lifestyle.
The past five years have shown that this doesn’t not work that way but by proffering the “anything it takes” policy, Draghi has in some way given a tacit promise to do what he can in order to make sure that it will.
Still only half time
The reason that some economies are weaker than others is because they don’t produce the same output as their peers. That naturally leads to, in some respects, the generic weakness of the banks in the weaker economies. Although lots has been done by the ECB and the other agencies to shore up the banking systems in both Spain and Italy, this is only improving life at a macro level. The cost of borrowing for companies, large and small, remains critically high so that their competitiveness which is already lumbered with lower productivity, both at a human and technological level, also has to contend with unfavourable financing costs.
So, instead of becoming more competitive, these companies – and with them their domestic economies – are becoming progressively less competitive. The single weapon open to less productive economies, namely devaluation of the currency, is of course not an option.
German industry has for decades been able to ride out ever-increasing currency disadvantage (I’m thinking the Deutsche Mark) by being technologically and qualitatively one step ahead of the opposition. Please don’t get me wrong for there are plenty of Italian companies which are world leaders too but they are markedly fewer and further between. As a whole, the higher cost of funding is pushing peripheral laggards further and further behind core leaders.
Is Fitch telling us the that the verbal bail-out which ECB President Draghi gave us in July is beginning to run out of steam? Is it flagging a warning that the fundamental reforms – or at least the green shoots thereof – which should have taken place in the lee of his promises have not progressed at all? The outcome of the parliamentary elections certainly would serve to attest to that.
As in the ManU/Chelsea game of yesterday, the ECB was leading 2:0 at half time but the Italian electorate has now also scored twice and we have to go to a replay where the outcome is totally open.
The bulls clearly remain in the driving seat and whoever is short the risk markets is looking deeply out of sorts. Nevertheless, there are serious issues stalking the hoped for recovery in Europe. I was staggered when I heard a gentleman on the wireless this morning declaring that the bull market is supported by the Fiscal Cliff having been resolved in January. Ummm? The sequester which took effect last Saturday was the US falling over the Fiscal Cliff. In January we enjoyed a postponement and nothing else and its time has run out. I was recently asked whether the Fiscal Cliff wasn’t the same as the debt ceiling. Talk of short memories. Anyhow, why should the budding US recovery along with its rally in equities automatically mean that Europe is in recovery too?
As said, stay long but, please, do not be too greedy to remember to use some of those lovely profits to keep a few sensible hedges in place – they are now, after all, here to protect gains and not to stop losses.