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Kiron Sarkar
January 27, 2012
Hi guys,
Mr Chandler has, once again, hit the nail on the head. Personally, I believe a haircut of around 40% (may even need to be higher now) on Portuguese debt will be required, as you know.
Whilst the Greeks maintain that negotiations with private sector bondholders will be concluded next week (the % haircut is insufficient), leaked reports suggest that the interim Greek PM (Papademos) cannot see a way out and is thinking seriously of an Euro Zone exit. The demands from the Euro Zone/IMF cannot be met and he understands that they will not be amenable to further delays/failure to implement much needed fiscal and structural changes in Greece, which he cannot deliver. The FT reports that Germany wants an EU Commissioner to take over the running the Greek budget in exchange for further bail out funds. Personally, I cant see that working for an extended period either. A hard default is becoming more and more likely by the day, in my humble view.
The contagion issue is now key. In a way (and assuming I'm right) it's good that this is happening, as the Euro Zone/ECB will have to get real and come up with some sensible solutions (finally), or the Euro is as dead as a dodo. Personally, I believe that the Euro Zone (and the ECB, in particular) will introduce measures to retain the Euro, as the alternative of a disorderly break up, is far, far far more costly - a meaningful fiscal compact (involving a firm Euro Zone agreement, rather than the proposed bilateral deals) and QE by the ECB, together with LTRO's (possibly of an even longer maturity than the current 3 years) remain serious possibilities. In addition measures to stimulate the Euro Zone economy (together with structural reforms) will be needed.
The Euro has picked up (US$1.32) from it's recent lows of around US$1.26 - for how long. I am and indeed have increased my Euro short against the US$. I remain of the view that the Euro will trade below US$1.20, indeed closer to US$1.10 this year.
Whilst the above is clearly negative, initially, for markets, I remain of the view that the financial sector (particularly those banks that do not need capital) will outperform, as the ECB is forced to flood the banks/Euro Zone with much more liquidity. Fitch's downgrade of a number of Euro Zone countries, including Spain and Italy (not France, as expected) is no great surprise, though the downgrades just reinforces the need for the ECB/Euro Zone countries to act.
Best
Kiron
European officials have insisted that Greece is unique. Many market participants do not believe them. Portugal appears to be headed down that same road. While we have warned in the past of risks that Portugal would need a second aid package, it is only since S&P joined the other major rating agencies on January 13 that more market participants have come over to this view.
Portugal's 10-year yield poked through the 15% level for the first time ever. On January 12th, the eve of the downgrade the yield was about 12.4%. The shorter end of the curve has also been crushed and 2-10 yr is inverted. The 2-year was yielding 12.31% before the S&P downgrade. Now it is approaching 17%.
After Greece, insurance on Portuguese debt is the most expensive in the world. The 5-year CDS was at 1066 on the Jan 12th and is at a new record high of 1425 today. The risk of a default has risen from about 62% on Jan 12 to near 75% today.
Of course, Portuguese officials are right. Portuguese macro fundamentals are superior to Greece. Debt/GDP is lower at about 112% vs almost 190% for Greece, for example. It has about 129 bln euros of outstanding debt instruments and the average maturity is just below 6 years.
Yet the difference is not of a sufficient magnitude to keep the wolf away from the door. The 78 bln euro aid package was too keep Portugal form having to issue medium and long term debt until May 2013. In October 2013, Portugal has a 9 bln euro bond maturing that it will need to roll.
This may seem to be too far in the future to be very meaningful, but these kind of things seem to take on a life of their own. Since Portugal is rated below investment grade, it is being ejected from benchmark indices that numerous fund manager use.
Once the investment grade status is lost, it takes some time (and effort) to recoup it. Moreover, conditions are likely to get worse in the coming months. Consider that the economy, that appears to have contracted by 1.6% in 2011 is expected to contract 3.5% this year and another 1% next year.
The risk that Portugal will not be able to return to the capital markets next year is important and it will require more aid. If Greece got to be forgiven for half the debt in private hands, why should Portugal not ask for some forgiveness too?
The rules of private sector engagement are IMF practices and the IMF often seeks private sector involvement/haircuts, as a condition of reducing debt to sustainable levels. Officials might not be able to say as much, but investors beginning to anticipate this eventuality.
Just as important the pressure on Portugal shows that the firewall around Greece, hoped to have been strengthened by the LTRO and euro area official efforts, has been breeched. Portugal is where Greece was 6-9 months ago. The question is while Portugal be where Greece is today toward the end of the year. Unless European officials take preventative action the rot will continue and the contagion risk remains real.
Marc Chandler | Global Head of Currency Strategy
BROWN BROTHERS HARRIMAN
140 Broadway, New York, NY 10005
212.493.8800 | marc.chandler@bbh.com
www.bbh.com
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